Factor inflation in your income plan

For a moment, imagine each person in the country earns an amount equal to ‘x’ per month. In the following year everybody works twice as hard and starts earning ‘2x’ per month. The spending power of the entire population has gone up. The buying power of the nation has doubled. Will it lead to price rise?

The answer is no!
Why not? How did the buying power double?

It is because everyone worked twice as hard. Which means they must have also produced twice as much. While on the one hand the buying power has doubled, on the other hand the supply of goods and services has also doubled. It is non-inflationary.

But when governments print money to spend, there is merely an increase in the supply of money without a corresponding increase in the supply of goods and services. More money now chases the same quantity of goods and services, and this leads to inflation.
Get off the treadmill.

The effect of inflation is bad enough even when you are younger, since you need to make sure that your rate of growth of earnings outpaces the rate of inflation. Else it will appear that you are making more money than before, whereas in real terms the purchasing power of your income will actually be falling.

While you are still working, the impact of inflation is partially, or entirely, offset by a continuous increase in income or profit. In the case of government and public sector employees and pensioners, this gets done by payment of dearness allowance (DA) which is a cost of living adjustment allowance.  

But inflation is a killer once you have stopped earning. If you have not invested wisely, it might well happen that the nest egg you kept aside to live on post-retirement may not even suffice for six months. The purchasing power of your savings dwindles as goods and services increase in price. How much will you need to compensate for the impact of inflation? Unfortunately, it is not possible to predict inflation with any precision. Of course, past data can give an indication but there is no guarantee that the trend will not change.

Are you aware of the rule of 72? If you wish to understand how long it will take for your money to double, divide 72 by the rate of interest. You can get a rough estimate of how many years it will take for the initial investment to duplicate itself... So, if the expected rate of inflation is say 6 per cent (consistently year on year), 72/6 = 12. Every twelve years the prices would have doubled (or the purchasing power of money would become half in twelve years). What costs 100 today, will cost 200 after twelve years, 400 after twenty-four years, and 800 after thirty-six years.

Excerpted with permission from the publisher, Penguin India