Inflation And Cost Of Living: Can You Beat It?

By MySpendingPlan.com Editorial Staff

Suppose you recently got a raise at work.  Wouldn’t that make you very happy?  After all, you were previously earning say $50,000 a year, whereas now your salary has been raised to $55,000 a year.  So, that gives you an additional $5,000 to spend as you wish, right?  Well, not quite.  Before you go out and blow all that money that you think is “extra”, you need to consider inflation and the rising cost of living index.

The Connection Between Inflation And Cost Of Living

Inflation is a fact of life in most countries.  You may have noticed that stuff costs a little more today than it did a few years back.  For instance, you could buy a pepperoni pizza for $15 last year, but now you have to fork out $18 for the same pizza.  This is due to inflation.  Inflation is the increase in prices of goods and services from time to time.

Inflation is a harsh reality of the modern world and it cannot be stopped.  As inflation rises, so does your cost of living.  The purchasing power of your money becomes less with inflation, as the cost of living rises and your dollar does not buy you what it once could.  Thus, before you can get excited about an increased salary, it is important to determine how much your “real” salary (i.e. adjusted for inflation) increased as opposed to your “nominal” salary (i.e. just the raw number).

The Real Cost and Value of Things

The real cost of things can only be determined after factoring in inflation.  Similarly, the real value of your money is its value after inflation.

Let’s say the inflation rate for the year 2005 was 5%, using the salary amount above.  This means that to continue enjoying the same standard of living that you did last year, it will cost you 5% more to do so.  So you will need $52,500 (5% of $50,000 + $50,000) this year as opposed to last.  Now coming back to that increase in salary as mentioned previously, your salary increased from $50,000 in 2005 to $55,000 in 2006.  So you received a 10% increase in your nominal salary.  However, since it now costs you $52,500 for the same things that it cost you $50,000 last year, the effective increase was only $2,500.  Therefore, your real salary rose by only 5%, and not 10% as you originally thought!

Similarly, the real value of your investments can also be calculated.  If you have invested some money at 5% interest rate and the inflation also rises by 5%, you will effectively not have earned anything.  However, if the inflation for the year is only 2%, you will have made a profit of 3% on your investments at a 5% interest rate.

But on the other hand, if inflation rises more than what you earn in interest or more than your salary raise, then you will not be able to enjoy the same standard of living, as your cost of living will go up, but your income will not increase in the same ratio.

Tips on Beating Inflation:

• Move to a city with a lower cost of living if your career allows it.  You can use a cost of living calculator to determine which city is cheaper to live in.  Many cost of living calculators are available online for free.  Remember that by moving you will not be lowering your standard of living, but will be able to maintain the same standard even with less money.  That is because taxes, government policies, real estate prices, etc. raise the local cost of living index, making it more expensive to live in certain cities than in others.

• When negotiating wage increases, make sure that inflation is accounted for.  You can even ask that your employment contract include a cost of living adjustment (COLA) so that your salary is increased according to the rise in inflation.

• Create a spending plan and budget your income properly.  Set aside at least 10% of your income as savings so that you can continue to beat inflation.

Everybody has to live with inflation.  However, with proper financial planning, you can ensure that you beat inflation and it doesn’t beat you.