Inflation And Cost Of Living: Can You
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
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.