How does inflation affect the budget

inflation

When the money slowly melts

Hendrik Buhrs
Expert for banks and stock exchanges As of October 14, 2020

Hendrik Buhrs

Hendrik Buhrs is an editor in the bank and insurance team. Before joining Finanztip, he reported on economic and consumer issues for the radio programs of the Hessian and later of the West German Broadcasting Corporation. Hendrik studied economics in Münster and Exeter. He gained his first professional experience at Radio Q and on Recklinghausen local radio. He likes to invest the money he has saved in travel.

  • Inflation means that prices in a country or currency area rise.
  • The inflation rate is measured by test buyers determining how the prices of frequently purchased products are developing.
  • The European Central Bank (ECB) finds inflation of up to 2 percent per year to be desirable for the economy.
  • The Finanztip inflation calculator shows you how much your purchasing power decreases over time.
  • There is nothing you can do about inflation itself. But you can calculate how inflation is affecting your everyday life and then try to compensate for it.
  • Price comparisons are particularly worthwhile for regular or expensive purchases. Finanztip helps you with a wide range of products from electricity to cell phones to insurance.
  • Above all, avoid negative interest rates and unnecessarily high balances without interest, for example on your checking account.

"Have they raised the price again?" - You will probably ask yourself this question several times over the course of a year. Whether in the supermarket, at the petrol station, at the ticket machine or in the restaurant: most things get more expensive at certain intervals.

Inflation is not a law of nature, because prices are naturally raised - or sometimes reduced - by people. In this guide we want to go into the background. And clarify what inflation means for your money and your investments. Because when daily life gradually becomes more expensive, you should take countermeasures so that you cannot afford less and less over the years.

How are the prices developing?

You will encounter the topic of inflation in the ice cream parlor, for example. You probably remember the price of a scoop in your childhood, after all, ice cream is one of the first things you pay for with your own money. Depending on how long ago that was, the price has increased noticeably.

The simplest reason why the ice cream dealer will eventually take 10 or 20 cents more for the ball than last year: Because it works. Nobody prescribes a certain price. However, he would notice that at 10 euros per scoop he would no longer find customers, and with 5 cents per scoop he could not pay for the ingredients, rent or employees. In this respect, the free pricing to a certain extent, limits are set. But within a medium range, the seller can pursue his own goal with the ball price: the highest possible profit, an attractive price-performance ratio or simply being cheaper than the competition.

The vast majority of entrepreneurs regularly make this assessment. Sometimes the decision-making processes are significantly longer when it is not about a scoop of ice cream but about a product of a global corporation. In other cases there are legal limits, for example, the rent cannot be increased at will. Some prices are contractually stipulated for a certain period of time, for example for an individual mobile phone contract or the doctor's fees applicable throughout Germany.

How is the inflation rate in Germany calculated?

In order to give everyone an indication of how prices develop over time, the Federal Statistical Office collects data on an ongoing basis Prices for 650 different goods and services. The price tag for this shopping cart (the so-called consumer price index) is published on a monthly and annual basis. In the calculation, the individual goods and services have different weights, based on the actual expenditure of a sample of around 80,000 people. By comparing how the price tag for the shopping cart has changed compared to the previous year, the rate of price increase is obtained. It is also called the inflation rate. In 2019 and 2020, the monthly inflation rate in Germany was mostly between 1 and 2 percent.

Since this is an average value, certain products can gain significantly more, for example some foods. But others get cheaper over time. In recent years this has been the case with gasoline or cell phone and internet contracts, for example. Many technical devices are also offered at lower prices - or with significantly more power. The statisticians try to take this into account. After all, it would be nonsense to compare a laptop from this year to a desktop PC from the 1980s.

This is how you can calculate the effects of inflation

Our inflation calculator shows you what inflation does with a specific amount of money.

Result

Does inflation affect your purchasing power?

Constantly rising prices would be a depressing affair if at the same time your budget remained unchanged for all time. Let's assume that you currently need 100 euros for a regular expenditure and that the inflation rate is 1.8 percent per year. After ten years, the same product or service would then cost 119.53 euros. Or to put it another way: With 100 euros in your pocket, after ten years of inflation you would only have one Purchasing power of 83.66 euros (100 divided by 119.53). You can easily look at other examples with our inflation calculator.

To compensate for this, however, your income also increases when things develop “normally”. There might be one every few years or even annually Raise - be it through a collective agreement or through individual negotiations. Or by switching to a better-paying job or making more profit as a self-employed person. The statutory pension or the Hartz IV rate are also regularly increased.

Exceptions and definitely also injustices confirm the rule. Just as not all providers can raise their prices equally, not all employees get evenly predictable wage increases. At least on average for the whole country, it usually works out. Because if money is becoming increasingly scarce for consumers, the prices of the providers will also rise less.

What is the European Central Bank doing?

The European Central Bank (ECB) in Frankfurt not only issues euro banknotes and coins, but also sets the key interest rate. At this interest rate, the individual banks can borrow money from the central bank - it is an important lever for the ECB to fulfill its core mission: the central bank should do the Price stability in the euro area and thus maintain the purchasing power of the euro. Put simply, a higher key interest rate means that banks and thus also companies are slowed down in their actions. Because it becomes more expensive for them to borrow for new investments. So the price development should be dampened. The opposite is the idea behind low key interest rates: companies can get money more cheaply from the ECB and invest more; Consumers too would rather spend their money than invest it at low interest rates. This should stimulate the economy and thus also give inflation a boost.

The aim of the ECB is to increase inflation "Below, but close to 2 percent" agreed. Many other central banks in developed countries have a similar inflation target. The idea behind it: Consumers and companies can cope with an inflation rate at this rather low level. Both a slide into negative territory, i.e. deflation, in which everything would become cheaper and cheaper on average, and so-called galloping or hyperinflation should be avoided.

The US Federal Reserve (Fed) announced in August 2020 that it would handle its inflation target more generously in the future: If inflation in the United States should remain above 2 percent for a while, for example in an economic upswing, the Fed will wait a while longer she takes countermeasures.

What is the real interest rate?

Would you like to have 5 percent interest on your savings account? This was common in the Federal Republic of Germany in the 1980s. However, inflation was also higher at the time than it is today. In 1981, for example, the Federal Statistical Office reported an inflation rate of 6.3 percent.

That leads us to the important Difference between nominal and real interest rates. The nominal interest rate is the interest rate that the banks advertise and that is credited to you for your investment. When we deal with interest on a day-to-day basis, it usually revolves around the nominal interest rate - in online banking, in the price notice of the banks and in many places here at Finanztip.

Ultimately, however, the real interest rate, i.e. the difference to the inflation rate, is much more important. Because the real interest rate shows you how much your invested money has gained or lost in value. In 1981, for example, the real interest rate was minus 1.3 percent. In the year in question, a savings account balance lost 1.3 percent of its value in real terms, despite the high interest on paper - because the rate of inflation was also very high. So the low interest rates are nothing new.

Of course, it makes sense to look around for the highest possible nominal interest rates, because then, despite inflation, a slightly higher real interest rate remains. But an important piece of advice: Do not rely on any advertising promises and interest rates that are unusually high compared to the market. Compare the promised return with the results in our calculators for overnight money or fixed-term deposits. If you are given the prospect of 2 or 5 percent a year instead of 0.5 percent, be suspicious. As a rule, there is a catch - perhaps the bank is located in an economically weak country that would have trouble supporting the financial sector in the event of a crisis. Maybe she doesn't even have a banking license and doesn't belong to a deposit insurance fund. Or the supposedly secure fixed-term deposit is actually a risky real estate business.

How do stocks help you fight inflation?

With low-risk investments such as overnight money, fixed-term deposits or German federal bonds, you will not be able to outdo inflation in the long term. It is all the more important that you familiarize yourself with widely diversified, inexpensive equity funds, so-called ETFs. Shares are company investments, i.e. tangible assets. Their value is not determined by a certain amount in euros, such as your bank balance, but fluctuates depending on the assessment of the investors.

If prices rise sharply, the tills of companies ring louder - so investing in stocks is a long way off inflation protected. Strong inflation will also hit companies on the cost side, as they will likely have to spend more on raw materials and employees. But with the ETFs that Finanztip recommends, you spread this risk among hundreds to thousands of individual companies that are active worldwide. And even in the event of a major economic crash (which hopefully does not come), it is good to have stocks in ETF form in the portfolio. These hold a certain value in all probability, as history shows: The devaluations in Germany after the two world wars hit owners of cash or savings accounts more severely than shareholders.

Gold and real estate are also real assets. Their value is also a conceivable protection against inflation. At Finanztip, however, we are cautious: gold does not add value by itself, it does not pay interest, dividends or rental payments. We therefore recommend it at best as a stabilizing component in the investment. Real estate, on the other hand, represents a cluster risk. Usually there is so much money in a single property that it significantly reduces the total assets if it loses value. That can happen, because the value of an individual apartment or house can be influenced by a wide variety of factors. If you only had shares from a single company in your portfolio, that would also be a lump risk: you are tying your investment to the fate of a company. Hence our tip with ETFs.

Is there an inflation coming?

It is not possible to reliably predict whether the corona crisis will lead to a more pronounced devaluation of money. With the right strategy for your investment, however, you can prepare yourself for the different scenarios. The governments of the industrialized countries are bringing a lot of new money into circulation through enormous aid packages. However, this has been happening since the financial crisis from 2008 onwards, without inflation having risen. Some arguments in debates about future price developments are:

  • Inflation will rise because the money supply grows. Companies use cheap loans to invest.
  • Inflation will not rise because central banks have much better methods of containment than they used to. You work more independently and transparently.
  • Inflation will rise because emerging countries like China will soon be buying more European products again, which will increase our prosperity and prices.
  • Inflation will not rise because globalization leads to global competition, which dampens the rise in prices and wages.

As you can see, some of these statements contradict each other - there are different scenarios and no one can say with certainty which one will occur. It makes the most sense if you position yourself as broadly as possible and mix higher-risk and lower-risk investments, i.e. index funds and fixed-term deposits.

Hendrik Buhrs

Hendrik Buhrs

Hendrik Buhrs is an editor in the bank and insurance team. Before joining Finanztip, he reported on economic and consumer issues for the radio programs of the Hessian and later of the West German Broadcasting Corporation. Hendrik studied economics in Münster and Exeter. He gained his first professional experience at Radio Q and on Recklinghausen local radio. He likes to invest the money he has saved in travel.

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