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An introduction to why prices rise over time and how that affects the value of your money.
Imagine finding a $20 bill in an old jacket from 1995. Back then, that bill could buy you three movie tickets and a large popcorn. Today, it might barely cover one ticket and a small soda. Why did your money 'shrink' while sitting in your pocket?
Inflation is the sustained increase in the general price level of goods and services in an economy over time. Think of it like a slow leak in a balloon; as the 'air' (value) escapes, the balloon gets smaller. When inflation occurs, each unit of currency buys fewer goods than it did before. The opposite process, where prices actually drop, is called deflation. While lower prices sound great, deflation can actually signal a struggling economy where people stop spending because they are waiting for even lower prices later.
Quick Check
If the price of almost every item in a grocery store rises by 3% over a year, is this inflation or deflation?
Answer
Inflation
Purchasing Power is the 'strength' of your money. It is the quantity of goods or services that one unit of money can buy. Inflation acts like a hidden tax because it erodes this power. If the price of a slice of pizza rises from 4.00, your $4.00 has lost half of its purchasing power—it used to buy two slices, but now it only buys one. We measure this using the Consumer Price Index (CPI), which tracks the cost of a 'basket' of common goods over time.
Let's look at how purchasing power changes with simple math: 1. In Year A, a movie ticket costs 20.00. 2. Total tickets you can buy: tickets. 3. In Year B, inflation has risen, and a ticket now costs 20.00: tickets. Your money stayed the same, but your purchasing power dropped by .
Quick Check
If your income stays exactly the same but inflation goes up, does your standard of living go up or down?
Answer
Down, because your money cannot buy as many things as it used to.
Inflation doesn't affect everyone equally. Savers are often the 'losers' because the cash they keep under a mattress or in a low-interest bank account loses value every day. However, borrowers can sometimes be 'winners.' If you borrowed $1,000 to buy a bike and inflation spikes, you are paying back that loan with 'cheaper' dollars that have less purchasing power than the dollars you originally borrowed. To protect themselves, banks charge an interest rate that is usually higher than the inflation rate.
Imagine you take out a loan for 5\%10,000. 2. But because prices tripled, $10,000 is now much 'easier' to earn than it was when you took the loan. 3. You effectively pay back the bank with money that is worth much less than what they gave you. In this scenario, the borrower wins and the lender loses.
What happens to the purchasing power of a dollar during a period of inflation?
If your bank account earns interest and inflation is , what is your real interest rate?
Deflation is always good for an economy because everyone loves lower prices.
Review Tomorrow
In 24 hours, try to explain to a friend why a borrower might be happy if inflation suddenly goes up.
Practice Activity
Ask an adult what a gallon of milk or a gallon of gas cost when they were your age. Use that to visualize how purchasing power has changed over their lifetime.