Capital markets generally serve an allocative function by allocating investment resources efficiently; however, this function could become impaired under inflationary conditions.
Savings accounts and money market funds with low interest rates are subject to inflation, which reduces their buying power over time. This effect becomes particularly significant if inflation exceeds their interest rate.
Cost of living increases
At times of inflation, maintaining your lifestyle becomes increasingly challenging as your savings and investments lose purchasing power due to rising prices for goods and services. But there are ways you can protect your finances against inflation by investing in safe assets such as bonds or certificates of deposit.
However, living costs vary greatly by region and for individual families depending on consumption of specific items like gasoline. Rising expenses tend to affect middle-class households more severely than lower-income ones.
The core inflation index does not account for improvements to existing goods or the invention of new ones, creating a “quality/new goods bias” that distorts inflation numbers accurately. However, this does not suggest you avoid purchasing innovative technology; often times newer versions tend to be cheaper in the long run due to being more efficient or innovative than older ones.
Interest rates go up
As inflation escalates, interest rates increase and borrowing money becomes more costly – making operations harder for companies and possibly leading to reduced profitability and stock values.
But inflation does not impact all investments equally; some may actually benefit from it, like commodities and real estate which tend to increase in value with rising prices.
Inflation tends to alter people’s investment preferences. For instance, inflation could prompt savers to switch their focus from investments such as social overhead capital and basic industries to physical assets like inventory or housing as a form of savings.
Distortions to supply and distribution can skew investments in favor of privately lucrative industries while neglecting socially rewarding ones, making diversification essential. Therefore, investing in different assets is vitally important.
Your purchasing power decreases
Inflation is one of those economic terms you hear economists and journalists discussing in the news, yet it can be hard to comprehend its effect on your personal finances. When inflation rises faster than your income, your money becomes worth less as prices increase more quickly. Retirees living off fixed incomes must make sure their investments offer higher returns than inflation rate in order to preserve purchasing power and avoid purchasing power loss.
Inflation makes debt repayment harder, as interest rates typically increase when an economy inflates. People with fixed-rate mortgages will find their monthly payments increase due to rising cost of living costs; inflation especially affects people on fixed incomes or retirees who need to budget carefully; when prices soar it is essential that income or expenses be adjusted up accordingly in order to cover them. When prices escalate it’s vital that one seeks ways to increase income or cut unnecessary expenses to make up for rising costs and keep pace with them.
You can’t afford to buy as much
inflation may be chipping away at the value of your savings and investments. According to the Consumer Price Index, inflation surged 8.6% between May 2015 and May 2016. Rising costs associated with gasoline, food, and housing largely account for this increase; fortunately any wages you earn or interest you collect on savings accounts can help offset some inflationary effects.
Savings accounts with low interest rates, money market funds and certificates of deposit (CDs) can take a hit when inflation is high as it reduces your purchasing power over time. Long-term debt with fixed rates also can suffer because inflation takes its toll.
Investments that appreciate in value over time despite inflation–like stocks and income-generating real estate–are ideal choices to protect wealth during inflation. A diversified portfolio that contains allocations across these asset classes may provide one way of mitigating this threat.