Inflation and the value of money

Ask a grandparent what a movie ticket cost them and the answer sounds absurd. That is inflation: the slow, general rise of prices over time. It is the reason the same dollars buy less every year, and it quietly shapes every saving and investing decision you will ever make.

What inflation actually is

Inflation is measured by tracking the price of a big basket of things Australians buy: food, rent, transport, power, and hundreds more. If the basket costs 3% more than a year ago, inflation is 3%. The Reserve Bank of Australia aims to keep it between 2% and 3% a year, and it moves interest rates up and down largely to steer it back into that band.

So what actually makes prices rise? At its simplest, inflation happens when the money chasing goods grows faster than the goods themselves. If wages and spending climb while the supply of houses, food and fuel does not keep up, buyers bid prices higher. Costs matter too: when the price of energy or shipping jumps, businesses pass it on. And expectation feeds the whole thing, because if everyone believes prices will rise, workers ask for higher pay and shops set higher prices, which helps make the rise come true. That last loop is part of why the Reserve Bank cares so much about keeping inflation low and steady, rather than just low: it wants to stop the expectation of rising prices taking hold in the first place.

A little inflation is considered normal in a healthy economy. The trouble comes when it runs hot. If prices rise 7% and your pay rises 3%, you got poorer this year even though your pay went up. What matters is never the number on your payslip. It is what that number buys.

How the Reserve Bank steers it

When inflation runs above the band, the Reserve Bank's main tool is the interest rate it sets, which ripples out to the rates banks charge on home loans and other borrowing. Raise it, and borrowing costs more, so households and businesses spend less, and slower spending eases the pressure pushing prices up. Lower it, and the reverse happens: cheaper borrowing encourages spending and lifts prices. It is a blunt tool with a lag of many months between the decision and the full effect, which is why the Reserve Bank moves carefully and why its rate decisions make the news.

The rule of 72

There is a quick trick for feeling what a percentage does over time: divide 72 by the yearly rate to get roughly how many years a doubling takes. At 3% inflation, prices double in about 24 years. At 8% growth, an investment doubles in about 9 years. The same maths that erodes idle cash grows invested money.

Try it both ways. At 3% inflation, 72 divided by 3 is 24, so prices roughly double in 24 years, which means a $5 loaf could be a $10 loaf by the time you are in your forties. At an illustrative 8% return, 72 divided by 8 is 9, so invested money doubles in about 9 years and doubles again in the 9 after that. The arithmetic that quietly halves the value of cash left in a drawer is the same arithmetic that, pointed the other way, doubles money that is invested and left alone. That single idea is most of the reason the investing topic exists.

What this means for your money

Cash hidden in a drawer loses buying power every year, guaranteed. Money in a savings account fights inflation and, in good years, beats it. Over long stretches, only investing has reliably outpaced it, which is exactly why the investing topic exists. Inflation is the reason doing nothing with money is not a neutral choice.