Inflation question

[jqrz]

I have a question in which the answer must seem obvious but would like an explanation

Hypothetical 2 yr scenario:

Assuming 3% annual inflation rate:

August, Year 1:
Total net worth of $300K (earning 0% interest in bank)
Zero debt
$12,000 annual income
$12,000 annual expenses

August, Year 3:
Total net worth of $300K (earning 0% interest in bank)
Zero debt
$12,411 annual income
$12,411 annual expenses (income + expenses increased 1.7% in year 1 and year 2, thus "breaking even")

Did this person "lose" 6% in real money - If so, how? It is hard to understand, since the person's annual expenses only increased 1.7% per yr due to careful budgeting.

However, how is it that the person still loses 3% a year?? Forgive me if this is an extremely elementary question, as I do not understand budgeting or inflation at all - but would like an explanation that makes sense... Thanks!!

 

[Texas Proud]

I will assume simple math and just add the two 3% inflation rate together and not put inflation on inflation....

The quick answer is NO... they withdrew $36 plus K of money out of their investments to live on...

So, $300 + $36 in earnings - $36 in expenses leaves $300.... so their earnings were $36/$300 or 12%....

Note.. doing a LOT of rounding here to make it simple.... but I think you get the idea....

 

[MooreBonds]

However, how is it that the person still loses 3% a year?? Forgive me if this is an extremely elementary question, as I do not understand budgeting or inflation at all - but would like an explanation that makes sense... Thanks!!

You have to look at the general overall inflation rate. Between Year 1 and Year 3, you might not have had every expenditure. What about transportation? Even if you only use public transportation, they might raise fares every 3-5 years, in 10%+ increments. So might not have any hit between Year 1-Year 3, but in Year 4 or 5 you might. Same with other things you might not buy then, but will later. Or if you had a used car for that time, and will replace it in year 5, you might not see the price impact that has been occurring each year, on average, until you need to buy it again in Year 5.

And inflation is an averaging. Not everything you buy will go up, on average, the same every year as the inflation rate. Some will go up more one year, less the next. And with your expenses, are you truly buying the same things? Or is there any substitution effect going on (buying chicken instead of beef, buying more canned goods than fresh, buying smaller packages because the manufacturer makes smaller packaging, etc.).

 

[perrytime]

I see the question differently, due to inflation, after year 1, the 300k only has buying power of 291000, after year 2, 282270. so they have lost 5.9% of buying power due to inflation.
The income equals expenses seems irrelevant to the question, except to point out the 3% inflation figure is not representative of the real inflation a consumer may experience as they don't buy just the products used to establish the 3% inflation rate.
So in that vein, the real lose due to this individuals spending habits, in this case, is less than 3% for the 2 years, 1.7% each year. But hesitate to extrapolate that for extended period of time.

 

[pb4uski]

Think of it this way. Assume that at year 1 (actually, time zero) that widgets cost $1,000 each... you could buy 300 widgets with $300,000.

At year 3, widgets cost $1,061 each ($1,000 inflated at 3% a year for two years), so for $300,000 you can only buy 283 widgets.

You still have $300,000 but its spending power has eroded as a result of inflation.

 

[audreyh1]

They lost buying power, not money per se. Due to their careful budgeting, they were able to reduce some of their expenses to offset the loss of buying power, so they may not feel it as much as if their expenses tracked inflation.

 

[Texas Proud]

Think of it this way. Assume that at year 1 (actually, time zero) that widgets cost $1,000 each... you could buy 300 widgets with $300,000.

At year 3, widgets cost $1,061 each ($1,000 inflated at 3% a year for two years), so for $300,000 you can only buy 283 widgets.

You still have $300,000 but its spending power has eroded as a result of inflation.

But you forget that he had three (or two) years of buying widgets along the way... year 1 he bought 12 widgets, year 2 he bought 12 widgets (using your example) so he already has 24 widgets plus the 283 that he still can buy is 307 widgets.. he has not lost buying power... he has already bought some...


IF you took out the income and expense parts, then yes there would have a loss of buying power.... but that was not the question...

 

[Sunset]

Inflation erodes away the buying power of the savings sitting in the bank (investment).

So if a person has an investment that pays equal or more to inflation, then they keep their purchasing power, if the investment pays less than inflation then the person can literally not afford to buy as much as before.

 

[eta2020]

I would say they lost 18000 USD of buying power (net worth) plus their income went down by about 310 dollars in real terms.... since income did not keep up with inflation.

 

[pb4uski]

But you forget that he had three (or two) years of buying widgets along the way... year 1 he bought 12 widgets, year 2 he bought 12 widgets (using your example) so he already has 24 widgets plus the 283 that he still can buy is 307 widgets.. he has not lost buying power... he has already bought some...


IF you took out the income and expense parts, then yes there would have a loss of buying power.... but that was not the question...

I was addressing the OP's question:

....Did this person "lose" 6% in real money - If so, how? ....

However, how is it that the person still loses 3% a year?? ..... Thanks!!

The person did lose 6% because the buying power of the $300k that they have can only buy 94% of the goods that it would buy two years ago.

The fact that their personal rate of inflation is only 1.7% helps the person situation, but there could be many reasons for the fact that their expenses have lagged inflation (buying less stuff, substituting hamburger for steak, etc.) OTOH, it could be that that person's particular basket of expenses (the things that they buy) are growing at less than the general 3% rate of inflation.

 

[eta2020]

I was addressing the OP's question:



The person did lose 6% because the buying power of the $300k that they have can only buy 94% of the goods that it would buy two years ago.

The fact that their personal rate of inflation is only 1.7% helps the person situation, but there could be many reasons for the fact that their expenses have lagged inflation (buying less stuff, substituting hamburger for steak, etc.) OTOH, it could be that that person's particular basket of expenses (the things that they buy) are growing at less than the general 3% rate of inflation.

+1

That is why pay raise of 2% in 3% inflation environment is actually pay cut of 1%....though boss could argue that it is a pay raise.

It is also why 6.5% returns in equities in 1.5% inflation environment is exactly same as 8.5% returns in equities in 3.5% inflation environment.

 

[Texas Proud]

I was addressing the OP's question:



The person did lose 6% because the buying power of the $300k that they have can only buy 94% of the goods that it would buy two years ago.

The fact that their personal rate of inflation is only 1.7% helps the person situation, but there could be many reasons for the fact that their expenses have lagged inflation (buying less stuff, substituting hamburger for steak, etc.) OTOH, it could be that that person's particular basket of expenses (the things that they buy) are growing at less than the general 3% rate of inflation.

I guess we will disagree.... the investments made money that was used to pay expenses... if he had not spent any of the money he would have more money and would not have lost 'real' money...

I am looking at the whole where I think you are looking at the principal left... I agree with you that if the only info we had was the $300K was the same at the beginning and the end there would be a 'real' loss of purchasing power.... I just do not think you can ignore the earned income that was spent.... even with how the question was worded....

 

[kcowan]

Here is a primer on sources of inflation:

You can see that there are many sources of inflation, and it is always bad, except for corrupt governments.

 

[eta2020]

I guess we will disagree.... the investments made money that was used to pay expenses... if he had not spent any of the money he would have more money and would not have lost 'real' money...

I am looking at the whole where I think you are looking at the principal left... I agree with you that if the only info we had was the $300K was the same at the beginning and the end there would be a 'real' loss of purchasing power.... I just do not think you can ignore the earned income that was spent.... even with how the question was worded....

He is saying that he earns 0% not that he earns 12k on 300k.......that is 300k of net worth (may include some housing)

I do not know where he gets 12k earned from.

 

[dallas27]

In economic terms, you are getting generally poorer. Done.

 

[Texas Proud]

He is saying that he earns 0% not that he earns 12k on 300k.......that is 300k of net worth (may include some housing)

I do not know where he gets 12k earned from.

Maybe it is me who is reading it wrong....

He said $12K annual income for the first year.... with expenses of the same amount... I am assuming that he meant that the portfolio earned him $12K and he spent all that money....

His income and spending was up by a bit the next year... again, spending all the income....


So, the question is where did that income come from... the portfolio or work I say it makes a difference to the answer he asked according to how this is answered....

 

[Spudd]

Maybe it is me who is reading it wrong....

He said $12K annual income for the first year.... with expenses of the same amount... I am assuming that he meant that the portfolio earned him $12K and he spent all that money....

His income and spending was up by a bit the next year... again, spending all the income....


So, the question is where did that income come from... the portfolio or work I say it makes a difference to the answer he asked according to how this is answered....

He specifically says it earns 0% in the bank, and the amount doesn't change over the time period, so I think the income must come from work (or some other outside source like welfare payments, SS, etc).

 

[pb4uski]

+1 That is the way I read it too.

 

[rayinpenn]

Point of order... If your income grows at the same rate as inflation you've neither gained or lost ground...

$300k earning zero interest is a mistake...

 

[Texas Proud]

He specifically says it earns 0% in the bank, and the amount doesn't change over the time period, so I think the income must come from work (or some other outside source like welfare payments, SS, etc).

+1 That is the way I read it too.

OK... I am wrong...

Missed that part....

Then yes, what you said is correct...

 

[Animorph]

The ratio of savings to spending is getting worse. That can't be good.

 

[pb4uski]

Point of order... If your income grows at the same rate as inflation you've neither gained or lost ground...

$300k earning zero interest is a mistake...

Agree but you overlooked this part:

....Hypothetical 2 yr scenario:....

 

[jqrz]

Thanks all for the feedback... It has given a better understanding of how inflation works. I perpetually find the issue confusing, particularly since the expenses haven't really gone up much - but it is true, i may not be spending it on some truly inflation-measured things. It is a hypothetical scenario - in actuality, I do have my money in investments that have earned around 4.5% (avg yearly) so far. With the amount that I have been spending for the past 2 years, I have nearly the same balance that I had 2 years ago which, i'm afraid, isn't good