11th August 2017 - 5 min read
Remember when things were a lot cheaper? That’s not just nostalgia talking, the costs of goods and services really are steadily rising and this is because of inflation. Understanding how inflation works is important because it can affect your retirement savings and even how you should ask for a raise. But before we get into that…
You may assume that inflation is what happens when prices rise, and you’re not exactly wrong. However, it might help to know why inflation happens at all. There are two major reasons:
As a country develops, its citizens start getting higher-earning jobs. When people’s purchasing power increases (more on this later), their demand for goods and services increases also. When more people want to and can afford to buy more, they will. This leads to a decrease in the supply of some goods and services.
When fewer items are available, people who are willing to pay more to obtain it, will do so. This leads to an increase in price, and results in what s is called “Demand Pull Inflation”. In short, when people can and want to spend more money, prices will rise to meet that need, resulting in inflation.
Another way inflation can happen is when resources suddenly become more scarce or expensive. Let’s say that oil prices are going up because worldwide oil production has slowed down. This means the cost of hiring a truck to deliver goods to places will rise also. The sellers of these goods will have to charge more to maintain their profit since they still need to pay their staff the same salary. When this happens, it’s called “Cost Push Inflation.”
That is to say, when external forces make it expensive to produce goods and services, prices go up.
There are other factors that can contribute to inflation, but for the purpose of our explanation, let’s stick to these two. As you can probably deduce already, the factors above come across from a naturally functioning economy, and not necessarily the result of terrible fiscal policy. In fact, a healthy growing economy would seek to have a positive inflation rate of about 2% each year.
Remember how we talked about purchasing power just now? Purchasing power refers to the amount of goods and services you can buy with the cash you have. This is important because your purchasing power changes depending on the rate of inflation.
Let’s say you have saved up RM100 in a savings account that pays 1% in interest, and RM100 is the cost of a pair of cool socks. After a year, you’ll have RM101 in your account. You can buy those socks and have RM1 left over. That’s a positive return, right?
However, if during that same year, inflation runs at 2%, that means those same socks now cost RM102. You actually need to borrow RM1 to buy those same socks you saved up for. Your purchasing power has been reduced by 1%.
At the time of writing, the average interest rate for savings account that Malaysian banks offer are between 0.1% to 3% depending on the bank. Meanwhile, Malaysia’s rate of inflation has averaged around 3.64% for the past few years.
As stated above, your savings won’t beat the inflation rate at all if the only thing you do with it is stick it in a regular savings account. However, there are a few ways you can beat inflation and come out on top.
Thankfully, most of you are already familiar with retirement funds such as the EPF and PRS which we’ve talked about before. Regular contribution to these funds will help since they’re used for investments which, when handled correctly, should net a return that’s higher than the rate of inflation.
Another way is to park your money in fixed deposit accounts which yield a much higher interest rate than regular savings accounts. At the time of writing, the interest rate for FDs are about 3.2%.
Investing your money in a simple unit trust can also help you net way more than the average rate of inflation. Getting started with investing is plenty rewarding if you have the patience and interest in it, but a unit trust does the job just fine.
Year on year, your salary increment should match or exceed the rate of inflation for your purchasing power to remain stable. If this hasn’t been the case and you’ve been pondering on how much to ask for a raise, consider an increase that’s on par with the inflation rate or higher.
Using your savings as capital to start your business has gotta be one of the better ways to put your money to work. This one takes the most effort and time out of all the others, but it can definitely be the most lucrative.
Our recommendation is to use a combination of two or three of these methods to help protect your savings from the ravages of inflation and maintain the value of your cash.
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