4 min read

Inflation Explained in Simple Terms

Inflation Explained in Simple Terms
My Philly cheesesteaks are shrinking over time! Is it from inflation?


As my macroeconomics professor in college once said, "all inflation is bad; it's just a matter of how much and in which direction." Inflation is the decline of purchasing power over time, generally paired with increased prices for things. Deflation is the opposite and hasn't happened in the US for many decades. Inflation is easier to think about using a simple real-life example like a cup of generic coffee:

The inflation of a basic cup of coffee, courtesy of saveforamerica.org, inflation explained
The inflation of a basic cup of coffee, courtesy of saveforamerica.org

I recently found an old receipt for a Philly cheesesteak I bought for $4.85 in 2005. Today, that same cheesesteak is about $10. That's a gigantic drop in how much a dollar is worth for the same cheesesteak, so let's determine how much of that was due to inflation. I googled and used this today's dollars calculator, and according to it, $4.85 in 2005 dollars is now worth $6.58 in 2021 dollars. That means there's much more than just inflation at play here - perhaps food costs or restaurant rent costs increased also. My point is that any specific example of purchasing power over time probably has other variables in the mix. Inflation is always one of the variables, though. It impacts every market, and every transaction. In stocks, this means that a 10% gain in a year is only something like 8% because inflation eats into your gains. It's not something you can do anything about, just something to be aware of.

You may be thinking: what about the 0.5% APR or less that my bank account gets as a return? Keeping your money parked in a bank is certainly safe, since it's federally insured up to $250,000 if the bank ever fails. However, because of inflation of about 2% per year, your money in an account with 0.5% annual interest is actually losing 1.5% in value every year. Yikes!

What Causes Inflation?

The US Govt keeps printing new money, which is one of the main reasons why inflation happens. Printing new money literally increases the number of dollars in circulation, and since there are more dollars in circulation, money is more abundant. The Federal Reserve interest rate also indirectly has an impact on inflation since the rate they set determines how freely regular banks will lend out their money to individuals and businesses. That also changes the supply of money - the number of bills out there - which impacts inflation.
Since 1990, Americans have enjoyed a pretty steady inflation rate of 2-3% each year, which is actually the target the Federal Reserve wants. In monetary theory, a small amount of inflation is thought to encourage consumer spending since people know that holding off on a purchase will require slightly more money for the same item in the future. For example, let's say you have $1000, and inflation is 2% each year. You let the money sit under your mattress for five years. Because of inflation, what your $1000 could buy five years ago would now require $1104. You can calculate this 2% change each year using our friendly MoneyChimp compound interest calculator.

Inflation Explained Summary

Inflation - a dollar buys less than it used to. Prices for things generally rise. The US inflation target set by the federal reserve is about 2-3% each year.
Deflation - a dollar buys more than it used to. Prices for things generally decline.

Because of the gigantic Covid relief packages passed by Congress, the US money supply is rising faster than it has in many years. Here is a clip of Warren Buffett's comments on inflation in light of covid and the relief package:

Here is a graph of the US inflation rate since 1915. Ever since the creation of federal agencies to reign in monetary policy, by the Federal Reserve bank, and wall street, by the Securities and Exchange commission, inflation has been pretty steady compared to the craziness of the great depression.

United States inflation rate since 1920, Inflation Explained
US inflation rate since 1920

Trades - Lots this Month

  • Kyla bought SmartSheet (SMAR) with her additional $1000.
  • Caitlin bought AutoDesk (ADSK) with about $500 of her additional $1000.
  • Michael added to his Tesla (TSLA) position with his additional $1000.
  • Connor sold out of his cryptocurrency holdings, I guess? He deleted all of his positions.
  • Milena needs to add details of her QuantumScape (QS) trade.

Please remember to update the google sheet detail tab when you buy/sell something. I look at the revision history each month so I can include your trade in this newsletter. The summary tab is at the bottom of this email as a picture and the live link to it is here.

I went ahead and added the new $1000 each to everyone's balance. Be sure to update the sheet when you buy something with it!

Current snapshot of Pasta Dollar / Poppy Seeds portfolio google sheets tracking spreadsheet.
Current snapshot of Pasta Dollar / Poppy Seeds portfolio google sheets tracking spreadsheet.
This post originally appeared in our family email newsletter called Poppy Seeds, which evolved into the Pasta Dollar website.