May 21, 2010

How does inflation impact your finances?


Let’s say your average monthly outgo is Rs 1 lakh currently. Have you ever thought how much you’re going to require, say, after 20 or 30 years hence to buy the same bag of items? Try guessing!

If inflation is pegged at 6%, you’ll require
Rs 3.21 lakh after 20 years and Rs 5.74 lakh after 30 years to buy the same basket of goods & services. In other words, you’re going to require an extra sum of Rs 2.21 lakh in the 21st year and Rs 4.74 lakh in the 31st year to buy the same qty of goods and services.

Inflation is a fact of life and erodes the purchasing power of money. Just about every good and services (with the exception of a few such as electronic goods) we consume goes up in price over a period of time. When prices of goods & services go up, your purchasing power goes down since each rupee now buys a smaller share of goods and services. For example, Rs 1 lakh in hand today will be worth only Rs 17,411 after 30 years assuming an inflation rate of 6%. And, if the average inflation figure turns out be a tad higher, say 8%, the purchasing power will further gets reduced to less than Rs 10,000.

What’s your inflation number?
Now, let’s come to the moot question: What’s your inflation number?
An inflation index such as Wholesale Price Index (WPI) or Consumer Price Index (CPI) doesn’t truly reflect the inflation figure relevant to your lifestyle. The actual inflation figure relevant to you is always substantially higher than these official indices.

As mentioned above, current spend at Rs 1 lakh per month at a projected inflation rate of 6% should be 3.2 lakh after 20 yrs to retain the same quality of life as now. But don’t our aspirations also increase with our rise in income over a period of time? Just think: Are you consuming the same qty and quality of goods and services you were consuming 5 or 10 years back? Will you continue to maintain your current living standard or upgrade it with the passage of time? Won’t you be consuming more of new / better goods & services? If yes, then you need to consider the ‘lifestyle inflation’ and take it into account while planning for your retirement kitty.

Suppose, 10 years back you used to reside in a 2 BHK house with a monthly rental of Rs 3000 p.m. and now the current monthly rental of the same flat is around Rs 8,000. But around 5 years back, you shifted to 3 BHK house and currently paying a rent of Rs 12,000 p.m. So we can say that while general housing inflation is 10.30%, the one applicable in your case is 14.86%. The difference of 4.56% is nothing but lifestyle inflation. This is a very crude example to clarify the concept of lifestyle inflation.

So, instead of wholesale price index (WPI) or consumer price index (CII), the relevant index for financial planning purposes is Personal inflation index (PII). To calculate the rate of inflation relevant to arrive at your future expenditure, you should add around 1-4% to general inflation rate depending on how fast you’re upgrading your lifestyle.

Following table list the Personal Inflation index (PII)

Yrs\Inflation -----------6%----------8%-----------10%---------12%

10-----------------------179----------216---------259----------311
20-----------------------320----------466----------673---------965
30-----------------------574--------1,006-------1,745-------2,996
40---------------------1,028--------2,172-------4,526-------9,305
50---------------------1,842--------4,690------11,739-----28,900

And if you want to calculate it for a different period and / or different inflation rate, you can take the help of this calculator:

Inflation Calculator
If you want to know how much something would cost after a particular period increasing it by the inflation number, use this Inflation Calculator:



Finally, a question: Does this article make you realize the importance of planning for your future financial goals such as child education and your retirement? Or, do you like shooting in the dark?


Also see:

1. 10 Reasons to have a Savings Plan
2. Why do we make fatal money mistakes?

2 comments:

  1. AnonymousJune 04, 2010

    good article i started thinking of retirment plan after looking at this my age is 28

    ReplyDelete
  2. Nice one! Very helpful :)

    ReplyDelete

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