The Danger of Inflation
Inflation is the effect of rising prices on your buying power. Inflation is often left out of the equation when calculating how much money you'll have available at some point down the road, but it can make serious inroads into the buying power of your money. The average inflation rate since 1994 has been approximately 2.5 percent, but in the early 1980s, we experienced double-digit inflation. Since 1980, the price of goods and services has increased 80 percent, so an item that cost $100 in 1980 costs $180 in 2002. Since much of our financial planning is done for years into the future, it's important to consider the impact of inflation when determining how much money you'll need in retirement, for example.
The $30,000 salary you earn this year will be worth only $28,800 next year if inflation is 4 percent. If you're fortunate, you'll get a salary increase annually that at least keeps pace with the rate of inflation; otherwise you fall further behind each year.
You can use the Rule of 72 to estimate the real buying power of a sum of money at some point in the future, taking inflation into consideration. If the inflation rate is 4 percent, prices will double in eighteen years (72 ÷ 4 = 18), so if you plan to retire in eighteen years and you need $3,000 a month in today's money, you'd need $6,000 a month to retain the same buying power you have today.