What Impact Does Inflation Have on a Dollar's Value Over Time?

Inflation decreases a dollar's value over time. This effect relates to the time value of money, which is a concept that describes how the money available to you today is worth more than the same amount of money at a future date.

This impact assumes that you do not invest the money available to you today in an equity security, a debt instrument, or an interest-bearing bank account. Essentially, if you have a dollar in your pocket today, that dollar’s worth, or value, will be lower one year from today if you keep it in your pocket.

Inflation's Impact on a Dollar's Value

Inflation increases the price of goods and services over time, effectively decreasing the number of goods and services that you can buy with a dollar in the future as opposed to buying them with a dollar today.

If wages remain the same but inflation causes the prices of goods and services to increase over time, it will take a larger percentage of your income to purchase the same good or service in the future.

Here’s a chart of the inflation rate from the late 1600s to today. Notice that since the 1950s, the rate of inflation has been positive for nearly every year.

If an apple costs $1 today, it's possible that it could cost $2 one year from today. This effectively decreases the purchasing power of money over that period, since it will cost twice as much to purchase the same product in the future.

To mitigate this decrease in the time value of money, you can invest the money available to you today at a rate equal to or higher than the rate of inflation.

Consider the chart below, which lays out the buying power of $100 from 1799 to today. Using the example above, if we had $100 in apples in 1799, those same apples would cost over $2,485 today.

What Causes Inflation?

Basically, inflation occurs when there's a rise in the price of goods or services. That rise in prices is driven by supply and demand. Holding all else constant, a rise in demand can push prices higher (if the supply of goods and services is stable), while a reduction in the supply of goods can also drive higher prices.

Demand

Demand can rise when consumers have more money to spend. More demand and spending increase inflation. When wages are steady or rising, and unemployment is relatively low, there's often greater consumer confidence. People with stable jobs spend more and inflation is likely to rise. In addition, manufacturers are likely to raise prices if consumers are willing, or capable, of spending more.

Supply

Lower supply can also push prices higher. A decline in supply can happen for a number of reasons, such as disasters that disrupt the supply chain or manufacturers’ capabilities. Or, an item that turns out to be very popular can sell out quickly, such as the case with iPhones. Low supply of a product coupled with strong demand for it mean higher prices for that product.

The Federal Reserve and Inflation

One of the Federal Reserve’s chief responsibilities is to monitor and control inflation. The Fed aims to keep the inflation rate around 2%. The Fed manages inflation in one of three ways—managing the federal funds rate, altering reserve requirements, and changing the money supply.

The Fed funds rate is the rate at which banks can borrow money from the government. To help curb rising inflation, the Fed will increase rates, which consequently increases interest rates charged by banks. This helps slow spending and forces prices lower, helping keep inflation in check.

Then there are reserve requirements, which relate to the amount of capital that banks must keep on hand for liquidity purposes. To curb spending and inflation, the Fed can increase the reserve requirement, which decreases the amount of money banks have available to lend.

Finally, there’s the nation's money supply, which the Fed directly influences by buying or selling securities. By controlling the amount of money in circulation, the Fed can affect the rate of inflation.

The Fed measures inflation with various price indexes that track price changes of particular goods and services. The index favored by the Fed is the personal consumption expenditures index that’s put out by the Department of Commerce. The PCE index contains a variety of goods and services that are part of household spending.

The Fed also consults other indexes, such as the Department of Labor’s consumer price and producer price indexes.

The Bottom Line

Rising inflation can take a toll on consumers due to higher prices now and the erosion of the value of the U.S. dollar (and what it can buy) in the future.

To fight inflation and its negative effects, the Federal Reserve Bank uses its monetary policy tools to slow demand and spending. Individual investors can also fight it by seeking the highest available returns (for an acceptable level of risk) on the money that they invest.