The cost of living gradually rises over time, reflecting the overall level of inflation in the economy and decreasing the amount of purchasing power that your money has. One key reason why investing is so important is to help you outpace rising costs of living and allow you to maintain your current standard of living. Unfortunately, as this cost of living calculator shows, the impact of inflation on your budget can be much larger than you'd think over long periods of time.
How inflation affects your standard of living
At its root, the concept of inflation is simple: The amount we pay for the things we need tends to rise over time. In a healthy economy like that of the U.S., the rate of inflation tends to be relatively low, and price increases aren't necessarily obvious over short periods of time. By contrast, unstable economies often have high rates of inflation that begin to erode the purchasing power of money almost immediately, creating structural challenges for producers in the way they handle their business -- and for consumers in how they handle their finances.
In some cases, price changes happen steadily over time without much volatility. For instance, if you pay rent for your home, you'll typically lock in a fixed monthly rental amount for the term of your lease, making it easy to predict your expenses during that period. Then, when it comes time to renew your lease, you'll typically face a price increase that takes effect at the beginning of the new period.
For other goods, prices can move dramatically in both directions. A good example is the price of gasoline. Over the long run, gas prices have climbed. However, there have been huge swings along the way, and as of late 2016, the current price of gasoline reflects the long-term upward trend in the energy market yet is also far below the peak gas price from just a few years ago.
Budgeting for rising costs of living
In order to save for a long-term financial goal like retirement, you need to be able to predict what your future costs will be. That's where a good cost of living calculator like the one above comes in handy, because it will help you figure out how large a nest egg you'll need in order to provide the cash to pay those costs of living.
The results depend heavily on the inflation rate assumption you make. For example, over a 20-year period, if you assume a low 2% rate of inflation, then for a typical family spending $4,000 a month now, you can expect your cost of living to increase to almost $6,000 per month 20 years from now.
However, if inflation rates are higher, than you'll need to spend a lot more to keep up your standard of living. Even a 4% rate of inflation results in costs of living that more than double over 20 years, forcing you to spend more than $8,750 to sustain a standard of living that only costs $4,000 today. At 6%, inflation causes your cost of living to more than triple to $12,800 per month.
How to fight inflation
In order to prepare for higher costs of living, the key is accounting for them in your financial planning. For instance, with retirement, many people will live 30 years or more after they quit work. If you don't take into account the fact that you might have to pay double or triple the amount for certain costs in your 80s that you had to spend in your 60s, then you won't save enough money. Instead, boost your savings goals to take those rising future expenses into account, and you'll be in a much better position to retire with the financial security you deserve.