"In the simplest terms, inflation occurs when there's too much money in the system." - Robert Kiyosaki
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Central banks often have a target inflation rate which they strive to hit. A central bank is an institution that manages monetary policy and oversees the commercial banking system within an economy. Examples of central banks include the Bank of England (UK) and The Federal Reserve (USA), also known as the Fed. The current target inflation rate for both of these central banks is 2% per year.
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The underlying reason as to why prices rise over the long run is due to central banks having the ability to create additional money. The three main ways in which they impact the money supply (total value of money available in an economy) is through:
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- Quantitative easing
- Setting interest rates
- Setting the reserve requirements for banks
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I will not delve into the details of how quantitative easing, interest rates and setting the reserve requirement for bank impacts the money supply, but if you want to know more about this, then watch the videos below. The main takeaway is that general prices will continue to rise throughout your lifetime as long as more money is continuously created out of thin air by central banks.
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The main thing to understand is that when additional money is created it makes the money already in circulation worth less, because there is now more of it. To put it simply if there is more money, there will be more spending by businesses and individuals, which would in turn lead to higher prices for things over time (aka inflation). Therefore, you can't afford to purchase as many goods or services i.e. money is worth less in terms of how far it will stretch.
The creation of money is not the only reason why prices rise. The two main others reasons for inflation is due to cost push inflation and demand pull inflation (which could be argued is partly caused by the creation of money), however the underlying reason why inflation exists is because over time there is more money in an economy.
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How do you protect your wealth from eroding over time then? Invest your money.