Inflation is the rate at which the general level of prices for goods and services rises over time, causing purchasing power to fall. When inflation is 3% per year, something that costs $100 today will cost about $103 next year. Over decades, this compounding effect can significantly erode the real value of money held in cash or low-yield accounts.

There are two ways to think about inflation's impact. First, the future cost: what will something that costs a certain amount today cost in the future? Second, purchasing power: what will today's dollars actually be able to buy in the future? Both perspectives are important for planning savings, investments, and retirement income.

To combat inflation, investors seek returns that exceed the inflation rate. For example, if inflation is 3% and your investments return 7%, your real (inflation-adjusted) return is roughly 4%. This is why holding all your money in cash or a savings account earning less than the inflation rate actually causes you to lose purchasing power over time.