What you will learn
- Explain inflation and how it changes what your money can buy
- Separate an investment's stated return from its return after inflation
- Estimate a real return by subtracting inflation from the nominal return
- Describe why keeping too much long term savings in cash can reduce purchasing power
Compounding can increase your account balance, but the number of dollars is only half the story. You also need to know what those dollars can buy. Prices tend to rise over time, so the same dollar usually buys a little less later. That loss of purchasing power is the effect of inflation, and it can turn a decent-looking return into a disappointing one.
Inflation by FQS
Short video made by the Finance and Quant Society on what exactly is inflation and how it is important. Watch before moving on!
Inflation and purchasing power
Inflation is a continuing rise in the overall level of prices across an economy. When prices rise, the same amount of money buys fewer goods and services. That means its purchasing power has fallen. Suppose a basket of groceries cost 100 dollars last year and costs 103 dollars this year. That change is about 3 percent inflation, and 100 dollars no longer buys the full basket. The Consumer Price Index, or CPI, tracks the price of a typical basket of goods and services and is the most common measure of inflation. You will study it again in the macro unit.
Key terms
- Inflation
- A continuing rise in the overall price level across an economy.
- Purchasing power
- The amount of goods and services your money can buy. Inflation reduces it.
- CPI (Consumer Price Index)
- A widely used inflation measure that follows the price of a typical basket of goods and services.
- Nominal return
- The stated percentage return before making any adjustment for inflation.
- Real return
- The return after inflation, which shows how much your purchasing power changed.
The return you see and the return you feel
A nominal return is the percentage shown on your account before inflation. A real return adjusts that number to show the change in purchasing power. For a quick estimate, subtract the inflation rate from the nominal return. If an investment earns 5 percent while inflation is 3 percent, its real return is about 2 percent. The account grew by 5 percent, but the amount of extra goods and services it can buy grew by only about 2 percent.
Adjust a return for inflation
Your investment gained 8 percent last year, and inflation was 5 percent. About how much did your purchasing power grow?
- Find the nominal return. The investment gained 8 percent before inflation.
- Take out inflation. Subtract 5 percent from 8 percent.
- Estimate the real return. The result is about 3 percent.
Why it matters: A large nominal return can leave you with a much smaller gain in purchasing power when inflation is high.
Find the real return
An investment returns 6 percent during a year when inflation is 4 percent. Using the quick estimate, what is its real return?
Real and nominal return (Khan Academy)
See how inflation changes a nominal return into a real return.
If your balance grows by 5 percent while prices rise by 5 percent, your purchasing power has not grown.
| Nominal return | Inflation rate | Approximate real return | Change in purchasing power |
|---|---|---|---|
| 8% | 2% | About 6% | Up |
| 8% | 8% | About 0% | About the same |
| 4% | 6% | About minus 2% | Down |
Did the account gain buying power?
Your savings account earns 3 percent this year, but prices rise by 6 percent. What happens to the real value of your money?
The approximate real return is 3 percent minus 6 percent, or minus 3 percent. The balance rose, but its purchasing power fell.Why cash can lose purchasing power
Cash usually earns very little, so holding too much of it for a long time can cost you purchasing power. Ten thousand dollars kept under a mattress will still be ten thousand dollars in ten years, but inflation means it will buy less. Investors accept some risk in stocks and bonds partly because they want a return that keeps up with inflation or beats it.
Inflation at both extremes
- Hyperinflation is a very fast, extreme rise in prices. It can destroy a currency and wipe out savings, as history has shown in places such as Weimar Germany and Zimbabwe.
- Deflation is a continuing fall in prices. Lower prices may sound helpful, but they can lead people to delay purchases and make an economic downturn worse.
Think about long term savings
Why could keeping all of your long term savings in a basic savings account be a problem? Answer in a couple of sentences and use the idea of real return.
Write an answer before comparing it with the model response.
Model answer
A basic savings account usually pays less than the inflation rate, so its real return can be negative. The account balance may never fall, but over many years it can buy less. Investments expected to beat inflation over the long run could protect and increase that purchasing power.
A stated return does not tell you how much ground you gained until you account for inflation. The next lesson returns to an earlier idea, liquidity, and asks how easily you can turn an asset into cash.