If you have ever heard an older relative say that a coffee or a train ticket used to cost a fraction of today's price, you already understand inflation. Inflation is the general increase in prices over time. It means that the same amount of money buys less in the future than it does today. For savers, this has important consequences. Here is how it works and how to protect your savings.
What is inflation and how is it measured?
Statistical agencies track the price of a "basket" of typical goods and services, such as food, housing, energy, transport and clothing, and publish a consumer price index (CPI). The percentage change in this index over twelve months is the inflation rate. Many central banks aim for a low and stable rate, often around 2% per year, although actual rates vary by country and period.
The effect over time
A few percent a year sounds harmless, but compounding makes it significant over the long term. The calculation is the same as compound interest:
- Future price = price today × (1 + inflation)years
- Purchasing power = amount today ÷ (1 + inflation)years
Example: At 3% inflation for 20 years, prices grow by a factor of about 1.81. Something that costs 1,000 today would cost about 1,806. Looked at the other way, 1,000 saved under a mattress would buy only what about 554 buys today. You lose nearly 45% of your purchasing power, even though the number on the banknotes has not changed.
Nominal vs real returns
The interest rate your bank advertises is the nominal rate. The real rate is what is left after inflation. A simple approximation is: real rate ≈ nominal rate − inflation.
- A savings account paying 4% when inflation is 3% gives a real return of about 1%.
- A savings account paying 1% when inflation is 3% gives a real return of about −2%; you are losing purchasing power each year.
Who is hurt and who benefits?
Savers holding cash at low interest and people on fixed incomes, such as certain pensions, are hurt most. Borrowers with fixed-rate loans can benefit, because they repay in money that is worth less than when they borrowed. Wage growth also matters: if your income rises faster than inflation, your living standard improves; if slower, it declines.
How to protect your money
- Keep only what you need in cash. Hold your emergency fund and short-term needs in an accessible account, and look for the best interest rate available.
- Compare rates with inflation. Shop for savings accounts and deposits that pay competitive interest, and review them regularly.
- Consider inflation-linked products. Some governments offer bonds whose value adjusts with inflation. Check availability and terms in your country.
- Invest for the long term. Historically, diversified investments in shares and property have tended to outpace inflation over long periods, but with ups and downs and no guarantees. Only invest money you will not need for several years.
- Increase your income. Negotiate raises, develop skills and look for opportunities, so your income keeps up with the cost of living.
- Manage your costs. Fix some large expenses when possible, such as a fixed-rate energy contract, and review recurring spending.
Plan with inflation in mind
When setting long-term goals such as retirement or a child's education, include inflation. If you need 2,000 per month in today's money in 25 years, at 2.5% inflation you will need about 3,700 per month in future money. Ignoring inflation leads to underestimating how much you need to save.
Use the calculator
Our Inflation Calculator shows what an amount will cost in the future and what your money will be worth in today's terms for any rate and number of years. The results are projections based on the rate you choose, not forecasts, and this article is general information rather than financial advice.