Inflation - Understanding the Falling Value of Money
Inflation is the rate at which the general level of prices rises over time. When inflation is present, each unit of currency buys fewer goods and services than it did before. Understanding inflation is essential for anyone who saves, borrows, invests, or earns a wage – in other words, everyone.
What Causes Inflation?
- Demand-pull: Too much money chasing too few goods – high consumer demand pushes prices up.
- Cost-push: Rising production costs such as oil prices or wages are passed on to consumers.
- Monetary: When a government prints more money, the extra supply reduces each unit's purchasing power.
Measuring Inflation: The Consumer Price Index (CPI)
The CPI tracks the price of a representative basket of goods and services over time.
Inflation rate = [(CPI this year − CPI last year) ÷ CPI last year] × 100
If the CPI rises from 110 to 115.5, inflation = (5.5 / 110) × 100 = 5%.
Purchasing Power
Purchasing power is the quantity of goods your money can buy. Inflation erodes it.
Real value after t years = Nominal value ÷ (1 + inflation rate)t
If inflation is 4% per year, £1 000 today has the purchasing power of:
£1 000 ÷ (1.04)5 ≈ £822 in five years' time – even though the number on the note stays £1 000.
Real vs Nominal Values
Nominal value – the face value in current prices (what the number says).
Real value – the value adjusted for inflation (what the money actually buys).
Real interest rate ≈ Nominal interest rate − Inflation rate (Fisher approximation).
Example: 5% savings interest with 3% inflation gives a real return of approximately 2%.
Worked Examples
Inflation = [(126 − 120) / 120] × 100 = (6 / 120) × 100 = 5%.
Future cost = 85 × (1.03)10 = 85 × 1.3439 ≈ £114.23.
Real wage change ≈ 2% − 4% = −2%.
The worker is worse off in real terms – their purchasing power falls by approximately 2% despite the nominal pay rise.
Real return ≈ 2% − 5% = −3%.
The saver is losing purchasing power at 3% per year, even though the nominal balance grows.
Inflation and Investments
For an investment to preserve its purchasing power, it must grow at a rate above inflation. This is why investors seek returns higher than the current inflation rate. A 7% investment return with 3% inflation gives a real return of approximately 4% – genuine wealth growth.
Hyperinflation
Hyperinflation occurs when inflation exceeds 50% per month. Prices rise so rapidly that money loses its value almost immediately. Historical examples include Germany in the 1920s (prices doubling every few days), Zimbabwe in the 2000s, and Venezuela in the 2010s. Hyperinflation destroys savings and causes severe economic hardship.
Key Takeaways
- Inflation = [(CPI now − CPI before) / CPI before] × 100.
- Inflation erodes purchasing power: real value = nominal value / (1 + r)t.
- Real interest rate ≈ nominal rate − inflation rate.
- Investments must outpace inflation to deliver genuine returns.
Practice Questions
- The CPI rises from 105 to 110.25. Calculate the inflation rate.
- A house costs £200 000 today. If house prices inflate at 4% per year, what will it cost in 8 years?
- A salary is £25 000. Inflation is 6% and the salary rises by 3%. Calculate the real change in purchasing power.
- A savings account offers 1.5% interest and inflation is 4%. What is the real return, and how much purchasing power does £10 000 lose in 3 years?
- An investor earns 9% per year on their portfolio. Inflation averages 3.5%. What is the real annual return?