Inflation: the silent tax
See why money kept still loses value, tell a nominal return from a real one, and work out what a rate of return is really worth in a year when prices move.
Inflation and purchasing power
Inflation is the rate at which prices in general rise. Purchasing power is the other side of the same coin: how much a fixed amount of money can actually buy. Money is a claim on goods, and inflation shrinks the claim while the number on the screen stays exactly where it was.
This is why "I have the same amount as last year" is not the same sentence as "I am where I was last year".
Prices rise 30% in a year
The same basket of things
last year 100
this year 100 x 1.30 = 130
Your 100, untouched in a drawer
what it buys 100 / 130 = 0.769 of the basket
power lost 1 - 0.769 = 0.231Prices +30% -> your money buys 23.1% less, not 30% lessThe two numbers are never the same, and the gap widens as the rate grows. At 100% inflation prices double and your money buys 50% less, not 100% less.
Check yourself
Prices where Sara lives rose 30% last year. She kept 5,000 in cash the whole year and says: "So I lost 30% of my money." Is she right?
- Yes, exactly: when prices go up by 30%, money you are holding is worth 30% less
- No, she lost nothing at all, because the 5,000 is still sitting there untouched
- Only if the things she personally buys went up by exactly 30% as well
- No: it buys about 23% less, since 5,000 / 1.30 is about 3,846 of last year's money
Show the answer
No: it buys about 23% less, since 5,000 / 1.30 is about 3,846 of last year's money
Right. Divide, don't subtract. Her 5,000 is worth about 3,846 in last year's prices, which is a loss of roughly 23%.
TWO RETURNS
Nominal and real
A nominal return is the change in the number: 100 became 125, so +25%. A real return is the change in what that money can buy once prices have moved. Only the real one tells you whether you are better off. From here on, every time a rate matters, ask which of the two it is.
Every advertised return you will ever see is nominal. Nobody puts a real return on a poster, because it is a smaller number and sometimes a negative one.
A one-year deposit paying 25%, in a year when prices rise 40%
Your money
start 100
end 100 x 1.25 = 125
The basket you were saving for
start 100
end 100 x 1.40 = 140
What your 125 now buys
125 / 140 = 0.893 of the basket
real return = 0.893 - 1Nominal return = +25%
Real return = -10.7%The statement grew by a quarter and you can buy about a tenth less than before. These rates are for illustration only; nothing here promises any return.
Check yourself
Omid's savings grew 25% last year while prices rose 40%. He is still better off than he was, because 25% is more than nothing.
Show the answer
False
Compare his growth with prices, not with zero. 1.25 divided by 1.40 is about 0.89, so his savings buy roughly 11% less than a year ago. Growth below inflation is a slower loss, not a gain.
Check yourself
Mina's salary rose 20% this year. Prices rose 35%, and her rent, food and transport all rose in line with them. What happened to her?
- She is 20% better off, because her income went up and her costs are covered
- She is 15% worse off, since 35 minus 20 is 15
- She can buy about 11% less than last year, because 1.20 / 1.35 is about 0.89
- Nothing really changed: income and prices both went up together
Show the answer
She can buy about 11% less than last year, because 1.20 / 1.35 is about 0.89
Yes. Divide rather than subtract: 1.20 / 1.35 = 0.889. A raise below inflation is a smaller pay cut, not a raise.
Not all cash is the same
Cash with a job
Your buffer from lesson 4, next month's rent, the money for a bill due in six weeks. This cash is not idle: being ready is its work. It loses a little value while it waits, and that loss is the price of being safe and reachable.
Cash with no job
Money that has sat in an account for years because no decision was ever made about it. It feels like the safe choice and it is shrinking every month. The difference between the two piles is not the account they are in. It is whether you decided.
Check yourself
Is this a nominal figure or a real one?
- "My salary went up 20% this year"
- "My savings grew 25% last year"
- "My income now covers two weeks less of my costs than it did"
- "The bank quotes 22% on a one-year deposit"
- "My net worth covers 9 months of my spending, down from 10"
Show the answer
Nominal: "My salary went up 20% this year", "My savings grew 25% last year", "The bank quotes 22% on a one-year deposit"
Real: "My income now covers two weeks less of my costs than it did", "My net worth covers 9 months of my spending, down from 10"
Living with inflation
- Ask of every rate you are shown: is this nominal or real? The advertised one is always nominal.
- Divide, don't subtract, when the numbers are large: (1 + growth) ÷ (1 + inflation) − 1.
- Your inflation is not the published average. If rent is a third of your spending and rent jumped 60%, the national figure does not describe your year.
- Measure progress in things, not numbers: months of spending covered, baskets you can buy, weeks of rent.
- Redo lesson 1's tracking and lesson 4's buffer target every few months. Where prices move, numbers go stale fast.
Check yourself
Match each one to what it actually means
Show the answer
- Nominal return → The change in the number
- Real return → The change in what the money buys
- +25% in a year when prices rose 40% → About 11% less buying power
- Cash held for years with no plan → A loss that never appears on a statement
- Prices rose 30% → Money kept still buys about 23% less
Lesson recap
- Inflation shrinks what your money can buy while the number on the screen stays the same.
- Prices up 30% means your money buys about 23% less. Divide by 1.30; don't subtract 30.
- Nominal is the change in the number. Real is the change in what it buys, and only real tells you if you gained.
- A 25% return in a 40% inflation year is a real return of about −10.7%: growth below inflation is a slower loss.
- Cash with a job earns its keep by being ready. Cash with no job is a decision nobody made.