Why do our savings accounts lose value over time? It’s a question that seems simple to answer at first glance. After all, inflation is why your money loses purchasing power over time. However, it’s not quite so straightforward when you start looking at how inflation affects your finances and why it happens in the first place/
Inflation is the rise in prices for goods and services over time.
If you look at an item you purchased a year ago, it may have cost $100. But now it costs $102, meaning that it has experienced inflation of 2%. In contrast, if you purchased a similar good or service this year and it cost $101, then there was no inflation (0%).
The result is that your “real” purchasing power—what you could buy with your money—has declined. When inflation rises above zero percent, your money loses its ability to purchase as much as it used to. When inflation falls below zero percent (deflation), more goods and services are available relative to the value of each currency unit in existence.
Purchasing power refers to how much purchasing a person can do with a unit of currency.
It can be measured in two ways: as the value of goods and services one could purchase for that amount or the buying power of said money over time.
When you buy something with your hard-earned money, you expect to be able to use that same money when you need it or want it again. However, this does not always happen due to inflation. An increase in prices across all markets reduces purchasing power for everyone who owns cash and/or financial assets. No one can escape that cycle.
Calculating Inflation
The inflation rate is a good indicator of how much money you need to buy things. The higher it goes, the less buying power your money has.
The formula for calculating inflation is:
Inflation = ((Current Price Level – Previous Price Level)/ Previous Price Level) x 100
Many factors, including increased production costs and demand, money supply, and exchange rates, cause inflation.
As prices increase, the purchasing power of your dollar decreases.
For example, if you buy a steak dinner today at the same price as you did yesterday, but inflation has risen 1%, then the steak dinner will cost more tomorrow than today ($6 instead of $5).
The interest rate reflects one’s expected purchasing power over a certain period.
The interest rate is the cost of borrowing money. The market determines it, and it measures how much risk there is in lending you money.
For example, if you’re buying a house, you can get an adjustable-rate mortgage with a low initial interest rate but pay more over time because that rate may increase every year.
If one person makes more than another on their investments, they will have more purchasing power even though they both have the same amount of money in their bank account.
Inflation is the reason why your money loses purchasing power over time
Two components that lead to the decline in purchasing power are inflation and exchange rates.
Inflation occurs when there is an imbalance between the amount of money available, its velocity (how often a unit of currency changes hands), and its demand (how much people want to buy). The Federal Reserve controls inflation by printing more money or taking some out of circulation. However, they can only guess what will happen next, so their predictions are always flawed!
The other way your money loses value over time is through exchange rates. The value of one country’s currency relative to another country’s currency changes constantly based on supply and demand factors specific to those countries’ economies.
For example, suppose a lot more Americans than Canadians want US dollars than Canadian dollars (and vice versa). In that case, the price ratio between them will change. Eventually, it settles into an equilibrium where both currencies have about equal purchasing power for goods.
Conclusion
Inflation is a natural part of the economy, and it always will exist.
It is important, however, that we understand what causes inflation so we can avoid it or control its effects on our lives.