Inflation – The Killer of Savings

Inflation is a global phenomenon. Inflation is a word that scares the middle class working for fixed incomes. Inflation, as understood is a persistent rise in prices of goods and services. It erodes the purchasing power of money. As a consequence of inflation, fewer quantities of goods and services can be bought with the same amount of money.

Inflation may be on account of different factors like general economic condition in the country as well as in world as a whole, economic policies pursued by governments and such factors that are powerful enough to affect the financial situation in the country and the world as well.

Generally, inflation is not harmful, given your income keeps on growing along with it. It is indeed, warranted and is a healthy feature of a growing economy. Inflation ruthlessly impacts your living unless your income grows substantially more than proportionately with it. Thus, if you are a fixed income earner or your income increases at a rate below the rate of inflation, you face the bitter hardship because there is a drastic drop in purchasing power of your money.

Why does inflation erode your savings?
Banks calculate interest rates on savings on the basis of percentage change in inflation between two inflation index figures in a year. During the period of high inflation, savings accounts actually lose money, as money that is locked in them, loses its purchasing power over time.

How inflation affects your savings?
As interest rates on savings are inter-linked to inflation rates, a change in inflation rates causes a change in interest rates. If the rate of inflation is higher than the interest rates on savings, then money in savings accounts would lose its buying power as it cannot pay for the same goods and services that were bought earlier with the same amount of money, because prices are increasing with increase in inflation rate.

Understanding how inflation erodes wealth over time
During the period of hyperinflation – a situation wherein inflation grows at a pretty fast rate, prices of goods and services increase faster than the returns on your savings. Further, it erodes your income and wealth over time. This can be explained with a hypothetical example of living expenses of a household, (expenses incurred by the household in every month for purchasing groceries and FMCG products). Suppose the cost of all grocery and FMCG items together equals Rs.1,000.

This amount of money, that is, Rs.1,000 which is saved in bank can be used to get the basket of goods for now. Next year, the same amount of money earning an interest that is less than the inflation rate, cannot pay for this basket of items as the cost of getting these items would be more than the money saved in your bank. This is because the amount of money that is, Rs.1000 has lost its purchasing power considerably in the next year due to the low interest rates on savings.

Year Cash in Hand Amount in Bank (Interest Rate in Savings AC is Banks 4%) Cost of Basket of Goods (Assuming Inflation Rate is 10%) Decrease in Purchasing Power
Compared to Cash in Hand Compared to Cash in Bank
0 1000 1000 1000 0 0
1 1000 1040 1100 -100 -60
2 1000 1082 1200 -200 -118
3 1000 1124 1300 -300 -176
4 1000 1169 1400 -400 -231
5 1000 1216 1500 -500 -284

The above table shows that the amount of money Rs.1000, that is saved in the bank has increased to Rs.1040, but this amount is not enough to pay for the same basket of goods which costs Rs.1100 the next year.

Thus, over a period of time, the money that is saved would lose its buying power persistently with rise in prices of goods. During inflation, savings are the only liquidity in the short-run. They are safe but the returns on them are low. By this we can say that, inflation robs you of savings and erodes your wealth over time.

Barring a few exceptions, such as creeping inflation, inflation in general, impacts almost every section of the economy. The brunt is borne by the middle class, who include daily wage earners, pensioners, people with holding saving accounts with banks, weaker sections of society- all having fixed incomes. It erodes their financial capability.

You may want to read:
Inflation May Remain Sticky in 2012-13: RBI

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