Contracts-For-Difference.com > Features > How Inflation Destroys Your Spending Power

How Inflation Destroys Your Spending Power

The Ravages of Inflation
Written by Andy

Unveiling the Illusion: How Fixed Deposit Accounts May Fail to Preserve Your Wealth

Inflation is a persistent increase in the general level of prices for goods and services in an economy over time. When inflation occurs, the purchasing power of money decreases, meaning that the same amount of money can buy fewer goods and services. This reduction in purchasing power can have a detrimental effect on your spending power over time.

Let’s understand how inflation erodes your spending power. Suppose you have $1,000 today, and the inflation rate is 3% per year. After one year, the prices of goods and services will have increased by 3%. Therefore, the same basket of goods and services that cost $1,000 today will cost $1,030 next year. If your money is not growing at a rate that at least matches or exceeds the inflation rate, you will be able to buy fewer goods and services with your money in the future.

Fixed Deposit Accounts: Why a 5% Return Might Not Be Enough to Beat Inflation

Now, let’s consider the scenario of depositing your money in a 5% fixed deposit account. At first glance, a 5% interest rate might seem attractive because it offers a higher return compared to the inflation rate. However, it’s important to consider the after-tax return and the impact of inflation.

Fixed deposit accounts typically provide a nominal interest rate, which is the stated rate of return before accounting for taxes and inflation. In reality, the actual return you receive after accounting for taxes may be significantly lower. Additionally, if the inflation rate exceeds the interest rate, your real return (adjusted for inflation) could be negative, meaning your spending power is still being eroded.

Let’s illustrate this with an example. If you deposit $1,000 in a fixed deposit account with a 5% interest rate, you will earn $50 in interest over the course of a year. However, if the inflation rate is 6%, the purchasing power of your money will decrease by 6%, or $60. Even though you earned $50 in interest, the rising prices have offset your gains, resulting in a net loss of $10 in purchasing power.

It’s important to note that fixed deposit accounts are generally considered low-risk investments, as they offer a predictable return and are typically insured by the government up to a certain limit. However, they may not be the wisest investment choice if your goal is to preserve or grow your purchasing power over the long term.

In the 1960s my Dad had about £4k in his TSB (was Belfast Savings Bank then B.S.B.)….In those days the average house cost about £2.2k (garage included)…..so his £4k was roughly worth £500k in today’s terms! With interest and more than your 6% in the 1970’s he passed away in 2017 and his £4k had turned into £15k….he wasn’t a spender! My sister and I have spilt the £15k inheritance and funny enough it didn’t seem to be able to buy a house each…wheras in the 60s it would have! I bought a half sovereign in 1973 for £5 (I was on 25p an hour then so it’s equivalent is £10 per hour and £200 in today’s terms) ….’bout right! But my Dad’s money in the bank £15k wouldn’t buy a decent greenhouse…let alone two houses today!

To combat the negative effects of inflation, it’s often recommended to consider investments that have the potential to outpace inflation. Some options include investing in stocks, bonds, real estate, or diversified investment portfolios that are designed to provide a return that exceeds inflation over time. However, it’s important to remember that these investments come with varying levels of risk and should be chosen based on your financial goals, risk tolerance, and time horizon.

In summary, inflation gradually erodes the purchasing power of money, making it essential to consider investments that provide returns that outpace inflation. While fixed deposit accounts offer stability and lower risk, they may not be the wisest option if your aim is to preserve or grow your spending power over the long term. Diversifying your investments and seeking professional financial advice can help you develop a strategy that aligns with your financial goals and helps protect against the effects of inflation.

About the author

Andy

Leave a Comment

Open an A/C at Trade Nation! Trade Nation are a reputable broker offering tight and fixed spreads and many markets to trade. Trade responsibly: 78% of people lose money when trading CFDs with this broker. Click Here!