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WalletPrep worksheet · Investing

What is inflation, and how does it shrink your savings?

Name ____________________ Date __________

Key ideas

  1. Inflation means each dollar buys a little less. When prices rise 3% a year, the same groceries cost more every year, while cash in a drawer stays the same number.
  2. Divide by the price growth to find buying power. After 10 years at 3%, prices are 1.3439 times higher. $1,000 ÷ 1.3439 = $744 of today's buying power.
  3. Real return is your return minus inflation. Savings earning 4.5% while prices rise 3% grow your buying power by only about 1.5% a year.

Vocabulary

Inflation
The rise in prices over time, which means each dollar buys a little less each year.
Compound interest
Interest earned on both your original money and the interest it already earned, so growth speeds up over time.
Emergency fund
Cash set aside only for surprises like a job loss, a car repair or a medical bill. A common goal is 3 to 6 months of essential costs.
Stock
A small piece of ownership in a company. Its price rises and falls with how investors value the business.
Index fund
A mutual fund or ETF that tries to match a market index by holding the investments in it, rather than picking winners.
Diversification
Spreading your money across many investments so that one bad company or sector does less damage to the whole.

Work it out

Lena keeps $1,000 in an envelope for 10 years. Assume prices rise 3% every year, which is an assumption, since real inflation varies.

  1. Assumed inflation a year
  2. Years
  3. Cash in the envelope
  4. Buying power lost
  5. Buying power, in today's dollars
  6. Same groceries today
  7. Price rise over 10 years
  8. Same groceries in 10 years

Check yourself

  1. Prices rise 3% a year for 10 years. About how much does $1,000 in cash buy in today's dollars?

    • A. $700
    • B. $744
    • C. $970
    • D. $1,000

  2. Your savings earn 2% while inflation is 4%. What is your real return, roughly?

    • A. −2%
    • B. 2%
    • C. 6%

  3. Which US agency publishes the Consumer Price Index?

    • A. The IRS
    • B. The FDIC
    • C. The Bureau of Labor Statistics
    • D. The SEC

Your turn

Find the interest rate on your checking and savings accounts and compare it with the latest CPI inflation rate from the BLS. Move cash you don't need for bills into an insured high-yield savings account.

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Answer key

What is inflation, and how does it shrink your savings?

Work it out

  1. Assumed inflation a year3%
  2. Years10
  3. Cash in the envelope$1,000
  4. Buying power lost− $256
  5. Buying power, in today's dollars= $744
  6. Same groceries today$1,000
  7. Price rise over 10 years$344
  8. Same groceries in 10 years= $1,344
  1. Prices grow 3% a year, so after 10 years they are 1.03 multiplied by itself 10 times, which is 1.03^10 = 1.3439 times higher.
  2. Lena's $1,000 buys $1,000 ÷ 1.3439 = $744 of what it buys today. She lost $1,000 − $744 = $256 of buying power.
  3. Seen the other way, groceries that cost $1,000 today cost $1,000 × 1.3439 = $1,344 in 10 years.
  4. Had the cash earned 4.5% in savings, her real return would be about 4.5% − 3% = 1.5% a year (1.46% exactly).

Check yourself

  1. B. $744 $1,000 ÷ 1.03^10 = $1,000 ÷ 1.3439 = $744.
  2. A. −2% Real return is about the stated return minus inflation: 2% − 4% = −2%. Your buying power shrinks.
  3. C. The Bureau of Labor Statistics The Bureau of Labor Statistics collects prices and publishes the CPI each month.