Inflation and the real value of money
By Johannes Nieuwboer · 5 min read
Inflation is the general rise in prices over time. A little inflation is normal in healthy economies, but even modest rates quietly reduce what your savings can buy.
How inflation compounds
Inflation compounds just like interest. At 3% a year, something costing $100 today costs about $134 in 10 years and $181 in 20 years. Put the other way, $100 kept in cash for 20 years buys only about what $55 buys today.
Nominal vs. real returns
The nominal return is the percentage your savings grow. The real return subtracts inflation. A savings account paying 2% while inflation runs at 3% has a real return of about −1%: the balance grows, but its buying power shrinks.
The precise formula is real return = (1 + nominal) / (1 + inflation) − 1. For small rates simply subtracting gives a close approximation.
Adjusting historical prices
To compare a price from the past with today, multiply it by the cumulative inflation in between. Official consumer price indices (CPI), published by national statistics offices, are the standard source for these figures.
What it means for planning
When estimating how much you'll need in retirement, think in today's money and use a real (inflation-adjusted) return. Salary negotiations are similar: a 2% raise during 4% inflation is a cut in real terms.