Inflation can throw a kink in your savings plans. To accurately know your rate of return, you need to do a little more than calculate what you’ll receive off of the
Inflation can throw a kink in your savings plans. To accurately know your rate of return, you need to do a little more than calculate what you’ll receive off of the nominal interest rate.
First off, returns on savings are taxed. Depending on where you live in the world, you’ll need to take out some portion of your returns to pay taxes. For our example, we’ll use 33%.
If your nominal interest rate is 6% and you save $100, your return is $6 at the end of the year. Now we need to take out that third for taxes, which leaves you with $4.
So far, so good. But we still haven’t arrived at the real interest rate after taxes, which is the nominal interest rate minus inflation. If inflation has been at a fairly low 3%, that means that the real interest rate before taxes in this scenario is 3%.
To account for inflation, that’s another $3 out of your original $6 return.
We’re down to a $1 return off of your $100 investment, bringing your nominal interest rate of 6% to a real interest rate of 1%. Yikes! But it’s still a net positive.
What if the nominal interest rate is 12% and inflation is at a moderate 9%? You would actually lose money with real interest rate of -1%. Your $100 would be, at the end of the year, equivalent to $99 in real terms.
As inflation gets higher, you can expect your real interest rate to dip further into the negatives. It makes less sense to save money under high inflation. The rational action under this scenario is to go ahead and spend money as quickly as you get it. Sadly, this makes the problem even worse as an increased velocity of money also increases inflation.
For refreshers on how inflation works and the quantity theory of money, check out these videos:
- Zimbabwe and Hyperinflation: Who Wants to Be a Trillionaire?
- Measuring Inflation
- Quantity Theory of Money
- Causes of Inflation
- Costs of Inflation: Price Confusion and Money Illusion
- Costs of Inflation: Financial Intermediation Failure
- Why Governments Create Inflation
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