Lesson 2.2 · 2 of 5 · Your money before the stock market
Inflation: how much cash at home loses each year, with examples
Inflation is the general rise in prices: the same money buys less and less. At 5% inflation a year, £10,000 kept at home will buy in 10 years what £6,139 buys today. You only really gain if your return beats inflation.
Terms in this lesson
- Inflation
- How much prices rose in a year: how much buying power your money lost.
- CPI
- The cost of a basket of goods and services, tracked month by month.
- Real interest rate
- What you really earn from interest, after taking off inflation.
- Compound interest
- You earn on your past earnings too, not just on the amount you started with.
Opening question
You have £10,000 in cash at home and prices rise 5% over a year. What do you have at the end of that year?
The amount in the envelope stays the same, but each pound buys less. Exactly: £10,000 ÷ 1.05 = £9,524 in the prices of a year earlier.
It does not matter if you get it wrong: trying first helps you remember.
What is inflation?
Definition
What is inflation?
The general rise in prices from one year to the next.
If a basket of shopping cost £100 last year and £105 this year, its price rose 5%. National statistics offices, such as the ONS in the UK and the Bureau of Labor Statistics in the US, track a large basket of goods and services and publish a consumer price index every month. Inflation is calculated from it.
Myth or fact?
“Inflation of 5% means every price has gone up by 5%.”
Myth. 5% is the average across the basket. Some prices rise far more, as energy and food did in 2022; others rise less or even fall. Your own inflation depends on what you buy.
What will £10,000 be worth in 10 years?
Inflation builds up year after year, like compound interest in reverse: each year you lose a percentage of an amount that has already shrunk.
Estimate
You keep £10,000 at home for 10 years and inflation is 5% a year. What will the money buy, in today’s prices? Give a range.
How sure are you?
About £6,139: £10,000 ÷ 1.05 to the power of 10. You have lost nearly 39% of your buying power without spending a penny.
Three lines start at £10,000 and fall over 20 years. With an example inflation rate of 3% a year, the money ends up buying what £5,537 buys today; with 5%, £3,769; with 8%, £2,145. The rates are examples, not actual inflation.
Real return: what you earn after inflation
Definition
What is the real return?
What you earn once inflation is taken off.
If a savings account pays 6% a year and inflation is 8%, you have more pounds, but they buy less. In short: real return is the return minus inflation. Exactly: (1 + return) ÷ (1 + inflation) - 1. For interest rates it is called the real interest rate.
Work it out
Your savings account pays 7% a year and inflation is 4%. Roughly what is your real return, in per cent?
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Create a free accountCheck yourself
Your savings account pays 3% a year and inflation is 5%. What is happening to your money?
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Create a free accountWhat would you do?
You have £20,000 you will not need for the next 10 years. At the moment it is in cash at home. What do you do?
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Create a free accountWhat you learned
- Inflation means the same money buys less and less, year after year.
- At 5% a year, £10,000 kept at home buys in 10 years what £6,139 buys today.
- Real return is the return minus inflation; you only gain if it is positive.
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Save your progress with a free accountLessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: UK CPI inflation in October 2022 (11.1%), Office for National Statistics; euro area in October 2022 (10.6%), Eurostat; US CPI in June 2022 (9.1%), US Bureau of Labor Statistics. The chart and calculations use constant inflation rates chosen as examples.