Understanding Interest, Inflation, and Purchasing Power
Interest, Inflation, and Purchasing Power
Suppose Devon is an avid reader and buys only reusable tote bags. Devon deposits $3,000 into a savings account that pays an annual nominal interest rate of 5%. Assume this interest rate is fixed, and so it will not change over time. On the day she makes her deposit, suppose that a reusable tote bag has a price of $15.00. Initially, Devon's $3,000 deposit has a purchasing power of reusable tote bags:
Devon's $3,000 deposit has a purchasing power of 200 reusable tote bags initially.
To calculate the initial purchasing power of Devon's $3,000 deposit, we need to divide the deposit amount by the price of a reusable tote bag on the day of the deposit. So, $3,000 divided by $15.00 gives us 200 reusable tote bags.
Devon's deposit of $3,000 into a savings account with an annual nominal interest rate of 5% means that she will earn $150 in interest per year (calculated by multiplying the deposit amount by the interest rate). However, inflation can decrease the purchasing power of Devon's money over time, meaning that the number of reusable tote bags she can buy with her $3,000 may decrease. For example, if inflation is at 2% per year, the price of a reusable tote bag may increase by 2% each year.
This means that after one year, the price of a reusable tote bag would be $15.30. If Devon keeps her money in the savings account earning 5% interest, her account balance would be $3,150 ($3,000 deposit + $150 interest earned). However, the purchasing power of her money would have decreased because she can only buy 206 reusable tote bags with her $3,150 (calculated by dividing $3,150 by $15.30).
Inflation can continue to decrease the purchasing power of Devon's money over time. However, if the interest rate on her savings account is higher than the inflation rate, her money may still be growing in real terms (meaning its purchasing power is increasing). Therefore, it is important to consider inflation when making financial decisions, such as saving and investing.
Question:
How does inflation affect Devon's purchasing power over time?
Answer:
Inflation can decrease the purchasing power of Devon's money over time by causing the price of reusable tote bags to increase, thereby reducing the number of bags she can buy with her savings.