How inflation eats into your savings? 

The first question that arises is what do we mean by inflation?

Inflation is simply the increase in the price level of goods and services, for instance, food or clothing. In simple words, when we say inflation is 5% per annum, it means the prices of goods and services have increased by 5% over the previous year.

Who calculates inflation and how is it calculated?

In India, Ministry of Statistics and Programme Implementation (Government of India), calculates inflation every month considering the change in the basket prices of goods & services.

• Consumer Price Index (CPI):It measures the change in the price level of a basket of goods & services at the consumer level. CPI measures the increase in the price of products & services that you consume on a regular basis. It must be noted that it is CPI that is used to calculate the Dearness Allowance (DA) for government employees.
• Wholesale Price Index (WPI):WPI, on the other hand, measures the change in the prices of products at the wholesale level only, that is, before it is available to the retail consumers. It is index which affects the manufacturing.

In India, both CPI and WPI are calculated and used by different stakeholders but it is CPI which is used to calculate the retail inflation. Average consumers like us should look for change in CPI as it measures the price change in a basket of goods and services that retailers usually buy; like food material, appliances, education, medical aid, etc.

How inflation affects your money?

Inflation reduces the purchasing power of money, as the same amount of money will buy less of any product/service in the future, due to the rise in their prices. Let us understand this with an example:

Let’s say, ₹100 enabled you to buy 2 dozen eggs @₹50/dozen. Now, a year later, the egg costs ₹55/dozen. With the same ₹100, you can now buy only 1.8 dozen eggs.

As the price of eggs have increased due to inflation, the purchasing power of ₹100 has reduced. If your ₹100 is lying idle or is invested in an avenue offering return less than inflation rate, the worth of your ₹100 would reduce.

This explains that Money has Time Value and worth of R₹100 may not be the same a year from now. Now, a very important question that arises here is, are you able to beat inflation? Is the return on your investment (ROI) greater than current inflation rate?

Let us extend the above example in today’s scenario & understand how inflation will eat into your savings!

• CPI was recorded at 6.26% in July 2021.
• SBI Saving A/c rate 2.70% p.a.
• Real Rate of Return: 2.70% – 6.26% = (-) 3.56%

Considering the above example of time value of money, you can see that ₹100 lying in your SBI bank A/c will become 102.70 (@2.70%) after a year, but your expenses have risen to ₹106.26 (@6.26%), implying your purchasing power has reduced by (-) 3.56%.

So, your real rate of return (Nominal Rate – Inflation Rate) is (-) 3.56%.

You need to have a positive real rate of return to increase your saving and to maintain your standard of living.

Investing idle funds in assets that offer positive real return in the long run is the only way to beat inflation. But always remember to evaluate your risk capacity before investing, as preserving your capital is more important than the return you generate on your funds.