Deepak Badri – Nov 25, 2024
Inflation — the rise in prices over time — is widely regarded as a key puzzle piece of an economy. The correct amount of inflation can be effective in the growth of an economy, but an excessive amount is detrimental.
But how does inflation affect savings and investment? The purchasing power (or real value) of money goes down as inflation increases. This relationship shows how the fluctuation of inflation changes how people save and spend their money.
Specifically, regarding savings, inflation is a big factor in determining what method of saving is best for optimal value. For example, the pros of keeping money in a low-interest savings account are that it is a safe place to store money and for it to grow at a small interest rate. However, with higher inflation rates, this could mean that the inflation rate could be higher than the nominal interest rate of the savings account. So, according to the CFI, the Fisher effect says this change would lead to the real interest rate (interest rate adjusted for inflation) being below 0%, so one would actually be losing money by using low-interest savings accounts. This would lead to money holders finding it in their best interests to save their money in various inflation-protected assets instead. Depending on the preferences, some choices would include gold or real estate.
On the other hand, for investments, people’s mindsets also change based on inflation. Their mindset — if looking to invest — should be based on real returns. So, like savings accounts, bonds are low interest rates, but safe options. However, the downside of both of these are that inflation erodes the value of the assets. Since both options come with fixed interest rates, money holders should look to invest in real assets because their value rises with prices. However, according to the Federal Reserve Board, inflation also creates uncertainty in capital investments and consumers’ personal investments, which must be taken into account.
Overall, inflation reshapes financial priorities for companies and people, emphasizing the protection of purchasing power under changing economic conditions. This is through the effect inflation has on various interest rates, which basically determines if how much saving and investing should be done and with which assets. In the end, moderate inflation is part of a healthy economy, but too much of it is bad for everybody.