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Saving enough is not enough – Effect of Inflation on Savings

This article talks about the time value of money and discusses the impact of inflation on savings.

You must have heard some elderly person saying “Hamare zamaane mein ghee 3 rupye kilo milta tha” (Translated, it means “In our young days, Ghee used to cost Rs. 3 per kilogram”).

Currently, it costs more than 30 times that much!

In general too, we observe that the prices of all goods and services keep increasing. Take anything – sugar, petrol, cost of postage – anything you take, you would see that its price has increased manifold over years.

This is Inflation that we always keep hearing about. And it can have a disastrous impact on your savings and investments. Reason enough to understand it better?

 

What is Inflation?

Inflation means reduction in the purchasing power of the currency. Simply put, it means that the same amount of currency would be able to get you less goods (and services) over time.

For example, say today, rice costs Rs. 20 per kg. After a year, its price goes up to Rs. 25 per kg. This means that its price has gone up by 25%, or that the inflation is 25%.

This means that for Rs. 100, you can buy 5 kilos of rice today. But after a year, you would be able to buy only 4 kilos of rice for the same amount.

Thus, the purchasing power of Rs. 100 has reduced, or, generally saying, the purchasing power of the currency has reduced. This is inflation.

(Note: In practice, inflation is derived from the price movements of a very large basket of goods and services. In the example, for simplicity’s sake, we considered only Rice).

This means that the value of a Rupee today is not the same as its value at a later time. This brings us to another interesting concept.

 

Time Value of Money

Through the example, we saw that the value of the Rupee keeps decreasing over time. The value is highest today, and becomes less and less as time goes by. Although the unit (the Rupee) remains the same, its purchasing power decreases over time due to inflation.

Therefore, you can not compare an amount today with an amount at a later date without considering the time.

Say you lend someone Rs. 1000 today, and he returns Rs. 1000 after a year. Are you at par? No – because the value of Rs. 1000 after a year is not the same as its value today. (You can invest the Rs. 1000 today at the rate of 7%, and can get Rs. 1070 after a year!)

 

How Inflation and Time Value of Money impacts your finances?

Now, we come to the crucial discussion!

The fact that inflation reduces the purchasing power of Rupees over time has very significant impact on your savings.

Suppose, a post graduate degree costs Rs. 2,00,000 today. You are planning for your daughter’s education, and want to save for it today when she is 10 years old. She would need the money after around 11 years.

How much should you plan to have at that time? Rs. 2,00,000? No! It is not enough to save that much, because this amount would have lost considerable purchasing power in all those years!

You would need to have a lot more at that time, because due to inflation, the same service (post graduate education) would cost a lot more at that time.

So, how much should you actually plan to have at that time? For finding that, we use the concept of compounding.

The article “Goal Based Investing” has a step-by-step explanation of how to save for a long term goal, taking into consideration the impact of inflation.

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