Math: interest vs inflation

Tutoring math, interest and inflation do come up, though not often enough.  To all my financial readers:  hang on to your hats!

When I earlier talked about inflation and interest here, I mentioned the rule of thumb that, generally, interest hovers around 3% above inflation. A saver might believe they are protected by that three percent spread.

Assuming interest stays three percent above inflation, you are (more or less) protected while both inflation and interest are low. However, witness the outcome of the following scenario:

Example 1: You have $1000 in a savings account. Inflation is high: 16%. Interest, following the 3 percent rule, hangs at 19%. Calculate your balance at the end of the year, adjusted for inflation.

First, the interest:

Converting 19% to a decimal, you get 0.19, which you then multiply by the principal of $1000:

1000*0.19=190

Adding the interest at the end of the year, your $1000 becomes $1190.

Now, consider inflation:

To adjust for 16% inflation, your balance of $1190 is worth 84% of its nominal value. (100 – 16=84)

Convert 84% to its decimal of 0.84, then multiply it by your year end balance:

0.84*1190=999.60

Adjusted for inflation, your $1000 has become $999.60: you’ve lost value.

Where did the lost value go? After all, you didn’t withdraw it.

The answer is that the borrowers got it. In an environment of high inflation, value is gradually transferred from lenders to borrowers. The reason is that the borrower pays back the lender with money that is worth less and less.

Through the 70s, many people’s mortgage payments remained basically constant while prices ballooned. Specifically, for the people who didn’t need to refinance, the payment got smaller and smaller relative to the paycheque. For those lucky people, inflation picked up a lot of the tab.

Of course, such high interest and inflation rates are very hard to imagine today. People likely felt the same in 1965….

Jack of Oracle Tutoring by Jack and Diane, Campbell River, BC.

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