Question

Elaborate on the following statement: "Inflation also casts its evil eye upon savers". Give an example to make your point clear.

Short answer

Inflation refers to the rising prices of goods and services, causing the purchasing power of money to fall. Savers are negatively impacted when the inflation rate is higher than the interest earned on their savings, resulting in a decrease in their purchasing power. For example, if a saver has $1000 in a bank account with a 2% interest rate, and the inflation rate is 3%, after one year, their money grows to $1020, but the purchasing power has decreased to roughly $1030 due to inflation. Thus, inflation effectively acts as a 'hidden tax' on savers by eroding the value of their savings.

Step-by-step solution

Defining Inflation

Inflation refers to the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. To put it simply, inflation occurs when the money in our hands and banks, buys less than what it used to, typically measured as an annual percentage increase.

Understanding the Impact on Savers

When inflation is present in an economy, the value of money decreases over time. This implies that, for savers, the buying power of the money saved will decrease as the prices of goods and services in an economy increase. Consequently, if the inflation rate is higher than the interest gained on savings, savers will lose purchasing power, which negatively impacts them.

Giving an Example

To make it clearer, let's present a simple example: Assume a saver has \$1000 in a bank account that offers a 2% annual interest rate, and the inflation rate is 3% per year. After one year, the saver's money grows to \$1020 (due to the 2% interest), but the actual purchasing power of that money has decreased. To buy goods and services that cost \$1000 a year ago, one would now need roughly \$1030 because of the 3% inflation rate. As a result, instead of gaining, the saver actually has less purchasing power at the end of the year - the 'evil eye of inflation' causing the value of their savings to decline.

Concluding

In conclusion, inflation acts as a 'hidden tax' on savers by eroding the purchasing power of money saved, especially when the interest earned on savings is less than the rate of inflation. It's for this reason that the statement uses the term 'evil eye' referring to the negative impact of inflation on savers.

Key concepts

Purchasing Power

Purchasing power refers to the quantity of goods and services that can be bought with a unit of currency. When inflation occurs, purchasing power decreases because the same amount of money buys fewer goods and services.
In an ideal situation without inflation, you should be able to purchase the same items at the same prices. However, when inflation affects prices, you might find that you can’t afford as much—or anything at all—with the same amount of money.
For instance, if you had $100 last year and could buy a basket of groceries with it, but now the same basket costs $103 due to a 3% inflation rate, your $100 will no longer suffice. This reveals how inflation shrinks purchasing power, making it imperative to earn more or to find better returns on savings to maintain financial stability.

Interest Rates

Interest rates are the percentage charged on the total amount you borrow or save. They significantly influence the economy by affecting consumer spending and saving behaviors.
When saving money, the goal is often to accumulate more through interest. However, if the rate of inflation surpasses the interest rate on your savings, then you actually lose money in terms of real purchasing power.
Let's say you deposit funds in a savings account offering a 2% interest rate. If inflation is running at 3%, you earn less than the inflation rate. Though the nominal amount increases, the real value of your savings (after accounting for inflation) declines. Recognizing this interaction between interest rates and inflation is important for financial literacy and can inform better decision making regarding where and how you save your money.

Savings

Savings are that portion of your income that is not spent and kept aside for future needs or emergencies. It’s a safety net that can improve your financial security.
But inflation can erode the value of your savings if not adequately managed. With rising prices, the money you save might not retain its value over time unless it is invested or saved in accounts with interest rates outpacing inflation.
For example, even if you diligently save $1000 now, it may lose value by the time you actually need to use it. Investing in options that combat inflation, like inflation-indexed bonds or stocks, might offer better protection for your savings’ value. Understanding how inflation affects savings can motivate better financial strategies to safeguard against potential erosion of saved wealth.

Economy

The economy is a large system of production, distribution, and consumption of goods and services within a society. Change in elements such as inflation and interest rates heavily influence economic activities.
The rise in inflation can indicate a growing economy but may also predict an overheating economy, leading to the erosion of purchasing power. Both consumers and businesses must adapt to maintain economic stability.
Government policies often attempt to manage the economy by adjusting interest rates to control inflation. For example, higher interest rates could curb inflation by discouraging borrowing and spending, yet simultaneously encourage saving. Understanding these economic relationships is vital for making informed personal and business financial decisions.

Financial Literacy

Financial literacy involves having the knowledge and skills to effectively manage financial resources and make informed decisions. It encompasses understanding concepts like inflation, interest rates, and how they impact savings and purchasing power.
Improving your financial literacy can help you navigate economic challenges, plan for future needs, and protect your financial health. With insights into inflation and its effects, you can devise strategies to mitigate losing money under inflation.
For instance, learning about various saving and investing options can lead you to better protect and grow your assets against inflation's "evil eye." This enhances your ability to plan for both short-term needs and long-term goals. Aim to continually educate yourself about financial trends to optimize your decisions in an ever-changing economic landscape.