When a Dollar Buys Less
A dollar will remain a dollar, while quietly becoming worth less. Imagine putting $100 in a drawer and returning ten years later. The $100 is still there. You haven’t lost a dollar – but you have lost purchasing power. Purchasing power refers to the goods and services that a given amount of money can buy. If something costs $100 today and prices rise 3% annually, it would cost roughly $134 after ten years. Your $100 hasn’t disappeared; what it can purchase has.
There are various ways to measure the value of money. Here we will discuss nominal value and real value. Nominal value is how many dollars you have. Real value is what those dollars can actually buy.
Inflation is a general rise in prices across an economy over time, resulting in each unit of currency purchasing less than it previously did. Inflation is not solely caused by companies raising prices nor by the government printing money – though these actions do impact the value associated with a currency. Contributing factors include increasing demand, rising costs, supply constraints, monetary and fiscal conditions, regulations, and expectations. Inflation often results from several factors rather than any single cause.
How Inflation Compounds Over Time
For example, at 3% annual inflation, something costing $100 today would cost approximately:
| Years | Price with 3% Inflation | Increase from today |
| 0 | $100 | – |
| 1 | $103 | 3% |
| 5 | $116 | 16% |
| 10 | $134 | 34% |
| 20 | $181 | 81% |
| 30 | $243 | 143% |
This numerical example illustrates how even modest annual price increases accumulate over time. The longer inflation persists, the greater the difference between the nominal value of money and what that money can purchase.
When Savings Fail to Keep Pace
Just as investment returns can compound over time, repeated increases in prices can compound the erosion of purchasing power. If you keep cash in a savings account that earns 1% interest annually, then over time the nominal value of your funds will increase. Nominal value may be increasing, while the real value is decreasing. In our hypothetical situation, since a 1% annual savings rate is less than a 3% annual inflation rate, the money in that account would purchase fewer goods and services over time.
When building out your personal portfolio, you should consider balancing your wealth between cash, savings, and investments based around your personal financial goals. Each of these categories serves a specific purpose and presents different risk and return profiles. The important takeaway here is that while one may assume that cash is the strongest and surest way to safeguard the value of your money, inflation is an invisible force that can slowly erode the purchasing power of savings.
Balancing Cash, Savings, and Investments
For simplicity, let’s divide an example portfolio into three practical categories: cash, savings, investments. Cash is readily accessible for immediate spending. Savings prioritize security and liquidity for near-term needs, ideally while earning interest. Investments offer the potential for long-term growth but involve greater risk and volatility. Financial literacy requires understanding how each of these serves a different purpose and allocating money according to your own needs, goals, and time horizon. Remember, money should be positioned according to its purpose.
Assuming a hypothetical 3% annual inflation rate, consider how different returns affect purchasing power:
- Cash earning 0% → purchasing power declines roughly 3% annually.
- Savings earning 3% → roughly maintains purchasing power (before taxes).
- Savings earning 4% → roughly 1% positive real return (before taxes).
- Investment earning 7% → roughly 4% real return (before taxes, with investment risk).
Interest earned on a savings account is generally more predictable and consistent than investment returns. Investment returns are less predictable and may fluctuate substantially, including the possibility of losses. Taxes also affect returns, but their implications extend beyond the scope of this article. This example demonstrates a useful approximation for understanding real returns: Real return ≈ nominal return − inflation
Why Inflation Affects Everyone Differently
Inflation does not affect everything equally. While a statistic may show 3% inflation, that does not inherently mean that all prices have risen exactly 3%. Housing, groceries, healthcare, transportation, and entertainment prices can fluctuate very differently from one another depending on what forces are causing the particular change. Inflation also impacts people differently depending on what they buy, what assets or income they have, or where they live. For this reason, a reported inflation rate should not be interpreted as the exact change in every individual’s cost of living.
Protecting Your Purchasing Power
Money behaves somewhat like water: it is a resource that needs somewhere to go. We need reservoirs for security, but leaving everything stagnant has a cost. Our task is not to keep every dollar constantly moving, but to build strong reservoirs to draw on in times of need while directing excess resources toward productive purposes. Cash reserves are not bad; emergency savings and short-term cash have important purposes. The argument here is against unproductive excess cash, not cash itself.
As an individual, begin by understanding what purpose your money serves. Maintain appropriate emergency savings, compare available savings rates, and consider whether the interest you earn is keeping pace with inflation. Money intended for longer-term goals can be invested according to your risk tolerance and time horizon. Periodically reconsider where your money is sitting, what it is earning, and what purpose it serves.
Do not confuse stability with preservation. Cash can appear perfectly still while its real value quietly diminishes. We cannot control the current, but we can decide how to build our reservoirs and where to direct the flow. The goal is not to fear inflation or avoid holding cash. It is to understand that doing nothing with money is still a financial decision.