Questions: Inflation and Purchasing Power

Question 1

Your savings account earns 2% annual interest. Inflation is running at 4% per year. What is happening to your real purchasing power?

• A. It is growing at 6% per year
• B. It is growing at 2% per year
• C. It is shrinking at 2% per year
• D. It is unchanged because your balance is increasing

Answer: (C)

Real return = nominal return − inflation rate = 2% − 4% = −2%. Even though your account balance is numerically increasing, each dollar buys less. After a year, your money buys 2% less in real goods than it did before — you are losing purchasing power despite earning interest.

Question 2

Getting a 5% salary raise when inflation is 5% is equivalent to receiving no raise at all in terms of purchasing power.

• T. True
• F. False

Answer: True

A raise equal to the inflation rate preserves your purchasing power but does not increase it. Your nominal salary is higher, but prices have risen by the same proportion, so the basket of goods you can afford is identical. This is why real wage growth (raise minus inflation) is the meaningful measure of whether workers are actually better off.

Question 3

Why does keeping large amounts of cash under a mattress hurt you financially over time, even though the cash itself is not being spent?

Model answer: Cash earns no interest, so inflation steadily erodes its purchasing power. Each year, the same bills can buy fewer goods as prices rise, making the real value of hoarded cash decline continuously.

Inflation compounds just like interest does — at 3% annual inflation, $1,000 in cash under a mattress has the purchasing power of only about $744 after ten years. Unlike a savings account (even a low-yield one), cash earns nothing to offset this erosion. This is why leaving large sums in cash is often described as a guaranteed way to slowly lose money in real terms.