What is Inflation and the Importance of Earning Interest on Your Savings

Posted on Wednesday 04 December 2019

What is Inflation and the Importance of Earning Interest on Your Savings

If you aren’t a banker, investment broker, or someone who deals with financial topics on a daily basis, you probably don’t have a good grasp of inflation. There's really no problem here. Economies are nothing short of complicated and there are plenty of factors that contribute to inflation.

Understanding the ebb and flow of inflation is a key part of ensuring that your personal finances are set up for success. This is particularly true if you plan on setting up an interest-bearing savings account—but inflation is going to affect your finances one way or another, from your mortgage to your daily cup of coffee. Due to inflation, some people end up taking guaranteed payday loans, especially because payday loans are quick to process and you can get the funds you need to meet your demands.

But what is inflation? How does inflation impact your savings account? Can you still have a savings account and build your finances when inflation rates are rising? If you are looking for the answers to these questions, you’re in the right place. In the sections below, we’ll tell you everything you need to know about inflation and the importance of earning interest on your savings.

What is Inflation?

Inflation refers to the widespread rising or falling of prices of goods and services, such as a college education, a car, or a new haircut. Because inflation is connected to overall prices, that means that inflation is also what determines the purchasing power of your money.

Let’s say that, for the past ten years, you have gotten a haircut every two or three months (and really, hats off to you for being so dedicated to hair maintenance). Rising inflation means that the average price of your haircut has increased over time. Decreasing inflation means that, on average, you’re spending less.

Today, women are likely to pay around $43 for a haircut and men will pay about $28. Think about what you paid for a haircut ten years ago. Did you pay more or less? You may not have gone to the same stylist, but you likely have been paying a little bit more for the same service from one year to the next. Costs can increase (inflation) or decrease (deflation). There are three main reasons this could happen:

  • Demand-pull inflation: This happens when the demand for goods and services increases faster than what production can keep up with. Prices rise because the inherent value of those goods and services are in high demand and short supply. If everyone in town needs a haircut but there are only three salons, you can bet that they are going to start charging higher prices.
  • Cost-push inflation: In this scenario, production prices become higher, which means that the cost of goods and services increases to offset the cost of production. If the cost of hair products or chair rentals goes up, those hairdressers are going to have to raise their prices to turn a profit.
  • Regulation: Unlike most services, the cost that applies for a payday loan online has actually decreased year over year in Canada. This is a result of the government repeatedly applying new regulations on the industry.

As prices rise, each dollar can purchase less and less. $20 today won’t buy as much as $20 did ten years ago—and that right there is inflation in a nutshell. It may sound counterintuitive (who wants to pay more for the things they need?), but a little bit of steady inflation is a good thing. It points to a stable and growing economy.

Canada’s national inflation rate currently sits at about 2 percent, which means consumers are paying 2 percent more overall for goods and services each year. And 2 percent is the ideal rate of inflation, which means Canadian consumers are currently in good economic hands.

How Does Inflation Impact My Savings?

Inflation doesn’t just drive up your cost of living by making goods and services more expensive. It can have some serious implications for the health of your savings account over time—and more specifically, on the interest that you earn on that chunk of change.

Consider this example: Let’s say that you open up a savings account with a 1 percent interest rate and deposit $300. If you let that $300 sit in your savings account for a year, you’ll end up with $303.

But if the rate of inflation is at 2 percent, you would need to have $306 in your savings account in order to even out your purchasing power. Inflation rates are decreasing the overall value of each dollar, so you need to save more to make up for that ever-so-slight decrease in purchasing power.

Where this gets really tricky is in retirement planning, where many Canadians have accounts set up to generate interest as a means of passive income. Because the interest rates earned purely by savings can effectively be diminished by national inflation rates, that passive income isn’t going to have the same purchasing ability.

Even if you aren’t necessarily planning for retirement (here’s looking at you, world travelers and master vacation planners), safeguarding your savings amidst inflation is a good idea. After all, if you’re setting money aside for the long-term, there’s no reason why that money shouldn’t be working for you! Some people might even take their money and proceed to start a business.

How Do I Protect My Savings (And My Interest Along With It)?

Earning interest is key when it comes to savings, especially accounts that are designed for long-term benefits. As mentioned above, retirement savings are often designed to create passive income through interest alone. Instead of getting a paycheque, you get “paid” regularly into your savings account through the interest yield.

But if inflation is potentially devaluing the power of each dollar, how can you keep your savings healthy from one year to the next? There are a few ways to safeguard your savings—and interest—from steady changes in inflation:

Invest in the stock market

This is a risky move, but it’s often applauded as one of the best ways to grow your savings without worrying about inflation. Market returns will generally out-perform inflation rates over time, so investing a little bit of your savings in stocks can be a good move.

If you’re worried about the risk involved with investing in the market outright, you can always opt for a mutual fund. These are professionally managed and represent a collection of investments, like stocks, bonds, and other securities. Any changes in a mutual fund are backed by researchers and implemented by a team of managers—so your finances are in safe hands.

Look into an employer pension plan

This is another way to set your investments up for long-term success regardless of the inflation rate. Matching contributions with your employer into a pension plan could definitely increase the overall return from these accounts.

If you’re saving for retirement with a good employer pension plan already, you can rest assured that you are growing your retirement with a tried-and-true method of overcoming inflation. If you also have good debt, you can take a few payday loans to meet some of your expenses so that nothing affects your budget structure.

Put your money in a money market account

A money market account (MMA) is essentially a high-powered savings account. There are certain disadvantages that come along with an MMA, such as a higher minimum balance requirement or withdrawal restrictions, but the best advantage is that MMAs typically have a higher rate of return in terms of interest.

They are also offered by many banks and credit unions across the country, both in brick-and-mortar locations and online, so MMAs are easy to get. If you want to keep your savings in a more traditional account (but get an extra safeguard against inflation), a money market account is your best bet.

As individual consumers, we may not have control over inflation—but we can certainly take advantage of methods to protect our savings against the inevitable ebb and flow of the economy. Understanding the changing dynamics of inflation and how it impacts your savings can be a valuable starting point to ensure that your money is truly working for you from one decade to the next.