If interest rates are at a level of 1% and expected inflation is 2%, would you prefer saving or spending your money?

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Mathematics

Kai Elliott

19 November, 21:19

If interest rates are at a level of 1% and expected inflation is 2%, would you prefer saving or spending your money?

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Amirah Nash · Answer 1

If interest rates are at a level of 1% and expected inflation is 2%, it would be preferable to spend your money instead of saving it.

Suppose you have $100 and you save it in a savings account that pays a 1% interest rate. After a year, you will have $101 in your account.

During this period, if inflation runs 2%, you would have to have $102 to make up for the impact of higher prices.

Since you will only have $101 in your account, you have actually lost some purchasing power.

If your savings don’t grow to reflect this rise in prices over time, the effect will be as though you are actually losing money.

This means that if you have $100 which you can use to buy a TV set, and you saved the money instead is a savings account that pays 1% interest.

After 1 year, because of inflation of 2%, the TV set now costs $102 whereas the money in your bang account wil be $101.

Thus, you actually need to get an extra $1 from somewhere to fund the TV set you could have been able to buy a year ago.