Understanding the Impact of Inflation and Interest Rates on Money

Many individuals find themselves questioning how their money continues to grow when interest rates are consistently below the inflation rate. This phenomenon is often termed 'money illusion'. This article aims to demystify the relationship between interest rates, inflation, and the value of money over time, while also discussing the best practices in saving and investing.

Money Illusion

When your interest rate on a bank deposit is lower than the inflation rate, it can be detrimental to the purchasing power of your money. For instance, while the nominal amount on your bank statement may seem to be growing, the real value of the funds decreases over time. This occurs because the purchasing power of money diminishes with rising prices, resulting in a higher nominal value and a lower actual value. This concept is commonly referred to as 'money illusion.' It’s important to understand that when the inflation rate surpasses the interest rate, the effect is a net loss of value, regardless of any nominal growth in your bank balance.

A Path to Real Growth

The key to overcoming the 'money illusion' lies in diversified and strategic investment. Instead of relying solely on banks for your savings, consider other avenues such as real estate, capital markets, or prudent investments. These methods can provide a real growth in your financial wealth.

Safekeeping vs. Investing

While banks do offer a safe and secure place to keep your money, they are not the ideal investment option. The value of funds in a bank account gradually decreases over time due to inflation. However, it’s still a prudent idea to set aside money for emergencies. Once you’ve accumulated a significant amount of savings, the better option is to invest in index funds. Over the long term, index funds have a consistent track record of beating inflation and outperforming other investment types.

Online Banking and Inflation Rates

Some online banks and financial instruments can offer better returns on your savings than traditional banks, especially when the nominal interest rates are higher than the inflation rates. For instance, online savings accounts, open-ended money market funds, and mutual funds can provide returns on your cash savings of around 2.06% to 2.5%, which is higher than the US inflation rate. It is worth noting that inflation rates can vary significantly across different countries; in some cases, like Egypt, the interest rates on local currencies can be higher than 7%. In Ukraine, the situation was more favorable in recent years, with an interest rate of around 20% in 2018, while the inflation rate was around 8% in December 2018, indicating a positive interest rate compared to inflation.

Conclusion

In conclusion, while the nominal value of your money may grow in your bank account, it does so at a slower rate than the devaluation caused by inflation. To ensure that your money grows in real terms, it is essential to combine safekeeping with strategic investments. Consider various financial instruments like index funds, real estate, or capital markets to outpace inflation and maintain the purchasing power of your money. This approach can help you navigate the challenges posed by inflation and protect your financial well-being.

Final Thoughts

Inflation continues to chip away at the value of money over time, while interest rates in banks often fall short of beating inflation. However, by taking a diversified investment strategy and choosing the right financial instruments, you can counteract the effects of inflation and ensure that your wealth continues to grow in real terms.