Explain purchasing power and show what steady inflation does to a fixed sum over ten years.
If you ask your parents what a plate of chicken rice cost in their first year of work, the price they give will sound like it came from another country. Put a typical lunch from your university days next to what the same lunch costs today and the difference is smaller, but it is still there. The rice and the chicken are the same as before. What has changed is how much of them your dollars can pay for, so a savings account whose balance never drops can still leave you worse off.
Inflation is a general rise in prices across the economy over time. The word that matters most in that definition is "general". Durian going up in a poor season, or tickets for a popular act selling for high prices, are cases of one market getting more expensive, and neither counts as inflation. Inflation is when prices across most of the things people buy go up together, so a basket of the same items costs more this year than it did last year. The movement inside that basket is uneven: some items climb faster, some climb more slowly, and a few may even get cheaper. Suppose inflation for one year is 3% (an invented figure). A typical basket would then cost roughly 3% more at the end of the year than it did at the start.
Purchasing power is the amount of goods and services a sum of money can buy. It moves the opposite way to prices, so when prices go up, purchasing power goes down. Your bank balance is counted in dollars, which means inflation leaves that figure untouched. What shrinks is the amount of shopping that figure will cover.
Price rises build on each other. Each year's increase applies to prices that already went up the year before, which makes inflation compound. You can therefore reuse the compound interest formula from Lesson 2.1, "Simple interest pays on what you put in, compound pays on what you earned", with one change: the inflation rate goes where the interest rate would normally sit.
Take S$10,000 left in a drawer for 10 years while inflation runs at 3% a year (both figures invented for the example). Start with the yearly rate and the number of years. Add the rate to 1 and raise the result to the power of the years: 1.03 to the power of 10 comes to about 1.344. You can use this growth factor to answer two different questions.
The first question is what the same things will cost after 10 years. To find it, multiply the starting sum by the factor: S$10,000 x 1.344 gives about S$13,439. The second question is what your money will buy, measured in starting-year dollars. To find that, divide the starting sum by the factor: S$10,000 / 1.344 gives about S$7,441.
At 3% for ten years, then, the S$10,000 ends up buying what roughly S$7,441 bought at the start. You have lost about a quarter of its purchasing power without spending any of it.
Lesson 2.3, "Estimate doubling time in your head with the rule of 72", gave you a quick way to estimate doubling, and it works for prices as well. Divide 72 by the yearly inflation rate and you get roughly how many years it will take prices to double. With inflation at 3%, 72 / 3 = 24 years. If inflation held at 3%, a 30-year-old today would be paying twice today's prices by their mid-fifties.
Small differences in the yearly rate turn into large differences over a decade. With the same S$10,000 over the same ten years, three rates give these results (all example figures):
2% a year: the money buys what about S$8,203 bought at the start, and prices double in about 36 years. 3% a year: it buys what about S$7,441 bought at the start, and prices double in 24 years. 4% a year: it buys what about S$6,756 bought at the start, and prices double in about 18 years.
Before you settle on how much cash to keep for the long term, work out how quickly prices double. Keep in mind that the rate does not stay fixed. There have been long periods of low inflation and other periods when it ran higher, and no one knows for certain what next year's rate will be. The fixed rates used above illustrate how inflation works and are not a forecast.
Singapore's Consumer Price Index, or CPI, is published by the Department of Statistics. It follows the prices of a basket of goods and services that households buy. When the news reports the headline inflation rate, it means the change in the CPI over one year. The most recent numbers are on SingStat, the Department of Statistics website.
MAS publishes a second figure. It is called core inflation, and it excludes accommodation and private road transport. Most of the accommodation cost is imputed rent on owner-occupied homes. That is meant to reflect what it costs homeowners to use their housing, but it is not cash that most households pay out, because most households own their homes. Private road transport costs are heavily shaped by the government's policy framework for controlling road congestion. With them taken out, core inflation gives a clearer view of underlying price trends in the economy. Since there are two official numbers, check which one a news report is using. The course "How the economy hits your wallet: rates, inflation and cycles" comes back to headline CPI and core inflation and explains how MAS uses them.
Every official figure is an average. You will get a clearer sense of inflation from the prices you pay yourself. Most people can recall a handful of old prices quite well, such as a meal they ate every week, a monthly phone bill, a haircut, a cinema ticket or the taxi fare home.
Think back about ten years and pick some of those memories. Then set them against what the same things cost now.
Pick three things you bought ten years ago. Find or estimate what each costs today, and work out how much more you now pay.
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