Inflation explanation

AllyT1232

My OH is trying to explain how £10,000 which has sat in a bank account for the last 10 years has lost money.  I'm trying to get my head around it.  I know the interest rate has crashed and become almost non-existent, but I can't understand how, even though the bank statement says I've now got more than the £10,000, my partner says it's worth less - could someone please explain this in very simple language? Hopefully yours

NottinghamKnight

Because of inflation, ie you can buy less than you could have done 10 years ago. If we take an inflation rate of 2% then over ten years the  money is 'worth' maybe £7,500 compared to what it was originally. 

AllyT1232

I think I kind of understand.  So how have I got more in the bank than £10,000?  Reversing what he's saying then, would I need to have put the money into something which paid more than 2% (in your example) to have really 'made' money?  Thank you

Albermarle

For the sake of making an example , lets say you had £10 ten years ago .
Now lets say you went to the supermarket ten years ago and bought two loaves of bread for £1 each ; a bottle of wine for £5; and a pizza for £3.
Now instead you put that £10 in the bank at 1 % interest rate and ten years later ( today ) you would have approx £11
But in the meantime inflation has been running at 3% pa , so when you go to the supermarket with your £11, you find that the bread is now £1.30 a loaf ; the wine is £6.50 and the pizza is nearly £4 - in total £13 . However you only have £11 so you have to put one or two of the items back because you can no longer afford them ,
Basically the money you have today has less buying power than it had ten years because the interest earned is less than the speed at which prices have risen .
The only to avoid this happening is to instead invest the money rather than leave it sitting in a low interest bank/savings account.

NedS

Try translating it into what it will buy you.

If 10 years ago you had £10,000 and your council tax bill was £1000/year, that £10,000 would buy you 10 years worth of council tax (or you could use gas, electricity bills, 20 cigarettes per day or whatever you actually spend your money on).

Now 10 years later, you may have £11,000 as you've received a small amount of interest over the years (yeah, your cash has gone up!). But your council tax bill is now £1450/year and your £11,000 now only buys you 7.5 years worth of council tax instead of the 10 years worth it did 10 years ago (oh dear, you've lost money!). You have lost 2.5 years worth of council tax, at £1450/year, or £3625 in total in today's money.

These are just fictitious examples to illustrate the point.

mclaren32

20 years ago £10,000 would have bought a brand new VW Golf, now it buys one that is 3 years old. That’s because £10,000 is worth less than it was.

You would have earned interest on your £10,000 and you might have £15,000 in your account, still not enough to buy a new VW Golf costing £20,000.

If you invested your £10,000 20 years ago it might not be worth £25,000 and you could buy a nice new BMW.

YellowStarling

AllyT1232 said:

Reversing what he's saying then, would I need to have put the money into something which paid more than 2% (in your example) to have really 'made' money?

In the example provided, yes.  To add: when the word "real" is used in the context of returns, etc. (i.e. the "real rate of return") this is usually referring to the 'absolute' rate of return you're expecting/advertised with inflation (or, indeed, deflation or other contributory or negating factors) taken into account.  For example, an anticipated 3% return in an anticipated 2% inflationary environment would be a 1% real return. 

Sometimes, such as in the case of your OH's argument/scenario, your real rate of return is negative (your £10,000 has grown in absolute terms, but inflation has chipped more than the size of this 'growth' away in terms of its purchasing power over time, as described in examples by posters above).

eskbanker

AllyT1232 said:

My OH is trying to explain how £10,000 which has sat in a bank account for the last 10 years has lost money.

Perhaps it would have been better if your OH had said (more accurately) that the £10K has lost value, in real terms, rather than losing money as such.  As with the above explanations, even if the £10K has become a higher absolute figure with interest, its buying power will have reduced if inflation has been higher than the interest it's earned.

Novice_investor101

The rather extreme way i use to describe it is:

In 1980, my dad bought a mid terrace house for £10,000. 

In 2013, i bought a mid terrace house for £100,000 & £10,000 was enough for a 10% deposit. 

In 2021, my house would now cost £140,000 & £10,000 isn’t enough for a 10% deposit anymore. 

House price inflation is extreme, but it gets the point across. 

Grumpy_chap

This calculator allows you to see how the value of things changed:
https://www.bankofengland.co.uk/monetary-policy/inflation/inflation-calculator

If you had £10k in 2009, that would be the same as having £13.5k in 2019.
The update that allows you to look at the period ending 2020 will be in the next few weeks (normally).

AllyT1232

Thank you all for your answers...you've helped me to understand it much better than my OH, but of course I won't tell him that!  Thanks againi