How Inflation Diminishes Savings

Last Updated Dec 10, 2010 3:49 PM EST

Part five in a series with videos that teach older kids about money:

It's often said that inflation is the worst enemy of a fixed income. That's because each year that prices go up your fixed income buys less. Understanding how to incorporate inflation into saving and borrowing decisions is one of five core competencies needed to reach financial security, according to researchers at the Financial Literacy Center.

You can talk to your young teens and nearly adult kids about what things will cost in the future and why they need to keep earning and saving more just to maintain their lifestyle. But a simpler, proven approach is to show them this video:
Or invite them to read this narrative:

This is the story of how a very cute plaid shirt inspired Lisa to save more for the future. Lisa and Beth were shopping together when Beth spotted the shirt and knew it would look great on Lisa. But when Lisa saw it, she had a flashback to the 90s, the last time plaid shirts were trendy. The new shirt cost $50 and Lisa remembered paying $30 for similar shirts back then. So the word "inflation" popped into Lisa's head.
Inflation describes price increases over time. Lisa realized that not only do shirts that used to cost $30 now cost $50 but lots of things that used to be $30 are now $50. When inflation rises, the same number of dollars buys less. So the price of a shirt, and other things like haircuts and groceries, can go higher.
Let's say inflation increases at 4%. Something that costs $100 at the beginning of the year will cost $104 at the end of the year. Which doesn't seem like a big deal, until you consider that, on average, everything is going to cost a bit more. If your income doesn't increase, you can't buy as much as you used to because prices are higher. Even if you're making more money than you used to, it still might not be enough if your income didn't increase as much as the cost of what you normally buy.
When Lisa had her plaid shirt aha moment, she realized that prices are higher now than they used to be and they're probably going to be even higher in the future. Her friend Beth understood that part, too. But Beth could not figure out how a shirt could go all the way from $30 in the 90s to $50 now when it doesn't feel like the prices make such huge leaps from one year to the next.
Lisa explained that it's because the price increases build upon one another. Let's say inflation increases at 3% every year for 20 years. A $100 bag of groceries will cost $103 after one year. After 10 years, it will cost $134 dollars, and the 3% just keeps adding up to more and more money so that after 20 years your $100 bag of groceries costs $181. In other words, your $100 groceries cost almost double 20 years later.
Lisa knows that when she thinks about how much money she'll need for the future, she needs to consider how much more things will cost. Since her paycheck won't buy as much as it used to, she needs to start planning. And if she forgets about inflation, then wearing her cute new shirt will remind her.
Research shows that these simple devices -- a video or narrative (both prepared by the Financial Literacy Center) -- will have a lasting impact on the financial knowledge and behavior of young adults who view or read them.

Photo courtesy Flickr user rmgimages
More video and narratives to share with kids on MoneyWatch:

More on MoneyWatch:
  • Dan Kadlec

    Daniel J. Kadlec is an author and journalist whose work appears regularly in Time and Money magazines. He is the former editor of Time’s Generations section, which was written and edited for boomers. Kadlec came to Time from USA Today, where he was the creator and author of the daily column Street Talk, which anchored the newspaper's business coverage. He has co-written three books, including, most recently, With Purpose: Going from Success to Significance in Work and Life. He has won a New York Press Club award and a National Headliner Award for columns on the economy and investing.