Office Hours: Costs of Inflation

This wk: Learn how adjust for taxes and inflation to calculate the real rate of return on your savings.

Next wk: Back to Everyday Economics with Tyler Cowen on American Culture and Innovation!

Inflation can throw a kink in your savings plans. To accurately know your rate of return, you need to do a little more than calculate what you’ll receive off of the nominal interest rate.

First off, returns on savings are taxed. Depending on where you live in the world, you’ll need to take out some portion of your returns to pay taxes. For our example, we’ll use 33%.

If your nominal interest rate is 6% and you save $100, your return is $6 at the end of the year. Now we need to take out that third for taxes, which leaves you with $4.

So far, so good. But we still haven’t arrived at the real interest rate after taxes, which is the nominal interest rate minus inflation. If inflation has been at a fairly low 3%, that means that the real interest rate before taxes in this scenario is 3%.

To account for inflation, that’s another $3 out of your original $6 return.

We’re down to a $1 return off of your $100 investment, bringing your nominal interest rate of 6% to a real interest rate of 1%. Yikes! But it’s still a net positive.

What if the nominal interest rate is 12% and inflation is at a moderate 9%? You would actually lose money with real interest rate of -1%. Your $100 would be, at the end of the year, equivalent to $99 in real terms.

As inflation gets higher, you can expect your real interest rate to dip further into the negatives. It makes less sense to save money under high inflation. The rational action under this scenario is to go ahead and spend money as quickly as you get it. Sadly, this makes the problem even worse as an increased velocity of money also increases inflation.

[merrilsamshiju]

You simply deserve a lot more viewers and subscribers!!!

[Claudia-yddd]

The money you invested looses also the percentage of the inflation rate, that means the real value of your investment, in this example 100.- $ declines over time. In the first example minus 3 %. So the real value is 98.- $, because: 100.- $ - 3 % Inflation + 1 % real interest after taxes = 98 $.

[bbeaum]

The math is seems oversimplified to the point that the results are not close enough for it to be useful. If I'm not mistaken in my figures below, MRU risks rejection by serious new econ students. I hope they revise this or take it down.

3rd row example:

Invest $100 during "base year"
Tax rate: 33%
Nominal Interest rate: 90%

Interest Earned: $90
Earnings after 33% tax: $60

Total return of principal and interest: $100 + $60 = $160

Inflation: 87%
Index deflator: 100/187

Base year value of principal and interest after inflation: $160 * 100/187 = $85.56 base year value if invested

If we simply apply -27% as stated in the video we get: $100 * 73% = $73 - worse than the real outcome, and not really even close enough for this to be a useful analysis process.

Base year value of principal if NOT invested: $100 * 100/187 = $53.48

Major loss of value (monetary value theft) either way.

Let me know if I didn't do that right, or please take this video down. MRU is too good to make itself vulnerable to dismissal by potential econ world-changers with gross/useless oversimplifications.

[ahmedbusiness]

really explain excellent over and good

[Xamarin]

This video never prepares viewers for the practice questions about unexpected inflation! WTF?

[teresadalessio]

I KNOW?! not one mention about the cap an institution can charge on an adjustable rate mortgage [loan]? adjustable interest rates save borrowers tens and hundreds (think compound interest) over the life of their loan, and are subject to a cap on the interest the borrower is charged. to further assuage fears, the borrower doesnt need a variable rate, in which the mortgage can change in relation to the mentioned from month to month, thus they can have the same monthly payment regardless of the adjustable interest rates. fixed rates are insanely high and are, quite frankly, predatory. there are other safety nets and avenue to financial relief for borrowers like refinancing and/or short selling back to the bank or privately (the latter is when a borrower sells the property back to the bank for the original sale price they paid when a property's true market value has dropped below what the borrower paid, and the bank forgives the losses.)

[field-yetian]

Sorry but the calculation is problematic. Simply, if you calculate the fourth row, with the method from the lecture, you will get a nominal rate of 600% and real return of -297%. You CAN‘T lose 297% of your money!!! You can lose at most 100%, which is all of your money. Instead, the correct calculation is, for the fourth row, assuming you deposited 100 dollars, with the assumed interest rate and tax rate, you get 700 dollars back, on paper. However, with a 897% inflation rate, your 700 dollars have the purchasing power of 0.779 last year's dollars. So you had lost 99.22% of you money. It is sad, and scary, but it makes sense

[AloTecnologia]

Existe um lapso de tradução ( a tradução some durante o vídeo) neste vídeo para o idioma "Português Brasil" - mais o(s) mesmos trecho(s) estão normais em "Espanhol". Isto acontece em muitos vídeos do curso de Macroeconomia da MRU oferecido pela ENAP aos servidores públicos federais no Brasil.

[teresadalessio]

I HAVE TO STRESS HOW FIXED RATE [MORTGAGE] LOANS ARE PREDETORY; any person with knowledge of the interest rate cap [safeguard, ] the difference between the terms: adjustable and variable loans and how they're not mandatorily inclusive [one can have a fixed monthly mortgage rate (payment amount) OR a variable one, a monthly payment changing alongside the interest rate set by the fed] and basic knowledge of compound interest and the tens and hundred of thousands one saves on the life of the loan, and/or the number of years to pay the loan off.

[Xamarin]

This video was the WORST section of the MRU lessons I have ever seen.