Activity 5(m)

Activity 5m: Where’s my purchasing power?

  1. On the face of it Ingrid should be happy with 5% interest (i.e. $100) given that inflation in Australia is relatively low (approximately 1%). This means that her real rate of return on her savings is 4%. 
  2. Ingrid is unlikely to be happy with a 5% rate of return if inflation was also running at 5% because it would mean that Ingrid’s $2000 investment is not growing at all in ‘real terms’. Over time, if her interest-rate and inflation stayed at the same level then her $2000 investment will have the same purchasing power in 10 years time than it does today. 
  3. If inflation were running at 10% then Ingrid would definitely be unhappy because for every year that she keeps her money in the bank earning only 5% it means that the purchasing power of her $2000 declines by 5% every year. In other words, the real value of her investment will be falling over time as she earns a negative rate of return on her investment.
  4. Angus is unhappy with a 3% increase in his wage because he grew accustomed to a 5% increase in previous years.
  5. It is likely that Angus would be content with a 3% increase in his wage if inflation fell to 3% (for example, from 5%) given that, in real terms, the purchasing power of his wage will have remained intact. In other words, his $103,000 should be able to buy the same basket of goods and services as the $100,000 he earned in the previous year.  [In fact, it is even possible that Angus will be happier with the 3% increase if inflation in previous years was running at more than 5%.]
  6. If inflation was less than 3%, then an increase in his wage by 3% will more than compensate for the increased cost of living and therefore result in an increase in his real wage. Angus is likely to be happy with this result as his $103,000 will effectively buy more goods and services than his $100,000 one year earlier.