Conventional wisdom says, you build wealth by saving. Let us take a scenario, you decide to save Rs.100 every month for 1 year. So say you put Rs.100 into a safe place every month for 1 year.
Mathematically, you will be Rs. 1200 richer by the end of the year. That is if there is no inflation. But in the real world, you will have Rs.1200, but it will be worth a lot less. Say you have an annual inflation of 8%, your Rs.1200 is just worth, Rs. 1104. This can be confusing. You will have 12, Rs.100 notes in hand (at the end of the year), but it will actually purchase what Rs.1104 can purchase now. That is what makes inflation so hard to understand or visualize.
By definition, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Basically the value of money decreases over time due to inflation. There are a multitude of factors that may affect inflation or price rise, including supply/demand, credit availability etc. Since we now use notional currencies it is even more prevalent and dangerous for a wealth builder. Inflation is not bad, it is an indicator of growth. It is when inflation becomes very high that we start getting into problems. Negative inflation or deflation is a indicator of a weak or non-growing economy. So most central banks try to maintain inflation in a range that they think are suitable for that country (e.g. the reserve bank has a range of 4-6% as their target for inflation in India). Mostly emerging economies have a higher inflation than developed economies, as they are growing faster.
Inflation also has an direct impact on the interest rates that a bank will provide. In most cases interest rates for savings accounts are usually lower than and rates on Fixed Deposits/CDs may at least break even or be a little higher than the prevalent inflation. Central banks also use interest rates to contain inflation. Higher the interest rate, less money gets borrowed, so less products are purchased and so less the inflation.
So from a wealth building perspective, if you are to retain the wealth you have, you still need to at least beat inflation. So for you to have Rs.1200 (or rather the ability to purchase goods worth 1200 now after 1 year) in 1years time, you will actually have to save Rs.1296 (assuming the same 8% annual inflation).
So when you put money into a saving account that gives you 5% returns when your annual inflation is 8% is actually a money losing effort rather than saving. In this scenario, your actual interest rate is a negative 3%.
In 2008, inflation went as high as 13% in mid August and at the end of the year has decreased to around 6% due to slowing economic growth. India's average inflation (based on WPI, all commodities) over the past 12 years (till 2007) has been around 5.2%. You can use an average rate like this to plan your savings for the future. Assuming that this average inflation figure remains the same over the next 12 years, your money will have to earn a return of atleast 5.2% to be from losing its value.
The current savings account bank interest rate in India is around 3.5%. Thus any money you have in the savings account is losing money at the rate of almost 1.7% a year based on 12 year average inflation. Thus your savings account is actually a negative growth account.
This is one of the main reason that people find it difficult to build wealth, because they do not plan for inflation.
There is a very simple inflation calculator available here, that you can use to see how much you need to save to have x amount in a few years time.
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