The Effect of Inflation on Rate of Return

Inflation is the devaluation of a currency. The dollar may devalue for many reasons, including an increase in the money supply because of lower interest rates or because countries sell off their dollar reserves. The noticeable effect of inflation is a rise in prices; the same dollar that could buy two bananas a week ago may now only be able to buy one. However, inflation is not always bad; low interest rates that sometimes correspond with inflation allow businesses easier access to credit, which may stimulate the economy. The level of inflation varies depending on economic conditions. James D. Gwartney, author of "Economics: Private and Public Choice," explains inflation from 1956 to 1965 was just 1.6 percent, but it skyrocketed to an annual rate of 9.2 percent from 1973 to 1981. From 1983 through 2006, inflation was 3.1 percent.

The rate of return is the expected or desired amount of money a person receives from an investment in a savings account, mutual fund or bond. The rate of return is expressed as a percentage: Thus, if you invest $100 in a savings account with a guaranteed yearly compound 3 percent rate of return, your investment will be worth $134 in 10 years.

Inflation has the power to erode a person's annual rate of return. When the annual inflation rate exceeds the rate of return, the consumer loses money when they invest it because of the decline in purchasing power. For instance, when hyperinflation ravaged countries such as Germany after WWI and Brazil in the 1980s, people with money in low interest-bearing savings accounts lost significant amounts of money. In cases of high inflation, people should spend money in the present to avoid having the money be worth less in the future. On the other hand, people have an incentive to invest money when their investment yields a greater return than the rate of inflation.

Knowing when to save money or spend it is difficult due to the unpredictability of the economy. No single party can control the rate of inflation, though some parties and institutions may try to control it through various actions and policies. For instance, the Federal Reserve may raise nominal interest rates to offset inflation concerns. When financial institutions expect a rise in inflation, they may offer higher interest rates to persuade investors to place money in their accounts. Thus, banks typically try to offer a rate of return on-par with the expected rate of inflation. If the interest generated from an investment is not guaranteed or otherwise unknown, as is the case with stocks and mutual funds, the investor may earn more or less than the expected rate of inflation.