A savings account is a safe place to store money and gain a modest a return, but inflation can eat into your savings. Inflation causes the value of currency to fall over time, which makes your savings and any interest you receive, less valuable. Low inflation does not increase the actual dollar amount of interest a savings account pays, but low interest rates can result in earning a higher "real" interest rate.
Inflation is the rate at which prices in the economy are increasing. Inflation erodes the purchasing power of currency: the amount of goods and services you can buy with a given amount of money. For example, if you can buy a hamburger for $5 today but the price of a burger goes up to $6 next year, the dollar has lost purchasing power because you need more dollars to buy the same product.
Nominal Interest Rates
A nominal interest rate is the stated interest rate on an interest-bearing account, like a savings account or a debt. When a bank advertises that a savings account pays a certain annual percentage yield, the APY is the account's nominal interest rate. The nominal interest rate indicates the amount of interest an account pays in terms of dollars and does not account for inflation. As a result, low inflation does not change your account's APY or the number of dollars your bank credits to your account as interest.
Real Interest Rates
A real interest rate is a nominal interest rate adjusted for the effects of inflation. Real interest rates show the percentage change in purchasing power that results from earning interest. For example, if your savings account pays a 4 percent nominal rate but the inflation rate is 3 percent, the real interest rate on the account is 1 percent. This means the amount of goods and services you can buy with your account only increases by 1 percent each year, even though the total balance of the account increases by 4 percent. Low inflation results in higher real interest rates for given nominal interest rates. For instance, if the inflation rate is 0.5 percent and you still have a 4 percent APY on your savings account, your real interest rate is 3.5 percent.
Savings accounts tend to offer relatively low nominal interest rates, so real interest rates can potentially be negative. For example, if your saving account has a 1 percent APY and the inflation rate is 2 percent, your real interest rate is -1 percent. In this case, you actually lose purchasing power over time, even though the dollar balance of your account goes up each year. Investing in stocks, bonds and other assets with high potential returns can increase the chances of beating inflation and growing wealth.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.