What inflation is, and how to find your real return

What inflation is, how it erodes purchasing power, and how to turn a nominal return into a real return with the exact and quick formulas.

Part of the Start Here: Money Basics track on Agenticks. About 9 minutes, written for a beginner reader.

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Key takeaways

Inflation is the rate at which prices in general rise over time. The Bank of England puts it simply: inflation is when prices rise, and how quickly they rise is the rate of inflation. If inflation is 2%, a basket of shopping that cost 100 a year ago costs about 102 today. In any single year that usually sounds small. The trouble is that it never stops, and it compounds. It quietly shrinks what money can buy, which is why a savings balance that never goes down can still leave you poorer, and why an investment return only means something once inflation has been taken out. This lesson explains how inflation is measured, what central banks aim for, and how to work out your real return: the growth in what your money can actually buy.

How inflation is measured Statistics agencies track the prices of a large basket of goods and services that households typically buy: food, rent, energy, transport, clothing, recreation and more. The change in the cost of that basket over a year is the headline inflation rate, reported through a consumer price index (CPI). Statistics Canada, the UK's Office for National Statistics and the US Bureau of Labor Statistics each publish one every month. The Bank of England notes that the UK basket covers about 700 items. Your own inflation rate can differ from the headline figure. A renter whose rent jumps feels more inflation than the index shows; someone who rarely drives feels less when fuel prices spike. The CPI is an average, and nobody is exactly average.

What central banks aim for Most central banks try to keep inflation low and steady rather than at zero. The Bank of Canada aims for the 2% midpoint of a 1% to 3% target range, measured by the total CPI. The Bank of England's target, set by the government, is 2%. The US Federal Reserve judges that inflation of 2% over the longer run is most consistent with its goals. A target is an aim, not a promise. Inflation in all three countries ran far above 2% in 2022, and it can run below target too. Even at a steady 2%, prices roughly double in about 35 years; at 3%, in about 23 years. That is the scale that matters for long-term money.

Purchasing power: what cash really loses Purchasing power is how much a sum of money can buy. When prices rise 3% a year, 1,000 kept in cash buys less each year, even though the number on the statement never changes. After ten years at 3% inflation, a basket that cost 1,000 costs about 1,344, so the original 1,000 now buys only about 74% of it. To put that in today's money, divide by 1.03 once for each year: 1,000 / 1.03 to the power of 10 is about 744. Interest helps, but only if it keeps up. Cash earning 1% a year grows to about 1,105 over the same ten years, which is still only about 822 in today's money.

A balance that never falls can still shrink

Inflation is why a number on a statement can stay the same, or even grow, while what it buys gets smaller. What matters is not how many units of money you hold, but what they can buy.

Nominal and real returns A nominal return is the percentage growth you see on a statement. A real return is that growth after inflation, so it measures the change in what your money can buy. The exact formula is: Real return = (1 + nominal return) / (1 + inflation) - 1 The quick approximation, which is close when both numbers are small, is: Real return ≈ nominal return - inflation For example, a 5% nominal return with 3% inflation gives an exact real return of 1.05 / 1.03 - 1 = 1.94%, against an approximate 2%. The exact figure is slightly lower because inflation also eats into the gains, not only the starting amount. The gap between the two methods widens when rates are high: at 10% nominal and 8% inflation, the shortcut says 2% while the exact answer is 1.85%. This link between nominal returns, real returns and inflation is a standard result in investment textbooks.

Worked example: 10,000 for one year with 3% inflation

Four places the same 10,000 could sit for one year, in any currency, while prices rise 3%. The rates are illustrative assumptions, not quotes for any real account or fund.

Cash earning 0% (real return 1.00 / 1.03 - 1 = -2.9%)10,000, worth about 9,709 today
Savings earning 4% (real return 1.04 / 1.03 - 1 = +1.0%)10,400, worth about 10,097 today
Investment up 7% that year (real return 1.07 / 1.03 - 1 = +3.9%)10,700, worth about 10,388 today
Investment down 10% that year (real return 0.90 / 1.03 - 1 = -12.6%)9,000, worth about 8,738 today
What decides itOnly returns above 3% increased what the money could buy

Illustrative one-year numbers. Investment returns vary from year to year and can be negative over long stretches as well as single years.

Why this matters for your plan Three practical consequences follow. Judge returns in real terms. A 6% return in a year of 6% inflation leaves your buying power exactly where it started. When you compare an account or a fund over time, ask what it did after inflation. Cash is safe from falls, not from inflation. Cash suits an emergency fund and money needed soon, because its value does not swing. Held for decades, cash that earns less than inflation loses buying power every year. Long-term money is where the trade-off between the swings of investing and the slow erosion of cash gets made, as risk and return explains. Know which kind of number a calculator gives you. If you enter a nominal rate, the result is in future money. Subtracting an inflation assumption from the rate first, for example entering 3% instead of 5%, gives a result in roughly today's money, which is easier to picture. The calculator in how to start investing works either way, as long as you know which one you are using. Inflation also explains part of why compounding over long periods matters: a return has to clear inflation before it builds any real wealth at all.

Buying power grew
Savings at 4%, inflation 2%, Investment up 8%, inflation 3%, Bond fund up 3%, inflation 1%
Buying power shrank
Savings at 1%, inflation 3%, Investment up 7%, inflation 9%, Cash at 0%, inflation 2%

You can see through inflation

You can now explain what inflation is and how it is measured, work out what cash loses in purchasing power, and turn any nominal return into a real return with the exact formula or the quick one.

Check your understanding

A nominal return is 6% and inflation is 4%. What is the exact real return?
About 1.92%. Right. 1.06 / 1.04 - 1 = 0.0192, or about 1.92%.
Prices rise 2% a year. Roughly how long until they double?
About 35 years. Yes. 1.02 multiplied by itself 35 times is about 2.
A savings account pays 1% and inflation is 3%. What is happening to the money's buying power?
It is shrinking by about 2% a year. Correct. The exact real return is 1.01 / 1.03 - 1, about -1.94% a year.
What does a consumer price index measure?
The change in the cost of a typical basket of goods and services. Exactly. Its yearly change is the headline inflation rate.

Common questions

What is inflation in simple terms?
Inflation is the rate at which prices in general rise. If inflation is 2%, a basket of shopping that cost 100 a year ago costs about 102 today, so the same money buys a little less.
What is the difference between a nominal and a real return?
A nominal return is the growth you see on a statement. A real return is that growth after inflation is taken out, so it measures the change in what your money can actually buy.
How do you calculate a real return?
Exactly: real return = (1 + nominal return) / (1 + inflation) - 1. As a shortcut, subtract inflation from the nominal return. For 5% nominal and 3% inflation, the exact answer is about 1.94% and the shortcut gives 2%.
Does cash lose value to inflation?
The balance does not fall, but what it can buy does whenever the interest earned is below inflation. At 3% inflation, 1,000 earning nothing for ten years buys about what 744 buys today.

Terms defined in this lesson

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Agenticks Learn is general education. It is not financial, investment, tax or legal advice, it does not take your situation into account, and nothing on it is a recommendation to buy, sell or hold any security or to open any account. Examples use illustrative numbers. Investing involves risk, including losing money you put in, and past performance does not predict future results. Tax rules and limits change; the official sources linked in each lesson are the final word.