Inflation, Purchasing Power,

and the Fed

Lecture 6
Rising prices
When I was your age, my hard-
earned nickel would buy me a
trolley ride down town, a ticket to
the cinema, and enough ice
cream to split with a friend!

In most modern economies, prices

tend to rise over time. This
phenomenon is known as inflation
and an introduction to the effects it
has on the consumer will be the
subject of this part of the lecture.
Inflation
It’s important to understand not only what inflation is,
but what it isn’t.
Ÿ Inflation is a technical term used by economists to describe
the increase in the price level over time.

Ÿ It does not make sense to talk about inflation in the price of a

single, specific good, as we buy many goods.

Ÿ While, over any given time period, the prices of some goods
may rise, and others may fall, inflation describes the changes
in the average price. If, on average, prices are increasing,
inflation is positive. If, on average, prices are decreasing,
inflation is negative (this is known as deflation).
Measuring Inflation
The Consumer Price Index
For one measure of inflation, the US government publishes the
Consumer Price Index (CPI). To compute the CPI, the Bureau of
Labor Statistics tracks the prices of a large basket of representative
goods and computes the weighted average of the prices. This average
is then indexed to some base year.
Consumer Price Index (Jan. 2000 = 100)
145

140

135

130

125

120

115

110

105

100
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20

Source: Federal Reserve of Saint Louis Economic Data (FRED)

The Consumer Price Index
Because the level of the CPI measures the level of prices,
changes in the level of the CPI can be used to estimate inflation.
Ex. In Country X, in December 2000, the CPI index was at 174.6 ; in
December 2001, it was at 177.4; and in December 2005, it was at 198.1.
What was the annual rate of inflation between December 2000 and
2001? What was it between December 2000 and 2005?

Ans. To compute inflation, compute the annual growth rate in the level
of the CPI. Between December 2000 and 2001, inflation was:

177.4
!= − 1 = 1.6%
174.6

Between December 2000 and 2005, average annual inflation was:

,
198.1 -
!= − 1 = 2.6%
174.6
The Consumer Price Index in the US
The chart below shows annual inflation rates from 1948 to 2016:
Immediately following World War II, inflation was very volatile; the late
1970’s was characterized by runaway inflation; and recently inflation
has been low and stable around 2-3%, with a short period of deflation
following the 2008 financial crises.
CPI Inflation (Y/Y)
15.0%

12.5%

10.0%

7.5%

5.0%

2.5%

0.0%

-2.5%

-5.0%
48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20

Source: Federal Reserve of Saint Louis Economic Data (FRED)

Core CPI
Some market observers pay more attention to core CPI. The core CPI
is similar to the CPI, but it excludes food and energy prices. Because
food and energy prices are highly volatile, core CPI inflation is less
volatile than CPI inflation. (Note that the Federal Reserve traditionally
monitors core inflation.)
Core CPI
CPI Inflation Core CPI Inflation
16.0%

14.0%

12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%

-2.0%

-4.0%
48
50
52
54
56
58
60
62
64
66
68
70
72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
10
12
14
16
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
20
20
20
Source: Federal Reserve of Saint Louis Economic Data (FRED)
Core CPI
Although core CPI excludes food and energy prices, long-term changes
in the price level are similar whether measured with CPI or core CPI.
Note that the CPI prices increase slightly more in the late 1970s (oil price
shock) and in the 2000s (commodities boom and higher fuel costs).
CPI (Jan. 2000 = 100)
CPI Core CPI

160

140

120

100

80

60

40

20

0
58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20

Source: Federal Reserve of Saint Louis Economic Data (FRED)

Inflation and purchasing power
The most obvious effect of inflation is that it reduces the
purchasing power of a dollar over time.
Ex. Today, a consumer spends an average of $150 per week on
groceries for his family. If the inflation rate is 3% (per year), how much
will it cost this consumer to purchase the same amount of groceries in 5
years?

Ans. Because prices are increasing by 3% per year, after five years,
$150 worth of groceries today will cost:

$150 ∗ 1.03( = $173.89

(Note that this assumes that the price of groceries changes with the
average price level. Of course, the change in the price of groceries
might differ from inflation due to supply and demand factors for
groceries.)
Inflation and purchasing power
When there is inflation, as time passes, it costs more
money to purchase the same amount of goods.

In general, the future price of a basket of goods can be

found using the following formula:

!" = !$ 1 + ' "

Where P0 is the price of the goods today, i is the

inflation rate, T is the number of years that pass, and PT
is the price of the basket of goods T years in the future.
Inflation and purchasing power
As a corollary, as time passes, the same amount of
money will buy less goods.
Ex. If the inflation rate is 3% and the consumer described above continues to
spend $150 per week on groceries, in five years will he be able to purchase
more, less, or the same amount of groceries each week?

Ans. Because groceries are now more expensive, the consumer is not able to
afford the same amount of groceries with the same amount of spending, and so
he can only purchase less groceries per week with the same $150.

Using the inflation formula, we can see that:

"
!$ 1 1
!" = !$ 1 + ' → = " = , = 0.86
!" 1+' 1.03

So, the same $150 in five years will buy 14% less groceries in five years.
Inflation and purchasing power
The more time passes, the further inflation erodes the
purchasing power of a dollar:

Future Purchasing Power of $100 with 3% Inflation

$100

$86.26

$80 $74.41

$60

$40

$22.81
$20

$5.20

$0
0 1 2 3 4 5 .. 10 … 50 … 100

Years from Today

Holding cash
Inflation is a tax on cash
Ÿ Holding cash over time is costly: the value of cash will
decrease overtime

Ÿ Cash is not a “secure” investment, there is an inflation risk

Ÿ Cash cannot be “indexed” to inflation; when there is

inflation, the return to cash is negative
Nominal and Real Prices
Real versus nominal prices
To control for the effects of the changing purchasing
power of the dollar on prices over time, economists
distinguish between real and nominal prices.

Ÿ The nominal price of a good is the actual number of dollars

that good costs (i.e., the sticker price). Because of inflation,
this will change over time.

Ÿ The real price of a good is adjusted for inflation, and is

indexed to the value of a dollar at some specified point in
time. The real price of a good will not change with inflation
(but may change due to supply and demand for that good).

The distinction between nominal and real prices is more

easily demonstrated using an example…
Real versus nominal prices
Ex. A business man buys a new suit of the same brand and style every
five years. In 1995, this suit cost the business man $400. In 2000, it
cost him $440. In 2005, it cost him $525. Inflation has been steady at
2% each year over this time period. What is the nominal and real price
of this suit in 1995, 2000, and 2005?

Ans. The nominal price of the suit is simply the sticker price and was
$400, $440, and $525 in 1995, 2000, and 2005, respectively. The
nominal price of the suit increased over this time period.

The real price of the suit can be found by adjusting the prices for
inflation in terms of some index year. Taking the index year to be 1995,
the suit in 2000 still cost the business man about $400 in 1995 dollars:

!"#$%&''' $440
!"#$%&''',$*++, = &'''0*++,
= ,
= $399
1+# 1.02

Thus, the real price of the suit did not increase between 1995 and 2000.
Real versus nominal prices
Ans. (continued)

Again taking the index year to be 1995, the suit in 2005 cost the
business man $431 in 1995 dollars:

!"#$%&''( $525
!"#$%&''(,$+,,( = &''(0+,,(
= +'
= $431
1+# 1.02

Thus, the real price of the suit increased between 1995 and 2005.

In other words, the price of the suit increased at a rate faster than
inflation over this time period. The rate of in the price of the suit over
those ten years was about 2.8%:

+
$525 +'
− 1 = 2.8%
$400
Real versus nominal prices
So while the nominal value of $100 may stay the same,
its real value declines with inflation:

Real vs. Nominal Value of $100 with 3% Inflation

Nominal Value Real Value

$100

$80

$60

$40

$20

$0
0 10 20 30 40 50 60 70 80 90 100

Years from Today

Inflation and Wages
Inflation and wages
When I was your age, it
took me a full day’s work
to mow three lawns and
paint one side of a fence,
and all I got was a
quarter!

Prices may increase over time, but so do wages. So

while inflation may reduce the purchasing power of a
dollar over time, the purchasing power of a day’s work
may not be effected…
Inflation and wages
Ex. Today, a consumer earns a salary of $65,000 per year and spends
an average of $150 per week, or $7,800 per year, on groceries for his
family. What proportion of his budget is spent on groceries per each
week? If inflation is 3% per year and the consumer’s income raises by
the same 3% per year, how much of his weekly budget will be spent on
groceries in 5 years? What if his salary does not rise at all?

Ans. Today, groceries take up 12% of the consumer’s annual budget:

$7,800
= 12%
$65,000

If both the price of groceries and his wages increase by the same
amount over the next 5 years, groceries will continue to cost 12% of his
annual income:
$7,800 ∗ 1.03/
/
= 12%
$65,000 ∗ 1.03
Inflation and wages
Ans. (continued)

However, if his salary increases less rapidly than the price of groceries,
groceries will cost a larger share of his annual budget. If his salary does
not increase at all, groceries will cost 13.9% of his annual budget:

$7,800 ∗ 1.03*
= 13.9%
$65,000

Because the price of groceries, in this example, increased at the rate of

inflation, the real cost of groceries did not increase at all. In the first
case, the consumer’s real wages were also constant, and so groceries
were no more or less expensive to him.

In the second, the consumer’s real wages declined, and so groceries

became more expensive; but, in real terms, this was not because the
price of groceries went up, but because his salary went down…
Real wages
Generally, wages increase over time, and often do so more
rapidly than inflation. As a result, real wages tend to increase
over time (because of improved productivity), though there are
periods of time where this is not the case…
U.S. Real Median Household Income
$60,000

$58,000

$56,000

$54,000

$53,657
$52,000

$50,000

$48,665
$48,000

$46,000

$44,000
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Source: Federal Reserve of Saint Louis Economic Data (FRED)

Inflation and Savings
Inflation and wealth
While incomes may not be effected by inflation in the long-run,
wealth is. If wealth is stored in cash, its purchasing power is
reduced with the purchasing power of the dollar…

Ex. In 1973, when Bob graduated from high school, his grandfather,
who lost all of his boyhood savings from a bank failure during the Great
Depression, gave him $500 dollars in cash with strict instructions to
keep it safely hidden under his mattress. Bob obliged and kept the cash
safely stored under his mattress, including through the highly inflationary
period through the 1970’s. It’s 40 years later in 2013, and inflation
has averaged 4.3% annually since Bob received the $500 in 1973. By
how much was the purchasing power of the gift reduced over the 40
years? How much was it originally worth in real terms (indexed to 2013
dollars)?
Inflation and wealth
Ans.

At 4.3% inflation per year over 40 years, the purchasing power of a

dollar will be reduced a lot:

"
!$ 1 1
!" = !$ 1 + ' → = "
= -$
= 0.186
!" 1+' 1.043

In other words, the real value of the $500 gift was reduced by 81.4%!

In 2013 terms, the gift was originally worth $500/0.186 = $2,688. That
is, it could buy as much in 1973 as $2,688 can buy today. Now, it can
only purchase a fraction of that amount…
This is one reason why it’s a bad idea to keep your money stored
under your mattress. Not only will you forego the interest you
would earn if you kept it in a bank account or more productive
investments, but you will allow inflation to eat away at its value…
Inflation and savings
Even if your savings earn interest, however, inflation will
reduce the gains in purchasing power that you would
otherwise realize.

Ex. Bob, realizing the error of his ways, gave his own son, Bobby,
$10,000 with specific instructions to invest them in high-yielding stock
mutual funds.

During the first year, the mutual fund returned 12%. Over the first ten
years, it yielded an average annual return of 10%. Inflation was a
constant and stable 2% per year over those ten years.

By how much did the real value of Bobby’s $10,000 increase after the
first year? At what rate did the real value increase over the first 10
years?
Inflation and savings
Ans.

After the first year, Bobby’s $10,000 will earn 12% and increase to:

$10,000 ∗ 1.12 = $11,200

However, after adjusting for the 2% inflation, the real value only
increased to:

$11,200
= $10,980
1.02

In other words, in real terms, the value only increased by:

$10,980
− 1 = 9.8%
$10,000
Inflation and savings
Ans. (continued)
After the first ten years, the nominal value of Bobby’s account will increase to:

$10,000 ∗ 1.10'( = $25,937

But, the real value only increased to:

$25,937
= $21,277
1.02'(

This implies real growth of:

'
$21,277 '(
− 1 = 7.84%
$10,000

In other words, the purchasing power of Bobby’s mutual fund investment

increased by 7.8% per year. This is 2.2% less than the nominal return of 10%.
Real versus nominal interest rates
In general, in the presence of inflation, the real value of
an investment will grow according to the formula:

1+( "
!" = $% "
1+)

Where P0 is nominal value of the investment today, n is

the nominal return on the investment, i is the inflation
rate, T is the number of years that pass, and VT is the
real value of the investment T years in the future
(stated in terms of today’s dollars).
Real versus nominal interest rates
This can be rewritten as:

!" = $% 1 + ( "

Where r is defined as:

1+)
(= −1≈ )−*
1+*

Because r is the rate of increase of the real value of the

investment, it is known as the real rate of return (or
real interest rate), while n is referred to as the
nominal rate of return (or nominal interest rate).
Real versus nominal interest rates
Ex. Using the real interest rate, calculate the real value of Bobby’s $10,000 in
ten years if he receives an annual nominal return of 10% and inflation is 2% per
year.

Ans. With a nominal return of 10% and inflation of 2%, the real return is:

1+% 1.10
!= −1= − 1 = 7.84%
1+& 1.02

Naturally, this is equal to the 7.8% real growth we found earlier. The real return
may also be estimated as:

! ≈ % − & = 10% − 2% = 8%

And it can be used to find the real value of the $10,000 investment ten years
from today:

01 = 23 1 + ! 1 = $10,000 1.0784 63 = $21,272

Real versus nominal interest rates
Because of inflation, real interest rates are generally lower than
nominal rates (and sometimes negative!):

T-Bill Returns (1953-2015)

Source: Nominal rates from Federal Reserve Bank of St. Louis (FRED). Real rates from Frederic S. Mishkin, “The Real Interest
Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy,15 (1981): 151-200: 151-200.
Measuring knowledge of inflation
Imagine that the interest rate on your savings account was 1% per
year and inflation was 2% per year. After 1 year, how much would
you be able to buy with the money in this account?

a) More than today

b) Exactly the same
c) Less than today
d) I do not know
e) Refuse to answer

Source: 2015 National Financial Capability Study

National Financial Capability Study
Imagine that the interest rate on your savings account was 1% per
year and inflation was 2% per year. After 1 year, how much would
you be able to buy with the money in this account?

a) More than today

b) Exactly the same
c) Less than today
d) I do not know
e) Refuse to answer

64% answered correctly.

Source: 2015 National Financial Capability Study

The Effects of Inflation
The effects of inflation
To summarize, the effects of inflation are:

Ÿ Inflation decreases the purchasing power of a dollar over long

periods of time.

Ÿ Real wages are set based on the supply and demand of labor. If
real wages remain constant, nominal wages must increase with
inflation. In this case, inflation does not reduce income.

Ÿ Inflation decreases real wealth if it is not invested to earn interest.

And if it is invested, inflation reduces the interest rate on
savings to a lower, real interest rate.
The effects of unexpected inflation
Inflation can be incorporated into financial planning but is itself
uncertain. Unexpected inflation has particularly important
consequences for borrowing and lending:
Ÿ Lenders are aware of inflation, and set nominal interest rates such that they
receive a real return based on their inflation expectations.

Ÿ If inflation increases, however, the real interest rate declines and the lender
receives payments with a lower real value than they expected. This helps
the consumer by reducing their debt burden, but hurts the lender by
decreasing their real return.

Ÿ If inflation decreases, the real interest rate increases, and the borrower must
make higher than anticipated real payments. This increases the consumer’s
debt burden and the lender’s return.

This is one of the reasons it is important to maintain a low and

stable rate of inflation.
The potential severe consequences of deflation
Note the short period of deflation following the 2008 financial crisis.

CPI Inflation (Y/Y)

15.0%

12.5%

10.0%

7.5%

5.0%

2.5%

0.0%

-2.5%

-5.0%
48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20

Source: Federal Reserve of Saint Louis Data (FRED)

Inflation
Video about inflation

“How Inflation Diminishes Savings”

http://gflec.org/education/educational-videos/
Inflation and the Fed

42
Money supply and inflation
To understand inflation, we need to understand
money and the money supply…

“Inflation is always and everywhere a

monetary phenomenon.”

Milton Friedman

43
The Fisher Equation and the Quantity Theory of Money
M *V = P*Y

M = money supply, P = Price level (GDP Deflator), Y = real GDP.

V = velocity of money = PY/M. We define V in this way.

If V and Y are constant, when the Central Bank doubles M, the result is
a doubling of P.

“Inflation is always and everywhere a monetary phenomenon”

This Friedman quote is not literally correct because of Y and V

movements, but it is approximately correct.
Inflation and Money Growth
Eastern Europe from 1995 to 1998

Source: Macroeconomics – Abel, Bernanke, and Croushore (2014), page 270.

Money growth rates and consumer price inflation from International Financial
Statistics, February 2003, International Monetary Fund)
Truly “Hyper”: 11.2 million %
Buying a beer in Zimbabwe in 2008

A “small” note

• That’s $1 million Zimbabwe dollars,

the price of a single beer purchased
at a bar in Harare on November
24th, 2008

46
Hyperinflation in Germany in the 1920s
Date Price of bread in marks

Dec 01, 1918 0.5

Dec 01, 1921 4

Dec 01, 1922 163

Jan 01, 1923 250

Mar 01, 1923 463

Jun 01, 1923 1,465

Jul 01, 1923 3,465

Aug 01, 1923 69,000

Sep 01, 1923 1,512,000

Oct 01, 1923 1,743,000,000

Nov 01, 1923 201,000,000,000

High Inflation Episodes
• Why does the central bank increase money supply so much?

• Periods of high inflation are often associated with large budget

deficits.

• Countries with high inflation are also those with central banks
that are not independent from the government.

• In these countries, when the government runs large deficits, it

pushes the central bank to buy the bonds the government issues
to finance its debt. When buying government bonds, the central
bank increases the monetary base and thus the money supply.
How to Fight Inflation

• Target money growth

• Appoint a “tough” central banker

For example, in 1979 the appointment of Paul Volcker to
be chairman of the Fed was designed to convince people
that President Carter was serious about stopping
inflation.
• Make central banks independent from the government

• Have a (low) inflation target

Central Bank Independence

The Economics of Money, Banking, and Financial Markets – Frederic S. Mishkin (2003), page 388
(Source: Alesina and Summers, “Central Bank Independence and Macroeconomic Performance:
Some Comparative Evidence,” Journal of Money, Credit and Banking 25 (1993): 151-162.)
Inflation Targeting
• Since 1989, several countries have adopted a system of
inflation targeting.

• New Zealand was the pioneer, announcing explicit inflation

targets that had to be met or else the central bank’s governor
could be fired.

• Canada, the U.K., Sweden, Australia, Spain, and others

followed with some version of inflation targeting.

• The European Central Bank uses a modified inflation

targeting approach.
 Inflation and
Retirement Planning
Inflation and retirement planning
In the last lecture, we saw how to plan for retirement given a
required retirement income and expected interest rates. In that
lecture, we made no adjustment for inflation. But if you don’t
account for inflation when planning for retirement, you may not
be able to enjoy the standard of living you expect.

Ex. A couple currently earns a combined salary of $70,000 per year.

They plan to retire in 35 years at age 65, at which point they hope to
maintain their current standard of living, and plan to save enough to do
so for 30 years. During retirement, their account will earn 3.5% per year
in interest. While saving, they expect to earn an average annual return
of 7%. They live in an economy where inflation is consistently 2% per
year.

If the couple ignores inflation and saves so that they can withdraw
$70,000 per year while in retirement, what will the real value of their
annual withdrawals be in retirement?
Inflation and retirement planning
Ans.

In the last lecture, we showed how to compute how much the couple
must save each year.
Time Value of Money

The couple wants to withdraw $70,000 per P/Y 1

PMT $70,000
year for 30 years in retirement. Assuming a FV $0
3.5% return on their savings while in N 30
I/Y 3.5%
retirement, the couple must save $1.29M.
PV= -$1,287,443

Time Value of Money

P/Y 1
PV $0 To save $1.29M over the next 35 years, the
FV $1,287,443 couple should make annual contributions of
N 35
I/Y 7.0% $9,313 assuming a return of 7.0% per year.
PMT= -$9,313
Inflation and retirement planning
Ans. (continued)

However, because of inflation (at 2% per year), the purchasing power of

their $70,000 withdrawals will be much less then they planned for.

In the first year of retirement, 36 years from now, the real value of their
$"#,###
$70,000 withdrawal will be cut in half to only = $34,316.
%.#'()

The real value of the $70,000 withdrawals will continue to decline

$"#,###
throughout the 30 years of their retirement it reaches = $19,323 at
%.#')/
the end of their planning horizon.
Inflation and retirement planning
Ans. (continued)

The following chart shows the real value of the couple’s withdrawals
throughout their retirement.

Real Withdrawals in Retirement

Nominal Withdrawal Real Withdrawal
$80

$60

$40

$20

$0
1 2 3 4 5 .. 10 … 30
Year in Retirement
Inflation and retirement planning
Now, we show that it is easy to do consider inflation when
making your retirement plans: to adjust for inflation, simply
plan using real interest rates and amounts.

Ex. In the example above, a couple currently earns a combined salary

of $70,000 per year. They plan to retire in 35 years at age 65, at which
point they hope to maintain their current standard of living, and plan to
save enough to do so for 30 years. During retirement, their account will
earn 3.5% per year in interest. While saving, they expect to earn an
average annual return of 7%. They live in an economy where inflation is
consistently 2% per year.

How much must the couple withdraw each year in retirement to enjoy
the same standard of living that $70,000 buys them today? And how
much must they save each year to be able to do so?
Inflation and retirement planning
Ans.

To account for inflation, use real interest rates to find the real target balance
and real annual contributions. Then, convert the annual contributions and
retirement withdrawals to nominal amounts.

Step 1: Convert nominal rates to real interest rates

While saving for retirement, the couple expects to earn a nominal return of 7%
on their investments. This corresponds to a real return of about 5%:

1+% 1.07
!= −1= − 1 = 4.90%
1+& 1.02

And the 3.5% nominal return the couple expects to earn while in retirement
corresponds to a real return of about 1.5%:

1+% 1.035
!= −1= − 1 = 1.47%
1+& 1.02
Inflation and retirement planning
Ans. (continued)

Step 2: Compute real target balance Time Value of Money

The couple wants to make real withdrawals P/Y 1

PMT $70,000
of $70,000 per year for 30 years during their FV $0
retirement while earning an expected 1.47% N
I/Y
30
1.47%
real return on their investment. To do so,
PV= -$1,688,280
they must accumulate a real balance of
about $1.69M.

Time Value of Money

Step 3: Compute real contributions
P/Y 1
PV $0 To do so, the couple must make real
FV $1,688,280 contributions of $19,083 per year for the next 35
N 35
I/Y 4.90% years, assuming a real return of 4.90%.
PMT= -$19,083
Inflation and retirement planning
Ans. (continued)

Step 4: Convert real amounts to nominal amounts

At the end of the first year, the couple should make a nominal contribution of
$19,083 ∗ 1.02 = $19,465.

They should increase this contribution by the 2% inflation rate each year until
they make a final contribution of $19,083 ∗ 1.02/0 = $38,164.

At this point, they should have a real balance of $1.691, as we saw in the last
slide. This corresponds to a nominal balance of $1.691 ∗ 1.02/0 = $3.381.

They should then withdraw $70,000 ∗ 1.02/3 = $142,792 in their first year of
retirement.

They should increase their withdrawal by the 2% inflation rate per year until they
withdraw $70,000 ∗ 1.0230 = $253,577 at the end of their horizon.
Inflation and retirement planning
Ans. (continued)

The following chart shows the real and nominal withdrawals the couple
should make during their retirement to maintain their pre-retirement
standard of living.

Real Withdrawals in Retirement

Nominal Withdrawal Real Withdrawal
$280

$210

$140

$70

$0
1 2 3 4 5 .. 10 … 30
Year in Retirement
Today we learned…
ü Inflation and purchasing power
ü Measuring inflation
ü Nominal and real prices
ü Inflation and wages
ü Inflation and savings
ü Effects of inflation
ü Inflation and the Fed
ü Inflation and retirement planning