What Is Inflation? How It Quietly Shrinks Your Savings

Many families save carefully for years, for a wedding, a house deposit or a child’s education, and then find that the money buys less than they expected. Nothing was stolen and no bank made a mistake. The quiet cause is usually inflation. If you have ever wondered what is inflation and why your savings seem to shrink while sitting still, this guide explains it in plain language.

I am a psychologist, not a financial adviser, so this is an explanation of how money works, not advice on what you personally should do. If you want the behavioural side, read my guide on the psychology of money and why we overspend.

Short answer: Inflation is the rate at which prices rise over time. When prices rise, each rupee, pound or dollar buys a little less. Money kept in cash with no return loses buying power every year that prices go up. Central banks such as the Bank of England, the US Federal Reserve and the Bank of Canada aim for low, stable inflation of around 2% a year.

• How it is measured: in the UK, the Office for National Statistics checks the prices of about 700 items in a “basket” every month (Bank of England).
• The usual target: the Federal Reserve aims for 2% inflation over the longer run (Federal Reserve).
• A target range: the Bank of Canada aims for the 2% midpoint of a 1% to 3% range (Bank of Canada).

What is inflation, in simple words?

Inflation means that the general level of prices goes up over time, and the inflation rate tells you how fast. The Bank of England gives a clear example: if inflation is 2%, a basket of goods that cost £100 a year ago costs £102 today (Bank of England).

The word “general” matters. Some prices rise fast, some slowly and some even fall. Inflation is the average change across a typical basket of what households buy, from bread and bus fares to larger items like cars and holidays.

How inflation is measured

Each country’s statistics office tracks prices and publishes a consumer price index (CPI). In the UK this is the Office for National Statistics, in Canada Statistics Canada, and in Pakistan the Pakistan Bureau of Statistics. The inflation rate is the change in that index compared with the same month a year earlier.

Your own experience may differ from the official figure. If a large share of your spending goes on rent, school fees or food, and those prices are rising faster than average, your personal cost of living can rise faster than the headline rate.

How inflation affects your savings

Here is a simple illustration, using made-up round numbers rather than any real rate. Imagine you keep 100,000 in cash at home, earning nothing, and prices rise by 5% over the year. Next year, the same shopping costs 105,000. Your 100,000 now buys only about 95% of what it used to. You still have the same number, but less buying power.

Now imagine the money sits somewhere that adds 3% a year while prices rise 5%. Your balance grows, but more slowly than prices, so your real buying power still falls by roughly 2%. Economists call the return after inflation the real return. It is the number that tells you whether your savings are keeping pace.

Over many years this adds up. A useful rule of thumb is the “rule of 70”: divide 70 by the inflation rate to estimate how many years it takes for prices to roughly double. At 2% that is about 35 years. At 7% it is about 10 years. This is an approximation, not a forecast (Corporate Finance Institute).

Why central banks want a little inflation, not zero

It can seem strange that central banks aim for 2% rather than 0%. The Bank of England explains that a 2% target is low enough to keep price rises small but high enough to avoid deflation, when falling prices can lead businesses to cut wages and jobs (Bank of England). The Federal Reserve adds that when people can expect inflation to stay low and stable, they can make sound decisions about saving, borrowing and investing (Federal Reserve).

The main tool is the interest rate. Higher rates make borrowing more expensive and saving more rewarding, so people tend to spend less and prices rise more slowly. Lower rates do the opposite (Bank of England).

The psychology: why we underestimate inflation

Behavioural economists describe a “money illusion”: the tendency to think in the number on the note rather than in what it can buy (Shafir, Diamond and Tversky, 1997). A salary rise of 4% feels like progress, even if prices rose 6%. A savings balance that never goes down feels safe, even if its buying power is shrinking. Because inflation works slowly and silently, it rarely triggers the alarm that a sudden loss would.

In many South Asian families, keeping cash or gold at home or in a committee feels reassuring and familiar. Understanding inflation does not mean those choices are wrong. It simply means asking a clearer question: “Over the years I plan to hold this, will it keep up with prices?”

Questions worth asking (not advice)

• What is the official inflation rate where I live and spend, and how does my own spending compare?
• For money I am saving for a goal years away, what is its expected real return?
• Which savings options fit my values, including Shariah-compliant ones if that matters to me?
• Do I need help from a regulated, qualified financial adviser before making a big decision?

Earning more is the other side of the equation. My guide on how students can earn money in college covers realistic income ideas for young people.

Frequently asked questions

Is inflation always bad?
No. Low, stable inflation is considered healthy, which is why many central banks target about 2%. High and unpredictable inflation is what causes real harm.

What is the difference between inflation and the cost of living?
Inflation measures how fast prices are rising. The cost of living is what you actually need to spend. When inflation is high, the cost of living rises quickly.

Does inflation affect people who send money home?
Inflation in each country affects what money buys there, and exchange rates move for many reasons. Families on both sides feel price changes differently.

Where can I check the current inflation rate?
Use your national statistics office, such as the ONS, Statistics Canada or the Pakistan Bureau of Statistics, or your central bank’s website. The Bank of England and Bank of Canada both offer inflation calculators.

Is this article financial advice?
No. It explains a concept. For decisions about your own money, speak to a regulated financial adviser.

References

1. Bank of England. What is inflation? https://www.bankofengland.co.uk/explainers/what-is-inflation
2. Board of Governors of the Federal Reserve System. Why does the Federal Reserve aim for inflation of 2 percent over the longer run? https://www.federalreserve.gov/faqs/economy_14400.htm
3. Bank of Canada. Inflation. https://www.bankofcanada.ca/core-functions/monetary-policy/inflation/
4. Bank of Canada. Inflation Calculator. https://www.bankofcanada.ca/rates/related/inflation-calculator/
5. Corporate Finance Institute. Rule of 70. https://corporatefinanceinstitute.com/resources/wealth-management/rule-of-70/
6. Office for National Statistics. Inflation and price indices. https://www.ons.gov.uk/economy/inflationandpriceindices
7. Statistics Canada. Consumer price indexes. https://www.statcan.gc.ca/en/subjects-start/prices_and_price_indexes/consumer_price_indexes
8. Pakistan Bureau of Statistics. https://www.pbs.gov.pk/
9. Shafir E, Diamond P, Tversky A. Money illusion. The Quarterly Journal of Economics. 1997;112(2):341-374. https://doi.org/10.1162/003355397555208
10. Bank of England. Inflation calculator. https://www.bankofengland.co.uk/monetary-policy/inflation/inflation-calculator

Last checked 17 October 2026. This article is for education only and is not financial advice. Written by Dr. Malik Sherjeel Awan (PsyD).

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Dr. Malik Sherjeel Awan

Dr. Malik Sherjeel Awan is a clinical psychologist based in Makkah. PsyD (Clinical Psychology), University of Karachi.
He writes practical, evidence-based psychology for everyday life.

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