Each year the Reserve Bank of Australia releases more money into circulation.
But because the total combined amount of money has the same value, each dollar is now worth less to make up for the extra dollars in circulation. This devaluing of the dollar is called inflation.
Remember back when milk was $1 and now it’s more than double that? It’s not that milk is more expensive, it’s that each dollar is worth less, so you need more dollars to buy an item of the same value.
This is also why, when you put money into a fixed-term deposit, even though the number of dollars has gone up each year due to the interest earned and added to the principal, the value of the combined amount remains virtually unchanged.
The number of dollars is called the nominal value and the after-inflation value is called the real value. So, the nominal value has increased by the amount of interest earned, but the real value has changed very little.
Those who don’t understand this and spend the interest thinking of it as income will eventually find that over time even though the nominal value remains the same, the real value will go down with inflation. Therefore, even though you have the same number of dollars, you have lost purchasing power. At a 3% inflation rate, it takes around 20 years for your money to halve in value.
So, if we’re going to be able to live off our investments for decades, we’re going to have to find something that has a higher return.