What You Need to Learn
- Define inflation and understand how it's measured (CPI)
- Understand nominal vs real interest rates
- Know the difference between simple and compound interest
- Understand fixed vs variable interest rates
- Know how inflation and interest rates affect savers and borrowers
📈 What is Inflation?
R Richard's Problem: Rising Prices
"I want to buy a second-hand estate car to transport my pottery more easily. When I started saving, the car cost £6,875. But now it's £7,387 - an increase of 7.45% in less than a year! My savings only earned 3% interest. The price is rising faster than I can save."
Inflation is the rate at which prices increase over time. It's measured as a percentage per year.
📊 Richard's Savings vs Car Price
| Car price (start of year) | £6,875 |
| Inflation on car (7.45%) | + £512 |
| Car price (end of year) | £7,387 |
| Richard's Savings | |
| Savings (start of year) | £5,000 |
| Interest earned (3%) | + £150 |
| Savings (end of year) | £5,150 |
Result: The car price rose £512, but Richard only earned £150 interest. He's falling further behind!
🎯 EXAM ALERT: When inflation is HIGHER than your savings interest rate, your money loses purchasing power - you can buy LESS with it over time.
🎯 The UK's Inflation Target
💡 Key Fact: The Bank of England has a target to keep inflation at 2%. The Monetary Policy Committee (MPC) adjusts interest rates to try to achieve this target.
M Marion's Pay Rise Problem
"I've just received an annual pay increase of 1.75% from the hotel. I'm disappointed because inflation is 2%. In real terms, the purchasing power of my salary has actually DROPPED by 0.25% since last year!"
📊 Marion's Real Pay Change
| Pay rise | 1.75% |
| Inflation rate | 2.00% |
| Real change in purchasing power | -0.25% |
Quick Check: Inflation Target
💰 Nominal vs Real Interest Rates
🎯 EXAM ALERT: Only 50% of students understood this! The formula is:
Real Interest Rate = Nominal Rate - Inflation Rate
Real Interest Rate = Nominal Rate - Inflation Rate
George's Savings Disaster
"I put £10,000 in the bank at 5% interest. I was happy to receive £500 interest at the end of the year. But inflation was 10%! I now need £11,000 to buy the same things my £10,000 would have bought a year ago. With only £10,500, I'm actually £500 WORSE OFF."
📊 George's Real Interest Rate
| Nominal interest rate (stated) | 5% |
| Inflation rate | 10% |
| Real interest rate | -5% |
George's money grew by 5%, but prices grew by 10%. In real terms, he lost 5% of his purchasing power.
| Term | Definition | Example |
|---|---|---|
| Nominal Rate | The interest rate as stated/advertised | Bank says "5% AER" |
| Real Rate | The rate after accounting for inflation | 5% - 10% inflation = -5% real |
Activity: Calculate Real Interest Rates
💷 Gross vs Net Interest
So Sophie's Savings Account
"I have a Regular Saver account that pays 2.50% gross interest. But 'gross' means before tax. If I had to pay tax, I'd receive less - that would be my 'net' interest. Luckily, I have a Personal Savings Allowance so I don't pay tax on my small amount of interest."
| Term | Meaning |
|---|---|
| Gross Interest | Interest BEFORE tax is deducted |
| Net Interest | Interest AFTER tax is deducted (what you actually receive) |
| AER | Annual Equivalent Rate - standardised rate for comparing savings accounts |
| APR | Annual Percentage Rate - standardised rate for comparing loans/borrowing |
📊 Simple vs Compound Interest
B Ben Learns About Interest
"Dad explained that there are two types of interest. Simple interest is calculated only on my original savings. But compound interest is calculated on my savings PLUS the interest I've already earned - so my money grows faster!"
📊 £1,000 at 10% Interest Over 3 Years
| Simple Interest (interest only on original £1,000) | ||
| Year 1: | £1,000 + £100 = | £1,100 |
| Year 2: | £1,100 + £100 = | £1,200 |
| Year 3: | £1,200 + £100 = | £1,300 |
| Compound Interest (interest on total balance) | ||
| Year 1: | £1,000 + £100 = | £1,100 |
| Year 2: | £1,100 + £110 = | £1,210 |
| Year 3: | £1,210 + £121 = | £1,331 |
Compound gives £31 more! The difference grows larger over longer periods.
⚠️ Warning: Compound interest works FOR you with savings, but AGAINST you with debts! Credit card debt compounds, making it grow rapidly.
Card Sort: Simple vs Compound Interest
🔒 Fixed vs Variable Interest Rates
🎯 EXAM ALERT: Many students confuse this! Fixed-rate loans are NOT affected by Bank of England rate changes. Only VARIABLE rates change.
D Daniel's Fixed Rate Mortgage
"I have a mortgage with a rate fixed for 2 years at 3.9%. Even if the Bank of England raises interest rates, my payments stay the same. I like knowing exactly what I'll pay each month - it helps me budget."
M Marion's Variable Rate Mortgage
"I want a variable mortgage because payments are low when Bank rate is low. If the Bank of England raises rates, my salary will probably rise too because the economy is growing. When rates fall again, my payments will drop automatically."
| Fixed Rate | Variable Rate |
|---|---|
| Stays the same for a set period | Changes when Bank of England rate changes |
| ✓ Easy to budget | ✓ Can benefit from rate cuts |
| ✗ Miss out if rates fall | ✗ Payments rise if rates increase |
| Daniel prefers this for certainty | Marion prefers this for flexibility |
🎯 Scenario: What Happens When Interest Rates Rise?
📋 The Bank of England raises interest rates by 0.5%
How does this affect different members of the Baker family?
| Family Member | Their Situation | Effect of Rate Rise |
|---|---|---|
| Marion | Variable rate mortgage | ❌ Payments INCREASE |
| Daniel | Fixed rate mortgage | ✓ No change (fixed) |
| Philippe & Lisa | Savings accounts | ✓ Earn MORE interest |
| Sue | Credit card debt | ❌ Interest charges INCREASE |
| Richard | No debts, has savings | ✓ Better for him |
🎯 Scenario: Inflation Affects Benefits
PL Philippe & Lisa's Winter Fuel Payment
"We get a Winter Fuel Payment of £200 to help with heating bills. Last year our winter energy bill was £400, so we paid £200 ourselves. But energy prices rose 10% while our payment stayed the same!"
📊 The Impact of Inflation on Benefits
| Last Year | |
| Winter energy bill | £400 |
| Winter Fuel Payment | -£200 |
| They paid | £200 |
| This Year (10% inflation) | |
| Winter energy bill | £440 |
| Winter Fuel Payment (unchanged) | -£200 |
| They must pay | £240 |
Result: Philippe and Lisa are £40 worse off because benefits didn't keep pace with inflation.
True or False
🏠 Marion's Flat: Interest & Inflation Combined
M Marion's Situation
"I bought my flat for £100,000. Low interest rates benefit me because I pay less on my mortgage. But high inflation actually helps too - because my flat's value increases! Last year with 10% inflation, my flat is now worth £110,000."
✓ Benefits Marion
- Low interest = lower mortgage payments
- High inflation = flat value increases
- She owns an asset that grows with inflation
✗ Risks for Marion
- High interest rates = higher payments
- Could struggle to afford mortgage
- Might lose flat if can't pay (repossession)
💡 Key Insight: Inflation can HELP people who own assets (houses, shares) because the asset value rises. But it HURTS people trying to save up to buy assets.
Fill in the Blanks
📊 The Baker Family's Interest Rates
| Family Member | Product | Interest Rate | Type |
|---|---|---|---|
| SAVINGS (AER) | |||
| Daniel | ISA | 1.50% tax-free | Variable |
| Sophie | Regular Saver | 2.50% gross | Fixed |
| Ben | Young Person's Saver | 0.75% gross | Variable |
| BORROWING (APR) | |||
| Daniel | Mortgage | 3.90% | Fixed (2 years) |
| Sue | Credit card | 18.90% | Variable |
| Richard | Personal loan | 6.20% | Fixed |
| Marion | Overdraft | 15.50% EAR | Variable |
⚠️ Notice: Savings rates (1-2%) are much LOWER than borrowing rates (4-19%). This is how banks make profit - they pay you little for savings but charge a lot for loans!
Flip Cards: Key Terms
📝 Practice Quiz
📚 Summary: What the Bakers Taught Us
| Topic | Key Learning |
|---|---|
| Richard's Car | When inflation > savings interest, your money loses purchasing power |
| Marion's Pay Rise | A pay rise below inflation means you're worse off in real terms |
| Real Interest | Real rate = Nominal rate - Inflation |
| Daniel vs Marion | Fixed rates = certainty; Variable rates = flexibility but risk |
| Philippe's Fuel | Benefits that don't rise with inflation leave people worse off |
| UK Target | Bank of England targets 2% inflation |