The Inflation Squeeze
A household earns a fixed nominal monthly income of ₦300,000. Last year it spent ₦210,000 on a basket of goods and saved the rest. This year the same basket costs ₦252,000, while nominal income has not changed. The central bank raises the policy rate to fight inflation, and the household is offered a fixed deposit paying 18% per year. Headline inflation is running at 20% per year. The household must decide whether to keep saving in cash, lock into the fixed deposit, or cut consumption.
1. Calculate the change in the household's real saving position and the real return on the fixed deposit.
Read the worked answer
Last year: saving = 300,000 − 210,000 = ₦90,000.
This year: basket = ₦252,000, so saving = 300,000 − 252,000 = ₦48,000 in nominal terms.
Basket inflation = (252,000 − 210,000) ÷ 210,000 = 20%.
Real saving fell sharply: nominal saving dropped from ₦90,000 to ₦48,000, and in real terms the fall is even larger because each naira buys less.
Real return on the deposit ≈ nominal rate − inflation = 18% − 20% = −2% per year. The deposit loses purchasing power despite a positive headline rate.
2. Which option should the household choose, and why is the 'obvious' answer misleading?
Read the worked answer
The 'obvious' answer - lock into 18% because it beats holding cash - is misleading: 18% is below 20% inflation, so the real return is about −2%. The deposit still erodes purchasing power, just more slowly than idle cash (which returns roughly −20% in real terms).
The rational choice is a combination: the fixed deposit is still better than cash because it slows the real loss, but the household must also cut consumption or raise income, since its nominal saving has already fallen from ₦90,000 to ₦48,000. Relying on the deposit alone will not restore the real position. The judgement is to compare real, not nominal, returns.