CPI and the Ultimate Effect it has on Nett Income

I had a question today from an old friend and thought it worth sharing. Sometimes we take it for granted that everybody understand what the impact of inflation (CPI) is on your nett salary over time.

The question was "I wonder if you can help - I do not have enough knowledge with regards to CPI and I would like to calculate the affect that it has combined with inflation on my monthly nett income."

My reply was:

CPI refers to Consumer Price Index which is a measure of inflation. A CPI typically measures the cost of a basket of goods over time in a geographical place.

Basically for every 1% local inflation, your purchasing power decreases by the same amount, if your net salary stays the same.

As an example lets take an annual inflation rate of 6%, a net salary of 110 (just to keep it simple) and a household budget of 100.

At the beginning of the year a net salary 110 covers the household budget of 100 with 10 spare (disposable income for holidays or savings). With an inflation rate of 6%, a year later the household budget of 100, all other things being equal, will have become 106 (100 + 6%). If the salary has not increased, the impact is that disposable income has dropped to 4 (110-106).

Another year of inflation at 6% will result in a household budget of 112.36 (106 + 6%). If the salary has still not increased then the disposable income will be zero and the household budget will have to be cut back by 2.36 to stay within the net salary of 110 or the deficit would have to be funded elsewhere (e.g. a second job, a loan, using savings.

Therefore to maintain purchasing power it is important that salary increases at least cover inflation. If inflation is higher than your salary increase then the bottom line is that you become poorer.

As an aside, on a larger scale, what happened in countries like Greece is similar to the above example. When the net income of the country dropped below its budget they effectively borrowed the difference and just kept increasing the debt each year instead of cutting back to live within their means. Eventually a point is reached when the size of the debt becomes to large and a crisis is reached.