AFN 221

Personal Finance

Lecture Topic:

Inflation and Money Management

Andreas Milidonis
Department of Accounting & Finance
University of Cyprus
Email: Andreas.Milidonis@ucy.ac.cy

“Concept Map” for the Course

Introduction Interest Rates Inflation & Time

Money Management

Savings Consumer Borrowing

(Credit)

Review & Midterm Exam

Mortgage Insurance & Risk Investing

Management

Retirement Risk & Return Biases

Review & Final Exam

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 Inflation and Purchasing Power

Rising prices

When I was your age, my hard-

earned nickel would buy me a
trolley ride down town, a ticket to
the cinema, and enough ice cream
to split with a friend!

In most modern economies, prices tend to

rise over time. This phenomenon is known
as inflation and an introduction to the
effects it has on the consumer will be the
subject of this part of the lecture.

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 Inflation
It’s important to understand not only what inflation is, but what
it isn’t.
 Inflation is a technical term used by economists to describe
the increase in the price level over time.

 It does not make sense to talk about inflation in the price of

a single, specific good, as we buy many goods.

 While, over any given time period, the prices of some goods
may rise, and others may fall, inflation describes the changes
in the average price. If, on average, prices are increasing,
inflation is positive. If, on average, prices are decreasing,
inflation is negative (this is known as deflation).
5

The Consumer Price Index (CPI) in the US

The chart below shows annual inflation rates from 1948 to 2016: Immediately
following World War II, inflation was very volatile; the late 1970’s was
characterized by runaway inflation; and recently inflation has been low and
stable around 2-3%, with a short period of deflation following the 2008
financial crises.
CPI Inflation (Y/Y)
15.0%

12.5%

10.0%

7.5%

5.0%

2.5%

0.0%

-2.5%

-5.0%

Source: Federal Reserve of Saint Louis Economic Data

(FRED) 6
 CPI
CPI prices increase slightly more in the late 1970s (oil price shock)
and in the 2000s (commodities boom and higher fuel costs).

CPI (Jan. 2000 = 100)

CPI

160

140

120

100

80

60

40

20

Source: Federal Reserve of Saint Louis Economic Data

(FRED) 7

The Consumer Price Index in Cyprus

The chart below shows annual inflation rates from 1960 to 2019: Immediately
following 1974, inflation was very volatile; and after the Euro introduction it
has been around 2-3%, with a period of deflation following the 2013 financial
crisis.

Source: Cyprus Statistical Service

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 Inflation and purchasing power
The most obvious effect of inflation is that it reduces the
purchasing power of a dollar over time.
Ex. Today, a consumer spends an average of $150 per week on groceries for his
family. If the inflation rate is 3% (per year), how much will it cost this
consumer to purchase the same amount of groceries in 5 years?

Ans. Because prices are increasing by 3% per year, after five years, $150 worth
of groceries today will cost:

$150 ∗ 1.03 $173.89

(Note that this assumes that the price of groceries changes with the average
price level. Of course, the change in the price of groceries might differ from
inflation due to supply and demand factors for groceries.)

Inflation and purchasing power

When there is inflation, as time passes, it costs more money to
purchase the same amount of goods.

In general, the future price of a basket of goods can be found

using the following formula:

𝑃 𝑃 1 𝑖

Where P0 is the price of the goods today, i is the inflation rate, T

is the number of years that pass, and PT is the price of the basket
of goods T years in the future.

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 Inflation and purchasing power
As a corollary, as time passes, the same amount of money will buy
less goods.
Ex. If the inflation rate is 3% and the consumer described above continues to
spend $150 per week on groceries, in five years will he be able to purchase
more, less, or the same amount of groceries each week?

Ans. Because groceries are now more expensive, the consumer is not able to
afford the same amount of groceries with the same amount of spending, and so
he can only purchase less groceries per week with the same $150.

Using the inflation formula, we can see that:

𝑃 1 1
𝑃 𝑃 1 𝑖 → 0.86
𝑃 1 𝑖 1.03

So, the same $150 in five years will buy 14% less groceries in five years.
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Inflation and purchasing power

The more time passes, the further inflation erodes the purchasing
power of a dollar:

Future Purchasing Power of $100 with 3% Inflation

$100
$86.26

$80 $74.41

$60

$40

$22.81
$20

$5.20

$0
0 1 2 3 4 5 .. 10 … 50 … 100

Years from Today

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 Holding cash
Inflation is a tax on cash
 Holding cash over time is costly: the value of cash will
decrease overtime

 Cash is not a “secure” investment, there is an inflation risk

 Cash cannot be “indexed” to inflation; when there is

inflation, the return to cash is negative

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Nominal and Real Prices

 Real versus nominal prices
To control for the effects of the changing purchasing power of
the dollar on prices over time, economists distinguish between
real and nominal prices.
 The nominal price of a good is the actual number of dollars
that good costs (i.e., the sticker price). Because of inflation,
this will change over time.

 The real price of a good is adjusted for inflation, and is

indexed to the value of a dollar at some specified point in
time. The real price of a good will not change with inflation
(but may change due to supply and demand for that good).
The distinction between nominal and real prices is more easily
demonstrated using an example…
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Real versus nominal prices

So while the nominal value of $100 may stay the same, its real
value declines with inflation:

Real vs. Nominal Value of $100 with 3% Inflation

Nominal Value Real Value

$100

$80

$60

$40

$20

$0
0 10 20 30 40 50 60 70 80 90 100

Years from Today

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 Real versus nominal prices
Ex. A business man buys a new suit of the same brand and style every five
years. In 1995, this suit cost the business man $400. In 2000, it cost him $440.
In 2005, it cost him $525. Inflation has been steady at 2% each year over this
time period. What is the nominal and real price of this suit in 1995, 2000, and
2005?

Ans. The nominal price of the suit is simply the sticker price and was $400,
$440, and $525 in 1995, 2000, and 2005, respectively. The nominal price of the
suit increased over this time period.

The real price of the suit can be found by adjusting the prices for inflation in
terms of some index year. Taking the index year to be 1995, the suit in 2000
still cost the business man about $400 in 1995 dollars:

𝑃𝑟𝑖𝑐𝑒 $440
𝑃𝑟𝑖𝑐𝑒 ,$ $399
1 𝑖 1.02

Thus, the real price of the suit did not increase between 1995 and 2000. 17

Real versus nominal prices

Ans. (continued)

Again taking the index year to be 1995, the suit in 2005 cost the business
man $431 in 1995 dollars:

𝑃𝑟𝑖𝑐𝑒 $525
𝑃𝑟𝑖𝑐𝑒 ,$ $431
1 𝑖 1.02

Thus, the real price of the suit increased between 1995 and 2005.

In other words, the price of the suit increased at a rate faster than
inflation over this time period. The rate of in the price of the suit over
those ten years was about 2.8%:

$525
1 2.8%
$400 18
 Inflation and Wages

Inflation and wages

When I was your age, it

took me a full day’s work
to mow three lawns and
paint one side of a fence,
and all I got was a quarter!

Prices may increase over time, but so do wages. So while

inflation may reduce the purchasing power of a dollar over
time, the purchasing power of a day’s work may not be
effected…
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 Real wages
Generally, wages increase over time, and often do so more rapidly than
inflation. As a result, real wages tend to increase over time (because of
improved productivity), though there are periods of time where this is
not the case…
U.S. Real Median Household Income
$60,000

$58,000

$56,000

$54,000
$53,657
$52,000

$50,000

$48,665
$48,000

$46,000

$44,000
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Source: Federal Reserve of Saint Louis Economic Data

(FRED) 21

Inflation and Savings

 Real versus nominal interest rates
Because of inflation, real interest rates are generally lower than
nominal rates (and sometimes negative!):
T-Bill Returns (1953-2015)

Source: Nominal rates from Federal Reserve Bank of St. Louis (FRED). Real rates from Frederic S. Mishkin, “The Real
Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy,15 (1981): 151-200:
151-200.

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Measuring knowledge of inflation

Imagine that the interest rate on your savings account was 1% per
year and inflation was 2% per year. After 1 year, how much would
you be able to buy with the money in this account?

a) More than today

b) Exactly the same
c) Less than today
d) I do not know
e) Refuse to answer

Source: 2015 National Financial Capability Study

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 National Financial Capability Study
Imagine that the interest rate on your savings account was 1% per
year and inflation was 2% per year. After 1 year, how much would
you be able to buy with the money in this account?

a) More than today

b) Exactly the same
c) Less than today
d) I do not know
e) Refuse to answer

64% answered correctly.

Source: 2015 National Financial Capability Study 25

Chapter 3
Money Management Strategy: Financial
Statements and Budgeting
 Chapter 3
Learning Objectives

LO3-1 Recognize relationships among financial documents

and money management activities.

LO3-2 Develop a personal balance sheet and cash flow

statement.

LO3-3 Create and implement a budget.

LO3-4 Relate money management and savings activities to

achieving financial goals.

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Successful Money Management

LO3-1:
Recognize relationships among financial documents and
money management activities.
• Daily spending and saving decisions are the main element of
financial planning.
• Decisions must be coordinated with needs, goals, and personal
situations.
• MONEY MANAGEMENT is the day-to-day financial
activities necessary to manage current personal economic
resources while working toward long-term financial security.

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 Opportunity Cost and Money Management

• Spending for current living expenses reduces the amount you

can save and invest.
• Saving and investing for the future reduces the amount you can
spend now.
• Buying on credit ties up future income.
• Using savings for purchases results in lost interest earnings and
depletes savings.
• Comparison shopping can save money but takes valuable time.

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Exhibit 3-1: Money Management Activities

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 A Personal Financial Records System

• An Organized System of Financial Records provides a

basis for:
– Handling daily business affairs, such as paying bills
– Planning and measuring financial progress
– Completing required tax reports
– Making effective investment decisions
– Determining available resources for current and future
spending
• Home file, safe deposit box, computer, cloud storage

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Personal Financial Statements

LO3-2:
Develop a personal balance sheet and cash flow statement.

• MAIN PURPOSES OF PERSONAL FINANCIAL

STATEMENTS
– Report your current financial position in relation to the value
of the items you own and the amounts you owe.
– Measure your progress toward financial goals.
– Maintain information on your financial activities.
– Provide data you can use when preparing tax forms or
applying for credit.

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 Personal Balance Sheet:
Step 1
• PERSONAL BALANCE SHEET: WHERE ARE YOU NOW?

– Also called the Net Worth Statement or Statement of Financial

Position
– Preparation requires using three steps

• STEP 1: LIST ITEMS OF VALUE

- Assets: what you own
 Liquid assets
 Real estate
 Personal possessions
 Investment assets
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Personal Balance Sheet:

Step 2 and 3
• STEP 2: DETERMINE AMOUNTS OWED
- Liabilities: what you owe
 Current liabilities (less than 1 year)

 Long-term liabilities

• STEP 3: COMPUTE NET WORTH

- Net Worth = Assets − Liabilities
- Assets = Liabilities + Net Worth
- Insolvency is the inability to pay debts when they are due

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 Net Worth

• Net Worth is an indication of your current financial position on

a given date
Items of value
(what you own)
- Amounts owed
(what you owe)
= Net worth
(your wealth)

• Ways to increase Net Worth

- Increasing your savings
- Reducing spending
- Increasing the value of investments and other possessions
- Reducing the amounts you owe

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Net Worth Calculation

• Example
If a household has $193,000 of assets and liabilities of $88,000,
then the net worth would be $105,000.

Assets − Liabilities = Net Worth

$193,000 − $88,000 = $105,000

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 The Cash Flow Statement

• WHERE DID YOUR MONEY GO?

– Cash Flow is the actual inflow and outflow of cash for a
given time period
– Also called a Personal Income and Expenditure Statement
– Process for preparing a cash flow statement:

Total cash Cash outflows

Cash surplus or
received during during the time
deficit
the time period period

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The Cash Flow Statement:

Step 1
• Preparation requires using three steps
• STEP 1: RECORD INCOME
- Wages, salaries, and commissions
- Self-employment business income
- Savings and investment income
- Gifts, grants, and scholarships
- Government payments, such as Social Security, public
assistance, and unemployment benefits
- Amounts received from pension and retirement programs
- Alimony and child support payments

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 The Cash Flow Statement:
Steps 2 and 3
• STEP 2: RECORD CASH OUTFLOWS
- Fixed expenses
- Variable expenses

• STEP 3: DETERMINE NET CASH FLOW

- The difference between income and outflows can either be
positive (surplus) or negative (deficit)
- Cash flow statement provides the foundation for preparing
and implementing a spending, saving, and investment plan

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Budgeting for
Skilled Money Management
LO3-3:
Create and implement a budget.

• A budget is a spending plan

• The main purposes of a budget are to help you:
– Live within your income
– Spend your money wisely
– Reach your financial goals
– Prepare for financial emergencies
– Develop wise financial management habits

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Exhibit 3-5: Creating and Implementing a Budget

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The Budgeting Process

• Step 1: Set Financial Goals

• Step 2: Estimate Income
• Step 3: Budget An Emergency Fund and Savings
• Step 4: Budget Fixed Expenses
• Step 5: Budget Variable Expenses
• Step 6: Record Spending Amounts
• Step 7: Review Spending and Saving Patterns
• Review Your Financial Progress
• Revise Your Goals and Budget Allocations

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 Characteristics of Successful Budgeting
• A budget will work only if you follow it.
• Experts advise that a successful budget should be:
– Well planned / Realistic / Flexible / Clearly communicated
Which one works for you?
• Types of budgets
– Mental budget
– Physical budget
– Written budget or computerized budget (excel)
– Online budget: use bank or financial institution website
– Budgeting app: use cell phone or tablet
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Personal Budget in Cyprus (1/7)

• Taxes and Contributions
– Social insurance
– General Health System (GHS)
– Income Tax
– Special contribution for defense
– Personal Expenses

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 Personal Budget in Cyprus (2/7)
Social Insurance
Social Insurance contribution varies:
• For employees: 21.5%, of which
– 8.3% is paid by the employee,
– 8.3% by the employer and
– 4.9% by the Republic.

• For employees covered by an occupational pension scheme

without the employee contributing to it: 21.5%, of which
– 4.2% is paid by the employee,
– 12.4% by the employer and
– 4.9% by the Republic.

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Personal Budget in Cyprus (3/7)

Social Insurance
• For self-employed workers: 20.5%, of which
– 15.6% is paid by employee and 4.9% by the Republic.

• For optional domestic insured persons: 18.4%, of which

– 14% is paid by the insured person and 4.4% by the Republic.

• For optionally insured abroad: 21.5%, of which 16.6% is paid

by the insured person himself and 4.9% by the Fixed Fund of
the Republic.
-Note that the rates above apply for the contribution years 2019 to 2023.

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 Personal Budget in Cyprus (4/7)
GHS
• Annual (personal) taxable income for GHS purposes: € 180,000.
• If person not a tax resident of Cyprus, contributions calculated only on the
income, earnings, and pensions that derive from the Republic of Cyprus,
excluding dividends and interest.
• Employers’ contributions and employees’ deductions are calculated on the
gross salary and will be paid through Social Insurances
From 1 March 2020 contributions are :
• Employees and pensioners: 2.65% of their income / on their pension
• Employers: 2.9% on the salary of every person employed
• The state: 4.7% on the salary of employees, remuneration of self-employed,
officials and on pensions
• Self-employed people: 4% on their remuneration
=> Contributions are income-tax deductible (up to 20% of income)
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Personal Budget in Cyprus (5/7)

Income Tax
• An individual is tax resident in Cyprus if (s)he spends in Cyprus more than
183 days in any one calendar year. Tax exemptions apply.
• https://taxsummaries.pwc.com/cyprus/individual/taxes-on-personal-income

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 Personal Budget in Cyprus (6/7)
Special Defence Contribution (SDC)
• The SDC tax applies only for income earned from
– Dividends
– Interest earned
– Renting out properties
– For both tax and non-tax residents

More information here:

https://www.mof.gov.cy/mof/TAX/taxdep.nsf/All/BFA1B33F3C95FFB9
C22582280036FEC3?OpenDocument

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Personal Budget in Cyprus (7/7)

Personal Expenses
• Loan payments
• Utilities (electricity, water, phone, internet etc.)
• Daily supermarket
• Car expenses
• Children’s budget (!)
• Entertainment
• Summer holidays
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 Summary

• Explained the concept of inflation

• Separated Nominal and Real interest rates
• Explained the impact of inflation on savings.
• Observed historical trends on the above.
• We then explained the concept of money management
through personal
― Cash flow statement
― Balance sheet
― Budget
― Goal setting and achieving
― Also gave the “Cyprus budget” big picture

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