What Is Inflation?
Inflation is the rate at which the general level of prices for goods and services rises over time, eroding the purchasing power of money. When inflation is 3%, something that cost $100 last year now costs $103. Understanding inflation is crucial for financial planning, salary negotiations, and investment decisions.
The Inflation Rate Formula
Where CPI = Consumer Price Index
Example: Calculating Annual Inflation
If the CPI was 292.7 at the end of 2023 and 304.7 at the end of 2024:
- Find the difference: 304.7 - 292.7 = 12.0
- Divide by original CPI: 12.0 ÷ 292.7 = 0.041
- Convert to percentage: 0.041 × 100 = 4.1% inflation
Purchasing Power Formula
Purchasing power measures how much your money can actually buy. As inflation rises, purchasing power falls.
Purchasing Power = Original Amount ÷ (1 + Inflation Rate)n
Example: Purchasing Power Erosion
What is $1,000 worth after 10 years with 3% annual inflation?
Purchasing Power = $1,000 ÷ (1.03)10 = $1,000 ÷ 1.3439 = $744.09
After just 10 years at 3% inflation, your $1,000 has the buying power of only $744. This is why keeping money in a zero-interest account loses value over time.
How $100 Loses Value Over Time
| Years | At 2% Inflation | At 3% Inflation | At 5% Inflation |
|---|---|---|---|
| 5 | $90.57 | $86.26 | $78.35 |
| 10 | $82.03 | $74.41 | $61.39 |
| 20 | $67.30 | $55.37 | $37.69 |
| 30 | $55.21 | $41.20 | $23.14 |
Real vs Nominal Values
Nominal values are stated in current dollars. Real values are adjusted for inflation to reflect actual purchasing power.
Real Return = Nominal Return - Inflation Rate
Example: Your investment earned 8% this year, but inflation was 3%. Your real return is approximately 8% - 3% = 5%.
Historical US Inflation Rates
| Decade | Average Annual Inflation | Impact on $100 |
|---|---|---|
| 1960s | 2.5% | $100 → $78.12 |
| 1970s | 7.4% | $100 → $48.52 |
| 1980s | 5.1% | $100 → $60.95 |
| 1990s | 2.9% | $100 → $74.90 |
| 2000s | 2.6% | $100 → $77.12 |
| 2010s | 1.8% | $100 → $83.65 |
Protecting Yourself Against Inflation
- Invest in assets that outpace inflation: Stocks, real estate, and TIPS (Treasury Inflation-Protected Securities) historically beat inflation.
- Negotiate regular raises: Your salary should increase at least at the rate of inflation to maintain purchasing power.
- Avoid holding too much cash: Cash in a zero-interest account loses value every year due to inflation.
- Consider inflation when planning retirement: You will need significantly more money in the future to maintain your current lifestyle.
- Lock in rates when possible: Fixed-rate mortgages and loans become cheaper in real terms during inflationary periods.
Try Our Free Calculator
Put your knowledge into practice with our easy-to-use percentage calculator.
Use Calculator