What is inflation?
Inflation is the broad increase in the prices of goods and services over time. As prices rise, the purchasing power of money decreases, meaning the same amount of money can buy fewer goods and services than before.
Inflation can happen for several reasons. Prices may rise when demand for goods and services grows faster than supply, when production costs increase, or when shortages limit the availability of goods and services. Broader economic conditions and monetary and fiscal policies can also influence inflation over time.
For example, imagine keeping $1,000 in cash for 10 years. You would still have the same $1,000, but if inflation averaged 3% per year, its purchasing power would be equivalent to approximately $744 in today's money. You still have the same $1,000, but its purchasing power has decreased because prices have increased.
Inflation can also be viewed from the perspective of rising prices. If something costs $1,000 today and inflation averages 3% per year, it could cost approximately $1,343.92 after 10 years.
For this reason, inflation is an important factor when saving money. Cash that does not earn a return can lose purchasing power over time. Even money in a savings account can lose purchasing power if the interest it earns is lower than the inflation rate.
For educational examples, inflation can be estimated using a constant annual rate, even though actual inflation rates can change from year to year.
The effect of inflation over time can be estimated using the following formula:
Future price
The estimated price after inflation has been applied over the selected period of time.
Current price
The price of the good or service today.
Inflation rate
The annual inflation rate expressed as a decimal. For example, 3% = 0.03.
Time
The number of years over which inflation is applied.