Inflation

Inflation is the rate at which the general price level of goods and services rises over time, reducing the purchasing power of each unit of currency. A dollar today buys more than a dollar in five years if inflation is positive.

How inflation is measured

Most economies track inflation through a Consumer Price Index (CPI) — a basket of representative goods and services whose prices are tracked periodically. Other measures focus on producer prices, services, or specific categories such as food and energy.

Example

If inflation runs at 3% per year:

• $100 today is worth roughly $86 in real terms after 5 years
• $100 today is worth roughly $74 after 10 years
• $100 today is worth roughly $55 after 20 years

Conversely, prices rise: a $4 coffee today costs roughly $5.37 in 10 years at 3% annual inflation.

Causes and types

• Demand-pull inflation — rises when demand for goods exceeds supply
• Cost-push inflation — rises when input costs (labour, energy, materials) increase
• Monetary inflation — rises when money supply grows faster than productive capacity
• Wage-price spirals — feedback loops between rising wages and rising prices

Why inflation matters

• Erodes savings held in cash — savings accounts that earn less than inflation lose real value each year
• Makes nominal returns misleading — a 5% nominal investment return when inflation is 4% is only a 1% real return
• Compounds over time — paired with compound interest, even modest inflation rates produce large long-term effects on purchasing power
• Drives interest rate policy — central banks adjust policy rates to keep inflation near a target (typically 2–3% in advanced economies)
• Affects financial planning — long-horizon plans (retirement, education funds) must inflate future costs to project realistic targets

When modelling future financial scenarios, distinguish between nominal and real returns and apply realistic inflation assumptions.