Inflation describes a broad rise in prices over time. When prices increase, the same number of dollars buys fewer goods and services, reducing purchasing power.
Inflation compounds over time
If prices rise by a percentage each year, the next increase applies to an already higher price level. The cumulative change over many years is therefore larger than simply adding the annual percentage.
For example, a constant three percent annual rate produces a price increase of more than thirty percent over ten years because of compounding.
Future cost and purchasing power are related
Future cost asks how much money may be needed later to buy something that has a known price today. Purchasing power asks how much today’s fixed cash amount may effectively buy in the future.
These are two views of the same inflation factor. One increases the estimated price while the other discounts the value of unchanged cash.
Different expenses have different inflation rates
A general inflation measure summarizes a broad basket of spending. Housing, education, health care, transportation, energy, and food may change at different rates.
A personal plan can use separate assumptions for unusually important expenses, especially when a goal is concentrated in one category.
Use a range in long-term planning
No one knows the exact inflation rate that will apply over several decades. Compare a lower, middle, and higher assumption to understand the sensitivity of a savings goal.
Inflation is one reason nominal investment returns should not be confused with increases in real purchasing power.
Change the assumptions and compare results using the free NumbersHub calculator.
Important limitation
This article is for general educational purposes. Financial products, tax rules, rates, fees, and individual circumstances vary. Review actual documents and consult an appropriate qualified professional before making a significant decision.