Inflation is the rise of prices of goods and services (reduction in purchasing power) over time.
Inflation rate can apply to:
individual items: an orange today costs $0.69 costs $0.64 last year; the inflation rate is 7.8%
commodity: inflation rate of bread is taken from average prices
basket of goods: general consumer prices
Example: average inflation rate
Given the base price of $100 in year 0, inflation rate in year 1 is 5%, year 2 is 3%, what is average inflation rate over two years?
First, find the real price at the end of year 2:
Then take average inflation rate which is constant and plug it into the equation:
where for 2 years. .
Inflation Rate (): annual rate of increase of cost to the same goods and services
Real Interest Rate ( or ): real growth of money ( excluding effect of inflation)
Real / Constant Dollars ($R$$ or ): dollar with constant purchasing power, expressed using base year ( excluding inflation)
Nominal / Market Interest Rate (): rate that one obtains in general market place ( includes inflation and real interest)
Nominal / Actual Dollars ($A$$ or ): money at face-value
The relationship between real and nominal interest rate is:
The relationship between real and nominal dollar is: