MECH 431

Inflation

Updated 2018-08-08

Inflation

Inflation is the rise of prices of goods and services (reduction in purchasing power) over time.

Inflation rate can apply to:

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:

\[100(1+0.05)(1+0.03)=108.15\]

Then take average inflation rate \(f\) which is constant and plug it into the equation:

\[100(1+f)^n=108.15\]

where \(n=2\) for 2 years. \(f=3.995\%\).

Definitions

The relationship between real and nominal interest rate is:

\[(1+i)=(1+i')(1+f)\]

The relationship between real and nominal dollar is:

\[R_N=\frac{A_N}{(1+f)^N}\]

or simply:

\[R_N=A_N(P/F, f, N)\]