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 \(f\) which is constant and plug it into the equation:
where \(n=2\) for 2 years. \(f=3.995\%\).
- Inflation Rate (\(f\)): annual rate of increase of cost to the same goods and services
- Real Interest Rate (\(i_R\) or \(i'\)): real growth of money (:x: excluding effect of inflation)
- Real / Constant Dollars ($R$$ or \(R_N\)): dollar with constant purchasing power, expressed using base year (:x: excluding inflation)
- Nominal / Market Interest Rate (\(i\)): rate that one obtains in general market place (:white_check_mark: includes inflation and real interest)
- Nominal / Actual Dollars ($A$$ or \(A_N\)): money at face-value
The relationship between real and nominal interest rate is:
The relationship between real and nominal dollar is:
\[R_N=A_N(P/F, f, N)\]