21.4 INFLATION

INFLATION

• Inflation is the term used to describe the continuous upward movement in the general level of prices.

• This has the effect of reducing the purchasing power of your money.

DETERMINING THE EFFECT OF INFLATION ON PRICES

Determining the effect of inflation on prices, is best demonstrated using an example.

Refer to Example 11 page 570

DETERMINING THE EFFECT ON PRICES OVER A LONGER PERIOD

Our understanding of compound interest, highlights that even if inflation is at a low rate for an extended period of time, prices will still increase significantly.

This is again best demonstrated using an example.

Refer to Example 12 page 570

INVESTIGATING PURCHASING POWER

Another way of looking at the effect of inflation on our money is to consider what a sum of money today would buy in the future.

Purchasing power describes what you can actually buy with your money.

INVESTIGATING PURCHASING POWER EXAMPLE

Suppose you have $100 and want to know what you could buy with it in 10 years time if the average rate of inflation is 4%. Using the compound interest formula, we can ‘deflate’ this amount back to current-day purchasing power dollars.

Solution:Using A = P x ( 1 + r_ )t and your calculator 100solve ( 100 = p.( 1 + 4_ )10 , p ) p = 67.5564 100That is, the money that was worth $100 now, has a purchasing power of only $67.56 after 10 years if inflation averaged at 4% per annum.

Refer to Example 13 page 571