Understand this tool
Think in purchasing power
- What the concept means
- Inflation is a broad rise in the price level over time, commonly summarized with a price index such as CPI.
- Why it exists
- The calculator compounds an assumed inflation rate to illustrate future cost or the erosion of purchasing power.
- When to use it
- Use it for scenario planning, not for predicting the price of one specific product.
- What the result means—and does not mean
- The output is a constant-rate model. Actual inflation changes over time, differs across spending categories and locations, and need not match an individual household’s experience.
Nominal and real values
A nominal amount is stated in money of its date. A real value adjusts for price-level change so purchasing power can be compared across time. Nominal growth can therefore coexist with little or negative real growth.
CPI tracks average price change for a defined basket and population. It is an index, not a claim that every item rises by the same percentage. Compounding matters because each year’s assumed increase applies to the prior year’s higher price.
Key concepts
Key concepts
- Consumer Price Index (CPI)
- An index measuring average price change for a specified basket.
- Nominal value
- Money expressed without an inflation adjustment.
- Real value
- A value adjusted for changes in purchasing power.
- Purchasing power
- The goods and services an amount of money can buy.
- Compound inflation
- Repeated price-level change applied to the prior period.
Method or process
Calculation method
Nominal and real values
A nominal amount is stated in money of its date. A real value adjusts for price-level change so purchasing power can be compared across time. Nominal growth can therefore coexist with little or negative real growth.
CPI tracks average price change for a defined basket and population. It is an index, not a claim that every item rises by the same percentage. Compounding matters because each year’s assumed increase applies to the prior year’s higher price.
Formula or rule
future cost = present cost × (1 + inflation rate)^yearsCompare the concepts
Nominal growth versus real growth
| Measure | Accounts for inflation? | Question answered |
|---|---|---|
| Nominal growth | No | How many currency units changed? |
| Real growth | Yes | How did purchasing power change? |
Common mistakes
Common mistakes
- Treating one assumed rate as a forecast.
- Assuming CPI describes every personal expense.
- Comparing money from different years without identifying nominal or real terms.
Edge cases and limits
Edge cases and limits
- Deflation is a negative inflation rate and reverses the direction.
- Periods of volatile inflation are poorly summarized by one average rate.