Lesson 6 of 10
Inflation and purchasing power
A larger number of dollars does not always buy more goods and services.
The idea
Nominal value is measured in dollars at the time being discussed. Purchasing power describes what those dollars can buy. To express a future amount in today’s purchasing power under constant inflation i, divide it by (1 + i)^t.
The exact one-period inflation-adjusted return is (1 + nominal return)/(1 + inflation) − 1. Subtracting inflation is a useful rough estimate at modest rates, but the division is the more precise calculation. These examples ignore taxes and personal differences in spending.
Worked example
Original arithmetic example: An item costs $100 today and rises 5% to $105 in one year. A fixed $100 can buy 100/105 = 95.24% of the original quantity. Separately, a 7% nominal return with 3% inflation gives 1.07/1.03 − 1 = approximately 3.88% real return.
| Measure | Illustration |
|---|---|
| Future nominal amount | $100 |
| One-year inflation assumption | 5% |
| Today’s purchasing power | $95.24 |
| Reduction in purchasing power | $4.76 |
A common mistake
Comparing a future nominal amount to today’s costs without adjusting either side.
Try it yourself
A future $1,210 will be received in two years. At a constant 10% annual inflation assumption, what is its value in today’s purchasing power?
Show the worked answer
$1,210 / 1.10² = $1,000 in today’s purchasing power.