Inflation adjustment

From Wikipedia, the free encyclopedia

Inflation adjustment is the process of adjusting economic indicators and the prices of goods and services from different time periods to the same price level. To adjust for inflation, an indicator is divided by the inflation index.

It is easy to show that 7% inflation, lasting 10 years, would nearly double the cost of living (1.07^10=1.96). A gallon of milk, for example, costing $4, could cost nearly $8, ten years later. Not surprisingly, inflation discourages saving and encourages spending. This, in turn, leads to higher costs of investment. Suppose that a firm is now able to borrow one million dollars at the interst rate of 8%. This is possible before the inflationary period begins. People save money at the interest rate of 3% and the firm can borrow it from the bank at 8%. The profit to the bank is 5% each year. Counting for 7% inflation, however, the bank is likely to increase the cost of borrowing from 8% to 15%.