Inflation rate (tutorial #6)

We are sure that all of our readers would have heard about inflation. Inflation can be thought of as the increase in the cost of living. For instance, if you were paying for your grocery shopping $100 per week last year, but $110 per week this year, then your grocery bill has inflated by 10% over the year.

The inflation rate is calculated in the same way as a rate of return. You would remember from the second tutorial that we can calculate an asset's return over a period t using the asset's prices at the start and at the end of the period (for simplicity let's assume zero dividends):

R_t = ( P_t - P_t-1 ) / P_t-1

When calculating the inflation rate, the same formula is used, but a price index is needed. Price indices track the prices of a basket of goods. The consumer price index is commonly used to calculate the inflation rate. If we denote the level of this index at time t as CPI_t, then the rate of inflation over the period t is:

I_t = ( CPI_t - CPI_t-1 ) / CPI_t-1

For instance, if the level of CPI increases from 100 to 105 in a year, it means that the inflation rate has been (105 - 100) / 100 = 5%.

In the next tutorial, we will make use of the inflation rate to make a distinction between nominal and real returns.

Next tutorial: Nominal vs real rate of return
Previous tutorial: Dollar vs rate of return

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