In more detail
It is usually measured as the yearly change in a consumer price index (CPI), the cost of a fixed basket of goods and services. Central banks typically aim for low, stable inflation, often around 2% a year. A "real" figure is a nominal one adjusted for inflation: the exact real return is (1 + nominal) / (1 + inflation) − 1, close to nominal minus inflation when both are small. Falling prices are deflation; a fall in the inflation rate (disinflation) only means prices are rising more slowly.
Why it matters
Cash and savings earning less than inflation lose purchasing power every year, and long-term plans for retirement or education must be made in today's money and then inflated. A raise below inflation is a pay cut in real terms.
Example
If the CPI rises from 300 to 309, inflation is 309 / 300 − 1 = 3%. At 3% a year:
- Prices double in about 24 years (Rule of 72)
- After 10 years, something costing $100 today costs $134.39, and $100 of cash buys what $74.41 buys today
- A savings account paying 5% earns a real return of
1.05 / 1.03 − 1= 1.94%