Many financial professionals use the average rate of inflation in order to calculate the return requirements for investment opportunities. This stipulates the amount of growth that an investment must produce in order to compensate for the rising price of goods and services over a certain period. It is also frequently used to determine cost of living raises for many jobs. To understand what this means, it is first important to understand what inflation is.
What Is Inflation?
Inflation is the term used to describe the increase in prices of consumer goods or services. As time progresses, so does the value of a dollar relative to what it is able to purchase. For example, many years ago a bottled soda would have cost about five cents, whereas today it costs over a dollar. This is the power of inflation.
How Is Inflation Determined?
Inflation is determined by the Bureau of Labor Statistics, which computes the value of a basket of goods at one point in time and then recalculates it at a later point in time to see if there was an increase. A basket of goods is simply a group of products that consumers often purchase and the government uses to measure changes in pricing.
What Is The Average Rate of Inflation?
The price of goods does not always have to rise; sometimes it may go through a decreasing period. This is known as deflation. But, it does increase a majority of the time although not at a steady pace. Therefore, it is useful to have an average by which to estimate yearly growth needed in income from a job or investments. The average rate typically used is 3 to 4 percent. Therefore, if the beginning amount was $60,000, the following year it would be $61,800 to $62,400 if growing at the average rate of inflation.
Why Is This Important?
In order to be able to purchase the same goods in the future, the dollar earned or invested now needs to grow at least as much as inflation throughout that time. Otherwise, it loses its purchasing power so that there is a reduction in how much that same sum of money can purchase.