When people talk about the effects of their money getting smaller over time, they are talking about the effects of inflation. The question is of course, why our money gets smaller. Economists offer several schools of thoughts. For example, if a country prints more money to solve problems in a time of crisis, the supply of money will go up. This in turn will lead to the money becoming smaller. Another reason could be the production costs of goods and services have gone up, this will also lead to our money being smaller. We know that inflation causes our money to become smaller over time, which is one of the reasons that people put money in the bank to earn interests to counter the effects of inflation.

The impact of inflation on financial modelling
In financial modelling, there are typically discussions on the nominal value versus the real value of something. The real value of something basically takes into account the effects of inflation. For example, if you have $1000 today, what is the real value in 5 years time? The real value of the $1000 in 5 years time is to take into account the effects of the yearly inflation. We can use the Time Value of Money concepts to discount the $1000 using the inflation rate over a period of 5 years. This leads us to question what the inflation rate is and how do we calculate the inflation rate?

Consumer Price Index
Many countries periodically measure the average price of goods and services purchased by households. This data is in turn published on official government websites. This data allow us to calculate the rate of inflation.

Inflation
Inflation is defined as the rise in the general level of prices of goods and services purchased by households. Or in other words, it is a measure of the percent change in the consumer price index (CPI).

This Inflation Calculator and Spreadsheet can be used to calculate the rate of inflation quickly and easily.

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