Inflation

Inflation refers to an increase in the price of goods and services, which consequently leads to a decrease in the purchasing value of money. Simply put, we can buy less with the same amount of money than we could buy earlier.

This section deals with the impact of inflation on the rate of return.

Note that inflation does not affect the $ value (unlike taxes which reduce the rate of return), but affects consumption i.e. the purchasing value of the $. So, inflation will not affect the money we earn (unlike taxes) but will affect what we can purchase with the money we earn.

Therefore, we need to modify the rate of return R in order to accomodate for the affect of inflation.

The real discount rate (or) real rate of return (RR) is given by:

$RR = \frac{(1+R)}{(1+\pi)} - 1 \approx R-\pi$

where $\pi$ is the expected inflation and R is the nominal rate of return.

We must now use RR in place of R in our previous formulae.

In our earlier examples, we were withdrawing $100 at the end of every year. We must understand that, with inflation, we will not be able to purchase the same amount of goods/services with that $100 as we could a year ago. So, our withdrawals need to keep increasing as well, based on the value of $\pi$, in order for us to be able to purchase the same amount of goods and services that we could purchase the previous year.

Note: The present value of the nominal cash flows at the nominal rate of return (R) is equal to the present value of the real cash flows at the real rate of return (RR).