Inflation
Inflation is the rate at which the general price level of goods and services rises over time, reducing the purchasing power of money. It is typically measured by the Consumer Price Index (CPI).
If inflation runs at 3% annually, $100 today buys the same as $103 in a year. Equivalently, the purchasing power of $100 in a year will equal only about $97 today.
Central banks (the Federal Reserve, Bank of England, Bank of Canada, RBA) target approximately 2% annual inflation as the "sweet spot" — enough to prevent deflation (falling prices, which discourages spending) without eroding purchasing power rapidly.
For investors and savers, the real return on any investment is the nominal return minus inflation. A savings account paying 3% when inflation is 4% has a real return of −1%.
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- Rate of Return
- A rate of return (RoR) is the net gain or loss of an investment over a specified period, expressed as a percentage of the initial investment.
- Compound Interest
- Compound interest is interest calculated on both the initial principal and the accumulated interest from previous periods. It causes savings and investments to grow exponentially over time.
- Time Value of Money (TVM)
- The time value of money is the principle that a dollar today is worth more than a dollar in the future because money available now can be invested to earn a return.