Understanding Inflation and Purchasing Power

Understanding the concept

Inflation describes a general rise in prices over time. When prices rise faster than your income or savings, the same amount of money usually buys fewer goods and services. Individual prices can move differently from the overall inflation rate.

These examples are for learning purposes, not personal financial advice. Check current terms and fees with your provider before making a financial decision.

Step-by-step method

To calculate the percentage change in a price, subtract the old price from the new price, divide by the old price, and multiply by 100. To estimate a future price after one year, multiply the current price by (1 + rate as a decimal).

Choose a consistent product or basket for comparison.
Record the original and new prices.
Calculate the dollar increase.
Divide the increase by the original price and multiply by 100.
Consider whether wages or savings have kept pace with the price change.

Quick-reference table

Item	Example or formula	What it means
Price change	(new − old) ÷ old × 100	Percentage increase
One-year estimate	Price × (1 + rate)	Illustrative future price
Two-year estimate	Price × (1 + rate)²	Assumes same rate each year
Purchasing power	Money buys less if prices rise	Real value differs from nominal dollars

Four worked examples

Follow the figures and method in each example.

Example 1: Grocery item

Situation: Old price $4.80; new price $5.40

Worked answer: ($5.40 − $4.80) ÷ $4.80 × 100 = 12.5% increase.

Example 2: Weekly groceries

Situation: Basket costs $180; rises by 5%

Worked answer: $180 × 1.05 = $189, an extra $9 per week.

Example 3: Two-year illustration

Situation: Item $100; prices rise 3% per year

Worked answer: $100 × 1.03² = $106.09 after two years.

Example 4: Pay versus prices

Situation: Wage rises 2%; prices rise 4%

Worked answer: Purchasing power falls approximately 2% in the year; the exact real change is 1.02 ÷ 1.04 − 1 ≈ −1.92%.

Common mistakes

Assuming every item increases by the same inflation rate.
Confusing a falling inflation rate with falling prices.
Adding yearly percentages when compounding is required.
Comparing prices for different sizes or quantities.

Practice questions

Try each question before expanding the answer.

Question 1: A price rises from $20 to $22. What is the increase?

10%.

Question 2: A $75 bill increases by 4%. What is the new amount?

$78.

Question 3: A $200 purchase rises 5% each year for two years. Estimate the price.

$200 × 1.05² = $220.50.

Question 4: Does inflation dropping from 6% to 3% mean prices generally fell?

No. It means prices are rising more slowly overall.

Question 5: Why compare unit prices during inflation?

Pack sizes can change, so unit prices help compare like with like.

Review checklist

Can you explain the key terms in your own words?
Can you reproduce the calculations with different numbers?
Have you checked fees, units, assumptions and rounding?
Can you explain when the method is useful in everyday life?