How do you do inflation calculations and estimates?

Question

I'm an engineer, not an accountant so I have no idea what formulas to use (or even the proper terms to google for). I've looked around on a couple of google results, but most of the explanations just fly over my head, so I'd really appreciate if you can help me calculate these 3 inflation related things. I'm interested on the formulas themselves because I don't live in the US so most online inflation calculators don't really apply to my situation.

1) If I had a salary of $1000 five years ago AND on average the inflation was 10%, what's it's equivalent today?

2) If my salary is $1000 today, what would it's equivalent estimated value be in 5 years, if I expect inflation to be on average 12% yearly?

3) How do you adjust the price or value of an item to compensate inflation; eg: Say I have a house I paid 1 million dollars 3 years ago (ignore depreciation and other factors that can affect the asset's value), if inflation was: Y1 = 10%, Y2 = 11% and Y3 = 12%, what would the value of the house be?

When I searched around on google I came across this post, according to its premise, I should be able to calculate 1 and 2 with a the following formula

Present amount * (1+inflation%)^number of years

Am I on the right track or are there other factors I'm missing to solve my problem?

Answer 1

The inflation has to be converted to a decimal, e.g. 10% inflation = .1

As for the questions you state:

1. The equivalent would be computed by taking 1.1 to the 5th power which yields 1.61051 so your salary equivalent would be $1,610.51 assuming dollars and cents like US and Canada.

2. Changing the percentage to 12 instead of 10, the value becomes $1,762.34.

3. In this case, it could be compounded by computing 1.1*1.11*1.12 = 1.36752, so the million dollar house is now worth $1,367,520.

Generally, the idea of inflation is the idea that prices will rise and thus one should be careful to be aware as to how much inflation will eat away at their investment returns.

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For #3, each year is at a different rate. By taking the product, I am compounding the effect on each year's total as if you look at the Simple Interest formula, you could note that the previous year's final amount is the next year's principle. So, to walk through #3 a bit slower, one could state it this way:

• Year 1, the house is worth $1,100,000 as this is 110% of $1,000,000.
• Year 2, the house is worth $1,221,000 as this is 111% of $1,100,000.
• Year 3, the house is worth $1,367,520 as this is 112% of $1,221,000.

Answer 2

Inflation is, generally, a measure of decreased buying power. If $1000 buys you 1000 loafs of bread today but only 500 loafs of bread tomorrow then there was 100% inflation (because you need $2000 tomorrow to buy what $1000 would buy today).

So, if you earned $1000 five years ago, the equivalent buying power four years ago, after 10% inflation, would be $1100. The next year, after 10% on top of the $1100, it would be $1210. This series continues until this year $1610.51 is equivalent to $1000 five years ago. The relationship of all of these numbers is that $1000 * 110% * 110% * 110% * 110% * 110% = $1000 * (1.1^5) = $1610.51, which is the formula you found while searching.

Increasing inflation to 12% means you're looking at $1000 * (1.12^5) = $1762.34

If the inflation changes year to year then instead of simply multiplying the same increase every year you have to multiply by each increase, so you would have $1000000 * 110% * 111% * 112% = $1367520.

Answer 3

While it doesn't quite answer the 'how,' The Inflation Calculator offers an interesting easy way to see the effect of inflation over time.

It offers a field to let you choose a starting dollar amount and two years to see the inflation the occurred over that period. You can see, for example, that the value of the dollar has dropped to 1/4 of its value since 1976, the year I graduated grade school.