What do people mean when they say a price is Inflation adjusted ? Like a car costing $100 in 1990 would cost $400 today adjusted to inflation?
If I buy a car at $100 today and inflation is 0.5%. What would be the value of the car in 5 years when inflation reaches 7%?
Inflation is basically this: Over time, prices go up!
I will now address the 3 points you have listed.
Suppose over a period of 10 years, prices have doubled. Now suppose 10 years ago I earned $100 and bought a nice pair of shoes. Now today because prices have doubled I would have to earn $200 in order to afford the same pair of shoes. Thus if I want to compare my earnings this year to 10 years ago, I will need to adjust for the price of goods going up. That is, I could say that my $100 earnings 10 years ago is the same as having earned $200 today, or alternatively I could say that my earnings of $200 today is equivalent to having earned $100 10 years ago.
This is a difficult question because a car is a depreciating asset, which means the real value of the car will go down in value over time.
Let us suppose that inflation doesn't exist and the car you bought for $100 today will depreciate to $90 after 1 year (a 10% depreciation).
But because inflation does exist, and all prices will be 0.5% higher in 1 years time, we can calculate the true selling price of the car 1 in year as follows:
0.5% of $90 = 0.005*90 = $0.45
Therefore the car will be $90 + $0.45 = $90.45 in 1 years time.
- If I take out a loan today that requires fixed payments of $100, if inflation is high, then over time this repayment becomes easier and easier to pay off, because wages increase over time due to inflation. In addition, the value of the asset you purchased will have increased in value more rapidly due to inflation, thus your sell value is high.
If inflation is low, then the repayments do not get much easier to pay back over time because wages have not risen by as much. Similarly the value of your underlying asset will not increase in value by as much.
However as compensation, the interest rates on loans are usually lower when inflation is lower.
Therefore generally it is better to get a loan in times of high inflation rather than low inflation, however it really depends on how the much the interest rates are relative to the inflation rate.
When we speak about a product or service, we generally refer to its value. Currency, while neither a product or service, has its own value. As the value of currency goes down, the price of products bought by that currency will go up. You could consider the price of a product or service the value of the product multiplied by the value of the currency.
For your first example, we compare two cars, one bought in 1990, and one bought in 2015. Each car has the same features (AC, radio, ABS, etc). We can say that, when these products were new, each had the same value. However, we can deduce that since the 1990 car cost $100, and the 2015 car cost $400, that there has been 75% inflation over 25 years. Comparing prices over time helps identify the inflation (or devaluation of currency) that an economy is experiencing.
In regards to your second question, you can say that there was 7% inflation over five years (total). Keep in mind that these are absolute cumulative values. It doesn't mean that there was a 7% increase year over year (that would be 35% inflation over five years), but simply that the absolute value of the dollar has changed 7% over those five years. The sum of the percentages over those five years will be less than 7%, because inflation is measured yearly, but the total cumulative change is 7% from the original value.
To put that in perspective, say that you have $100 in 2010, with an expected 7% inflation by 2015, which means that your $100 will be worth $93 in 2015. This means that the yearly inflation would be about 1.5% for five years, resulting in a total of 7% inflation over five years. Note that you still have a hundred dollar bill in your pocket that you've saved for five years, but now that money can buy less product. For example, if you say that $100 buys 50 gallons of gasoline ($2/gallon) in 2010, you will only be able to afford 46.5 gallons with that same bill in 2015 ($2.15/gallon). As you can see, the 7% inflation caused a 7% increase in gasoline prices.
In other words, if the value of the car remained the same, its actual price would go up, because the value stayed the same. However, it's more likely that the car's value will decrease significantly in those five years (perhaps as much as 50% or more in some cases), but its price would be higher than it would have been without inflation. If the car's value had dropped 50% (so $50 in original year prices), then it would have a higher price (50 value * 1.07 currency ratio = $53.50). Note that even though its value has decreased by half, its price has not decreased by 50%, because it was hoisted up by inflation.
For your final question, the purpose of a loan is so that the loaner will make a profit from the transaction. Consider your prior example where there was 7% inflation over five years. That means that a loan for $100 in 2010 would only be worth $93 in 2015.
Interest is how loans combat this loss of value (as well as to earn some profit), so if the loaner expects 7% inflation over five years, they'll charge some higher interest (say 8-10%, or even more), so that when you pay them back on time, they'll come out ahead, or they might use more advanced schemes, like adjustable rates, etc. So, interest rates will naturally be lower when forecasted inflation is lower, and higher when forecasted inflation is higher.
The best time to get a loan is when interest rates are low-- if you get locked into a high interest loan and inflation stalls, they will make more money off of you (because the currency has more value), while if inflation skyrockets, your loan will be worth less to loaner. However, they're usually really good about predicting inflation, so it would take an incredible amount of inflation to actually come out on top of a loan.
Inflation refers to the money supply. Think of all money being air in a balloon. Inflation is what happens when you blow more air in the balloon. Deflation is what happens when you let air escape.
Inflation may cause prices to go up. However there are many scenarios possible in which this does not happen. For example, at the same time of inflation, there might be unemployment, making consumers unable to pay higher prices. Or some important resource (oil) may go down in price (due to political reasons, war has ended etc), compensating for the money having less value.
Similarly, peoples wages will tend to rise over time. They have to, otherwise everyone would be earning less, due to inflation. However again there are many scenarios in which wages do not keep up with inflation, or rise much faster. In fact over the past 40 years or so, US wages have not been able to keep up with inflation, making the average worker 'poorer' than 40 years ago.
At its core, inflation refers to the value of the money itself. As all values of other products, services, assets etc are expressed in terms of money which itself also changes value, this can quickly become very complex.
Most countries calculate inflation by averaging the price change of a basket of goods that are supposed to represent the average Joe's spending pattern. However these methods are often criticized as they would be 'hiding' inflation. The hidden inflation may come back later to bite us.
Money itself has no value. A gold bar is worth (fuzzy rushed math, could be totally wrong on this example figure) $423,768.67. So, a 1000 dollars, while worthless paper, are a token saying that you own %.2 of a gold bar in the federal reserve.
If a billion dollars are printed, but no new gold is added to the treasury, then your dollar will devalue, and youll only have %.1 percent of that gold bar (again, made up math to describe a hypothetical).
When dollars are introduced into the economy, but gold has not been introduced to back it up, things like the government just printing dollars or banks inventing money out of debt (see the housing bubble), then the dollar tokens devalue further.
TL;DR: Inflation is the ratio of actual wealth in the Treasury to the amount of currency tokens the treasury has printed.
I've seen a lot of long and complicated answers here so here is my simple and short answer:
Let's say the economy consists of: 10 apples and 10$. Then an apple costs 1$.
If you print 10$ more you have: 10 apples and 20$. Then an apple costs 2$.
That is it! It's not what Kenshin said:
Over time, prices go up!
However I would like to add something more on the topic: inflation is theft!
If I hack the bank and steal 10% from each account it's obvious that it is theft. It's a bit less obvious when the government prints out money and people loose 10% of the value in their bank accounts but the end result is the same.
Final note: some may disagree but I do not consider inflation when 5 of the apples rot and you have: 5 apples and 10$ and an apple now costs 2$.
This is a drop in supply and if the demand stays the same prices will rise.