How inflation really works?

Question

I have a simple question about inflation, what an inflation rate of 10% in 2022 means if in 2021 it was 5% (for example) and 5% in 2020? Let’s say my salary is $1000 since 2020 and it didn’t change, does that mean that the value of my $1000 is $900 in 2022 (considering only the 10% rate) or it should be -20% which is $800..

Thanks !

The inflation rate is a measurement of how much prices have gone up over a period of time, not something that causes everyone to adjust their prices on a set date. Rates don't add. If something increased 5% in 2020 and 5% in 2021, it still increased 5% between 2020 and now. — chepner, Nov 19 '22 at 13:53
(Though you get into compounding, depending on exactly what you are measuring.) — chepner, Nov 19 '22 at 14:01
No, that's why I mentioned compounding; my first comment wasn't entirely accurate. If the price increases 5% from 2020 to 2021, and 5% again from 2021 to 2022, the overall increase from 2020 to 2022 is actually 10.25%. The 2021 price is 1.05 times the 2020 prices, and the 2022 price is 1.05 times the 2021 price. I got confused with a 5% inflation rate over the 2-year period 2020 to 2022, which would break down into an annual inflation rate of just under 2.47%. — chepner, Nov 19 '22 at 14:18
Anytime you see a statement like "inflation is X%", you have to know what the starting point was. "X% since 3 months ago" is very different from "X% since 10 years ago". — chepner, Nov 19 '22 at 14:20
@will No, they don't add. They multiply. 5% per year for two years is not 5+5 but 1.05 x 1.05 = 1.1025, that is, 10.25%. This is called "compounding". If prices go up by 5% in 2019 and by another 5% in 2020, the 5% in 2020 is 5% of what prices were in 2019, not 5% of what they were in 2018. So not only do you pay an extra 5% of the original amount, but also an extra 5% of the 5% increase from last year. — Jay, Nov 19 '22 at 21:48
often we are lazy and we just say 5%+5%=10% because the difference is only 0.25% but sometimes that difference does matter. — user253751, Nov 23 '22 at 11:17

score 66 · Accepted Answer · answered Nov 19 '22 at 13:41

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Let’s say my salary is 1000$ since 2020.

OK. If a pizza costs $20 that means you can buy 50 pizzas.

what an inflation rate of 10% in 2022 means if in 2021 it was 5% (for example) and 5% in 2020

At the end of 2020 the price of pizza went up 5% to $21. Now you can but 47.6 pizzas.

At the end of 2021 it went up 5% more to $22.05 which now means you can buy 45.4 pizzas.

At the end of 2022 it will go up 10% more, that means pizza will now cost $24.25 now you can buy 41.2 pizzas. That means it is like you were only making $824 back when pizzas only cost $20.

Of course with inflation not everything goes up the same amount, and they don't go up only at the end of the year. Businesses raise prices when their costs go up, and they can no longer absorb the higher costs. Sometimes they make the pizza smaller. Or they offer you a discount if you pick it up.

Hopefully your wages will also go up, so that you can still afford your pizzas.

answered Nov 19 '22 at 13:41

mhoran_psprep

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I'd change the wording here from "will go up at the end of the year" to "has gone up over the course of the year". The first way around makes it sound like inflation is driving the price changes whereas it's the other way around and inflation is just measuring what's already happening. – Kaz Nov 20 '22 at 23:39
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I object to "Businesses raise prices when their costs go up, and they can no longer absorb the higher costs". PG and others have openly bragged to their shareholders about their ability to raise prices unilaterally without any loss of demand or cost pressure. Prices go up when businesses can get away with it, not just when their costs go up. – Lawnmower Man Nov 21 '22 at 09:19
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@LawnmowerMan: The assumption here is capitalism - a free market where effective competitors exist. This is relevant, because a general increase in cost will affect all competitors. PG raises prices because they reasonably believe that their competition will have to follow. But yes, PG will also raise prices if a major competitor goes bankrupt, not just in response to inflation. – MSalters Nov 21 '22 at 10:04
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now I'm a bit wiser and hungry.. – iLuvLogix Nov 21 '22 at 11:29
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@MSalters hmm so we don't live in capitalism? – user253751 Nov 21 '22 at 11:41
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@user253751 we don't live in pure capitalism, no matter what brand of it you live in. So even if "capitalism" there are tons of things that exist to warp reasonable responses (IE: regulations, covid responses - lockdowns, blocked global supply chain, etc, taxes, monopolies, government interference, etc) and stuff like printing billions in response to covid lockdowns is absolutely not "capitalism" and is a large reason (Covid Lockdowns lowered products, printed money dumped money into system and created demand while keeping people from working). Tons of stuff in our "capitalism" that isn't cap. – WernerCD Nov 21 '22 at 14:15
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@LawnmowerMan That concept is called price elasticity (of demand). Being able to increase prices without changing demand means either 1) your product enjoys an inelastic market (they really need the product so they make it work), or 2) you've been undercharging all this time which means you're bad at business. That's theoretically why companies make their price change decisions. Very practical reasons certainly include increasing costs to produce the product/service. – Nov 21 '22 at 19:26
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You're not making a valid objection. You're just repeating the clickbait "Company X increased prices because they're dicks. Oohhh, companies, bad bad bad, very bad." – Nov 21 '22 at 19:28
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@26460 you forgot 3) price collusion, 4) uninformed buyers. For instance, a buyer might search for cheaper prices under a static market, but accept price increases in an inflationary one even if they could find cheaper ones.
Anyway, you agreed that prices can change in response to factors other than cost increases, so you validated my objection and then said it's "not valid". Value judgments about the practice are orthogonal to whether it occurs.
– Lawnmower Man Nov 21 '22 at 22:58
@LawnmowerMan You should reread what you wrote. "I object to "Businesses raise prices when their costs go up, and they can no longer absorb the higher costs"." --- Okay, except that's a very typical reason businesses raise prices. There is simply no fact based objection to that statement. You're just pushing some anti business narrative. – Nov 22 '22 at 00:05
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@26460 I'm sorry that you're triggered by any critique of markets. I'll try to make this a safe space for you going forward and remember to signal the virtues of corporations and their free markets. – Lawnmower Man Nov 22 '22 at 01:46
@LawnmowerMan Thanks, as long as you stick to your word. – Nov 22 '22 at 02:04
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"Businesses raise prices when their costs go up" - Businesses raise prices when doing so increases their profits over not raising prices. Prices going up can be one trigger for this, but so can having monopolistic market power or consumers with more cash or a higher demand for dividends and less for growth from their owners. Businesses don't say "10$ is enough". – Yakk Nov 22 '22 at 02:13
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@26460 Supplychain issues are a major factor with the current inflation as well. An interesting thing that is that, in normal times, if, say, a car maker raises their prices too far above production costs, they are at risk of being undercut by competitors. But, in the current landscape, if their competitors are unable to get parts needed to produce more cars, that no longer is a factor. And since the overall supply of cars is constrained but demand has not decreased in kind, they can charge more. This is why the used car market went a little crazy recently. – JimmyJames Nov 22 '22 at 18:28

How inflation really works?

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