How can you account for inflation when forecasting finances?

1 Nominal vs real values

When forecasting finances, you need to distinguish between nominal and real values. Nominal values are the current or projected amounts of money without adjusting for inflation. Real values are the nominal values adjusted for inflation, which reflect the actual purchasing power of money. For example, if you expect to earn $100,000 in 10 years, that is your nominal income. But if the inflation rate is 3% per year, your real income in 10 years is only $74,409, which means you can buy less with your money than today.

2 Inflation rate and index

To account for inflation, you need to estimate the inflation rate and use an inflation index. The inflation rate is the percentage change in the average price level over a period of time. You can use historical data, forecasts, or assumptions to estimate the inflation rate for your financial planning. An inflation index is a measure of the average price level of a basket of goods and services over time. The most common inflation index is the Consumer Price Index (CPI), which tracks the changes in the prices of consumer goods and services. You can use an inflation index to convert nominal values to real values and vice versa.

3 Real growth rate

Another concept you need to understand when accounting for inflation is the real growth rate. The real growth rate is the percentage change in the real value of a variable over a period of time. It measures the actual increase or decrease in the purchasing power of money. To calculate the real growth rate, you need to use the nominal growth rate and the inflation rate. The formula is: Real growth rate = (Nominal growth rate - Inflation rate) / (1 + Inflation rate) For example, if your nominal income grows by 5% per year and the inflation rate is 3% per year, your real income growth rate is: Real income growth rate = (5% - 3%) / (1 + 3%) = 1.93% This means your real income increases by 1.93% per year, which is less than the nominal income growth rate of 5%.

4 Forecasting methods and tools

There are different methods and tools you can use to account for inflation when forecasting finances. One method is to use real values and real growth rates for all your variables, such as income, expenses, savings, investments, and debt. This way, you can avoid the distortion caused by inflation and compare the values in terms of purchasing power. Another method is to use nominal values and nominal growth rates for all your variables, but apply an inflation factor to adjust them for inflation. The inflation factor is: Inflation factor = (1 + Inflation rate) ^ Number of periods For example, if the inflation rate is 3% per year and you want to forecast your finances for 10 years, the inflation factor is: Inflation factor = (1 + 3%) ^ 10 = 1.344 This means you need to multiply your nominal values by 1.344 to get the real values in 10 years.

You can use various tools to help you account for inflation when forecasting finances, such as spreadsheets, calculators, or online apps. These tools can help you perform the calculations, apply the formulas, and create charts and tables to visualize your financial plan. You can also use scenarios and sensitivity analysis to test how your finances will change under different inflation rates and assumptions.

Accounting for inflation when forecasting finances is important to ensure that your financial plan is realistic and accurate. By using the concepts and methods explained in this article, you can adjust your financial variables for inflation and plan your finances accordingly.

5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?