4-4Average inflation rate
To account for the effect of varying yearly inflation rates over a period of several years, we can compute a single rate that represents an average inflation rate. Since each individual year’s inflation rate is based on the previous year’s rate, all of these rates have a compounding effect. As an example, suppose we want to calculate the average inflation rate for a two year period: the first year’s inflation rate is4%. and the second year’s rate is 8% each on a base price of $100.
Step1. to find the price at the end of the second year, we use the process of compounding:
100(1+4%)*(1+8%)=112.32
Step 2: 100*(1+f)2=112.32, we can obtain f=0.0598
We can say that the price increases in the last two years are equivalent to an average annual percentage rate of 5.98% per year. Note that the average is a geometric average over a several year period. Our computations are simplified by using a single average rate such as this, rather than a different rate for each year’s cash flows.
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