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dresser drawer, planning to treat yourself to a candy bar in 40 years, when the day arrived
you would be sadly disappointed to find that you come up almost $2 short!
Of course, that example is obviously unrealistic. No one actually sets aside loose change
and then patiently waits 40 years to buy a candy bar. Yet actually this is not all that far off
from what we did in some of the examples in the previous section. We tend to base our
future financial goals on what money is worth today, ignoring the fact that what looks like a
lot of money today may not seem so impressive after years of inflationary compounding.
In problems where we set a goal of $1,000,000 in a retirement account, we failed to
take into account that in the future, $1,000,000 will almost certainly not carry the same
buying power as it does today. The mathematics was correct, yet when we set the million
dollar goal we were thinking about how much money a million dollars is on the basis of
how much that much money is worth at the prices we see today. In other words, we were
thinking about $1,000,000 in today’s dollars, an expression that means that we really are
thinking about the buying power that $1,000,000 represents today. Given the inflationary
facts of life, 40 years from now $1,000,000 will almost certainly not have as much buying
power as it does today. So if we set our goal to be one million actual dollars, when retire-
ment comes we will find ourselves just as disappointed as the person trying to buy a $2.57
candy bar for 65 cents.
When making long-term financial planning decisions, it is easy, but foolish, to overlook
the impact of inflation. This is especially important in retirement planning, since the goal
is often a very long-term one, but it also can be important in long term business planning
as well. Yet, it is not at all uncommon to see retirement or long-term business plans that
nonetheless ignore inflation altogether. In this section, we will explore ways to take infla-
tion into account mathematically.Long-Term Predictions about Inflation
One huge problem that will confront us here is that we don’t really have any idea of what will
happen to prices in the future. Some economic prognosticators will tell you that free market
competition paired with advances in productivity and technology will make inflation a non-
issue for the foreseeable future. They can back up that claim with very convincing arguments
and compelling evidence. Other forecasters predict that growing populations and rising living
standards will combine with shortages of commodities and/or labor to drive prices through
the roof. They can make an equally compelling case for this view. There is some truth in the
old joke that God created economists to make weather forecasters look reliable.
The fact of the matter is that no one knows what the future holds, for inflation rates or
anything else. While we can’t pretend inflation does not exist, we also can’t know in advance
what will happen, either. Any projections we make will have to rest on assumptions, and so
our predictions are just educated guesses calculated from other educated guesses. We can
never know for certain that things will work out according to what we’ve planned, but if our
assumptions are reasonable, we at least have a reasonable expectation that our projections will
give us a good enough basis on which to make sound financial decisions.
The following example will illustrate the mathematics of making these sorts of projections.Example 7.3.1 Suppose that a lawnmower costs $189.95 today, and that you expect
lawnmower prices to rise at a 4% effective rate in the future. If your assumption is
correct, how much would this mower cost 20 years from now?Prices rising at an annual infl ation rate are mathematically equivalent to money growing at
en effective compound interest rate. So:FV PV (1 i)n
FV $189.95(1 0.04)^20
FV $416.20On the basis of these assumptions, we can predict that the lawnmower would cost $416.20
twenty years from now.7.3 Assessing the Effect of Inflation 323