## The Average 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 pervious year's rate, they have a compounding effect. As an example, suppose we want to calculate the average inflation rate for a 2-year period for a typical item. The first year's inflation rate is 4% and the second year's is 8%, using a base price index of 100.

• Step 1. We find the price at the end of the second year by the process of compounding:

• Step 2. To find the average inflation rate f over a 2-year period, we establish the following equivalence equation:

Solving for f yields f = 5.98%

We can say that the price increases in the last 2 years are equivalent to an average annual percentage rate of 5.98% per year. In other words, our purchasing power decreases at the annual rate of 5.98% over the previous year's dollars. If the average inflation rate is calculated based on the consumer price index (CPI), it is known as a general inQation rate (f).