Why adjust for inflation annually, as opposed to realising it after the holding period?
I would use neither method.  Taking a short example first, with just three compounding periods, with interest rate 10%.  The start value y0 is 1. So after three years the value is 1.331, the same as y0 (1 + 0.1)^3. Depreciating (like inflation) by 10% (to demonstrate) gets us back to y0 = 1 Appreciating and depreciating by 10% cancels out: Appreciating by 10% interest and depreciating by 3% inflation: This is the same as y0 (1 + 0.1)^3 (1 + 0.03)^-3 = 1.21805 So for 50 years the result is y0 (1 + 0.1)^50 (1 + 0.03)^-50 = 26.7777 Note You can of course use subtraction but the not using the inflation figure directly.  E.g. (edit: This appears to be the Fisher equation.) 2nd Note Further to comments, here is a chart to illustrate how much the relative performance improves when inflation is accounted for.  The first fund's return is 6% and the second fund's return varies from 3% to 6%.  Inflation is 3%.
"Krugman argues (and I agree with him on this one) that this is a telltale sign that the US is in a [liquidity trap](http://en.wikipedia.org/wiki/Liquidity_trap). Basically interest rates are near 0 and the banks are very risk adverse right now, so they sit on reserves instead of lending them out. In this scenario, the government ""printing"" money has no effect on inflation (or much of anything) because it just sits in bank reserves.  A more right wing economist might spin a different story though." What is much more likely is immediate or close to immediate investment.  but this is exactly my point of contention with how they do things. I know for a fact that the money is immediately invested, which is why i find it wrong that interest for money collected in a given financial year is announced after the end of the next financial year.  i was wondering if this was a common practice in other countries. Inflation is not applicable in the said example. You are better off paying 300 every month as the balance when invested will return you income. You are losing something - interest on your deposit.  That money you are giving to the bank is not earning interest so you are losing money considering inflation is eating into it. "Let's say there's a product worth $10 in July and the inflation rate in August is 10%. Will it then cost $11 in August? Yes.  That's basically what inflation means. However.  The ""monthly"" inflation numbers you typically see are generally a year over year inflation rate on that month.  Meaning August 2017 inflation is 10% that means inflation was 10% since last July 2016, not since July 2017. At the micro consumer level, inflation is very very very vague.  Some sectors of the economy will inflate faster than the general inflation rate, others will be slower or even deflate.  Sometimes a price increase comes with a value increase so it's not really inflation.  And lastly, month over month inflation isn't something you will feel.  Inflation is measured on the whole economy, but actual prices move in steps.  A pear today might cost $1, and a pear in five years might cost $1.10.  That's 10% over 5 years or about 2% per year but the actual price change might have been as abrupt as yesterday a pear was $1 and now it's $1.10.  All of the prices of pears over all of the country won't be the same.   Inflation is a measure of everything in the economy roughly blended together to come up with a general value for the loss in purchasing power of a currency and is applicable over long periods.  A USD inflation rate of 3% does not mean the pear you spent $1 on today will necessarily cost $1.03 next year." The general discussion of inflation centers on money as a medium of exchange and a store of value. It is impossible to discuss inflation without considering time, since it is a comparison between the balance between money and goods at two points in time. The whole point of using money, rather than bartering goods, is to have a medium of exchange. Having money, you are interested in the buying power of the money in general more than the relative price of a specific commodity. If some supply distortion causes a shortage of tobacco, or gasoline, or rental properties, the price of each will go up. However, if the amount of circulating money is doubled, the price of everything will be bid up because there is more money chasing the same amount of wealth. The persons who get to introduce the additional circulating money will win at the expense of those who already hold cash. Most of the public measures that are used to describe the economy are highly suspect. For example, during the 90s, the federal government ceased using a constant market basket when computing CPI, allowing substitutions. With this, it was no longer possible to make consistent comparisons over time. The so-called Core CPI is even worse, as it excludes food and energy, which is fine provided you don't eat anything or use any energy. Therefore, when discussing CPI, it is important to understand what exactly is being measured and how. Most published statistics understate inflation. Is it true that due the to the increase in interest rates that inflation is likely to increase as well? It is typically the reverse where inflation causes interest rates to rise. Interest rates fundamentally reflect the desire for people to purchase future goods over present day goods.  If I loan money to someone for 5 years I lose the ability to use that money.  In order to entice me to loan the money the borrower would have to offer me an incentive, that is, they would have to give me additional money at the end of that 5 years.  This additional money is the interest rate and it reflects the desire of people to spend money in the future versus the present day.  If offered the same amount of money today versus 5 years from now almost everyone would chose to take the money now.  Money in the present is more valuable than the same amount of money in the future. Interest rates would still exist even with a currency that could not be printed. I would still prefer to have the currency today than in the future. If the currency is continually devalued (i.e. the issuer is printing more of the currency) than borrowers may charge additional interest to compensate for the loss in purchasing power when they make a loan. Also, it is hard to compare interest rates and inflation.  Inflation is very difficult to calculate. New products and services, as well as ever changing consumer desires, continually change the mixture of goods in the market so it is nearly impossible to compare a basket of goods today to a basket of goods 5, 10, 20, or 30 years ago. "Over time, gold has mainly a hedge against inflation, based on its scarcity value. That is, unless finds some ""killer app"" for it that would also make it a good investment. The ""usual"" ones, metallurgical, electronic, medicine, dental, don't really do the trick. It should be noted that gold performs its inflation hedge function over a long period of time, say $50-$100 years.  Over shorter periods of time, it will spike for other reasons. The latest classic example was in 1979-80, and the main reason, in my opinion, was the Iranian hostage crisis (inflation was secondary.) This was a POLITICAL risk situation, but one that was not unwarranted. An attack on 52 U.S. hostages (diplomats, no less), was potenially an attack on the U.S. dollar. But gold got so pricey that it lost its ""inflation hedge"" function for some two decades (until about 2000). Inflation has not been a notable factor in 2011. But Mideastern political risk has been. Witness Egypt, Libya, and potentially Syria and other countries. Put another way, gold is less of an investment that a ""hedge."" And not just against inflation." The answer would depend on the equities held. Some can weather inflation better than others (such as companies that have solid dividend growth) and even outpace inflation. Some industries are also safer against inflation than others, such as consumer staples and utilities since people usually have to purchase these regardless of how much $ they have. In looking over the data comparing S&P 500 returns, dividends, and inflation, the results are all over the map. In the 50's the total return was 19.3% with inflation at 2.2%. Then in the 70's returns were 5.8% with inflation at 7.4 percent, leading one to think that inflation diminished returns. But then in the 80's inflation was 5.1%, yet the return on the S&P was up to 17.3% Either way, aside from the 70's every other decade since 1950 has outpaced inflation (as long as you are including dividends; hence my first paragraph). S&P 500: Total and Inflation-Adjusted Historical Returns Also, the 7% average stock appreciation you mention is just that, an average. You are comparing a year-over-year number (7% inflation) with an aggregated one (stock performance over x number of years) and that is a misrepresentation and is not being weighted for the difference in what those numbers mean. Finally, there are thousands of things that have an effect on the stock market and stocks. Some are controllable and others are not. The idea that any one of them, such as inflation, has any sort of long-term, everlasting effect on prices that they cannot outmaneuver is improbable. This is where researching your stocks comes in...and if done prudently, who cares what the inflation rate is? It is supported by inflation and historical values. if you look at real estate as well as the stock market they have consistently increased over a long period of history even with short term drops. It is also based on inflation and the fact that the price of land and building material has increased over time. I believe that the Wikipedia article is attempting to draw a difference between dollar cost averaging as a result of investing when money becomes available (i.e. 401k contributions from your paycheck) and spreading out a lump sum investment. For the former you want to continuously invest as the money becomes available following your predetermined plan for allocation. For the later it may be reasonable to consider the market as you decide how and the timing for investing. "The time value of money is very important in understanding this issue.  Money today is worth more than money next year, two years from now, etc. It's a well understood economics concept, and well worth reading about if you have some, well, time. Not only is money literally worth more now than later due to inflation, but there is the simple fact that, assuming you have money for the purpose of doing something, being able to do that thing today is better than doing that same thing tomorrow.  ""A bird in the hand is worth two in the bush"" gets to this rather directly; having it now is better than probably having it later.  Would you rather have a nice meal tonight, or eat beans and rice tonight and then have the same nice meal next year? That's why interest exists, in part: you're offered some money now, for more money later; or in the case of buying a bond, you're offered more money later for some money now.  The fact that people have different discount rates for money later is why the loan market can exist: people with more money than they can use now have a lower discount for future money than people who really need money right now (to buy a house, to pay their rent, whatever).   So when choosing to buy a bond, you look at the money you're going to get, both over the short term (the coupon rate) and the long term (the face value), and you consider whether $80 now is worth $100 in 20 years, plus $2 per year.  For some people it is - for some people it isn't, and that's why the price is as it is ($80).  Odds are if you have a few thousand USD, you're probably not going to be interested in this - or if you have a very long term outlook; there are better ways to make money over that long term.  But, if you're a bank needing a secure investment that won't lose value, or a trust that needs high stability, you might be willing to take that deal." "The public doesn't really need to ""notice"" for inflation to take effect.  Inflation happens there's more money relative to things to buy.  Most people think that if say we increase the money supply by 2x, everything should get more expensive.  But it matters ""where"" the increase in money supply is and to ""whom"" is receiving it.   For example, the liquid money supply for US$ increased almost 4 times from 2009 to 2017 via quantitative easing, where the central bank purchased not just short term treasuries, but also longer term bonds.    You would think that having 4x the amount of US$ circulating would lead to a lot of inflation on consumer prices.  For every $1 that was floating around in 2009, we now have $4, so people should be willing to pay more for a given good, increasing its price.   However, the ""new"" money has been primarily used to purchase assets, and drive up their prices.  It has not really found its way to into worker pay (or to the general public), as median income for workers has stayed relatively flat in that time frame.   So it can be argued that the ""asset"" markets are feeling the effects of ""inflation"" from the increased money supply.  Where real estate prices, public stock prices, venture capital investments, etc. have all seen a large increase in their costs to acquire relative to the same asset and opportunity.   These assets are acting like a ""sponge"" for the ""new money"" that prevents the effects of its inflationary properties from exiting out into the consumer economy.   That is also why central banks across the globe are in a predicament in how to ""stop"" quantitative easing.  If they were to shrink the money supply, the inflationary pressures on assets would go down because there's not enough new money to keep raising their prices.  Doing it the wrong way would cause housing, stocks, and investment markets to stop growing, because there wouldn't be as much ""new money"" creating demand for those assets.   The best way I can illustrate this is with an example:  Say you have an economy that consists of an ""Orange Tree"" that produces 10 oranges per year.  There are 10 people in this economy that each want 1 orange per year.  And there is a circulating money supply of $10.   The owner of the Orange Tree hires all 10 people to pick 1 orange for him, and pays them $1 to pick.   In this scenario, each person picks 1 orange and gives it to the owner.  They then receive $1.  They then turn around and purchase one of the oranges from the owner of the tree.  Because demand is 10 oranges, and supply is 10 oranges, and the money supply is $10, each orange is priced at $1 and everyone is happy.   Now let's say the central bank ""prints"" $100 more dollars.  If the central bank gave it to the ""people"" evenly, each person would end up with $11.  Now we have 10 people that want 10 oranges and each have $11.  So, the price for the oranges would ""inflate"" to $11 per orange.   Now let's say instead of giving the extra $100 to the ""people,"" the central bank instead gives it to the ""orange tree owner.""  The owner can still pick his 10 oranges with the 10 people (the labor force), and can still charge $1 per orange.  As long as oranges are still $1, he doesn't really need to increase the ""wages"" of the orange pickers.  So, instead, he invests the $50 into building a bigger house for himself, and then puts the remaining $50 into developing an ""orange picking machine.""  The supply of oranges is the same, the demand for oranges is the same, and the supply of money that demands oranges is the same, so each orange will continue to be priced at $1.  In this scenario, the supply of money increased by 10x, but the prices of oranges did not inflate.  This is because the new money went into assets, not consumer demand.   Now play this scenario forward a few years.  The orange tree owner now has a machine that picks oranges, so he stops hiring people to pick oranges.  Now he has a new house and all the oranges he can eat.    Now let's say this economy was replicated 100 times, but here are only 20 houses.  So there are 100 ""orange tree owners"" and 1,000 people that get paid to pick oranges and are willing to pay to consume oranges.   The central bank hands $100 to each of the 100 orange tree owners.  In this case, some of the Orange Tree owners will bid up the price of the houses from $50 to $100.  The other Orange Tree Owners may invest in bigger and better ""Orange Tree Picking"" machines.  That automation will lower the cost to pick oranges, and increase profits if prices stay the same.  Eventually, those owners will be able to bid more than $100 for one of the 20 houses.   As this plays out, the price of a house will continue to increase until all orange picking is automated, but no one can afford oranges because they are not needed to pick them anymore.   This is a simplified version of what's basically happening on a global scale." The Gordon equation does not use inflation-adjusted numbers. It uses nominal returns/dividends and growth rates. It really says nothing anyone would not already know.  Everyone knows that your total return equals the sum of the income return plus capital gains.   Gordon simply assumes (perfectly validly) that capital gains will be driven by the growth of earnings, and that the dividends paid will likewise increase at the same rate. So he used the 'dividend growth rate' as a proxy for the 'earnings growth rate' or 'capital gains rate'. You cannot use inflation-removed estimates of equity rates of return because those returns do not change with inflation.  If anything they move in opposite directions.  Eg in the 1970's inflation the high market rates caused people to discount equity values at larger rates --- driving their values down -- creating losses. First off, inflation doesn't necessarily imply that goods and services will rise in price.  The amount of goods &amp; services increases over time as well, and this is balanced (partly), by an increase in the money supply.  Without inflation you lose the incentive to invest, as your dollar would become more valuable over time.  Why invest in a risky venture if I know that my dollar will buy more if I just wait it out.  Might as well stick the money under the mattress. (This is bad)