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Inflation
Inflation is the general increase in the price of goods over a given period of time, usually a year. It is usually measured in terms of percentage change of a price index.
Inflation Adjustment
To be able assess true capital gains the misleading effects of inflation need to be removed. This is done by setting some point as the starting year, and then adjusting the future values back to this point.
Non-inflation adjusted values are usually referred to as nominal values or as being expressed in nominal terms.
Inflation adjusted values are usually referred to as real values or as being expressed in real terms.
As such gains in value are often measured in real terms rather than nominal terms.
Distortions due to inflation
Increases in value due to inflation are misleading because typically everything else also inflates in value meaning that no real comparative gain has been made.
This is demonstrated in this graph: Graph of Nominal Vs Real Values (Source= Reserve Bank of New Zealand) As you can see here if you only looked at nominal values you would mistakenly believe that properties only ever rise in value and hardly ever fall. However in real terms you can see that values of properties both rise and fall over time.
Example
Suppose you purchase a property for $100000 with a $20000 deposit and hold that property for ten years. Let us suppose that it is cashflow neutral so it costs you nothing to hold and in ten years time it's nominal value is $200000. You sell the property paying off the $80000 loan and removing the $20000 deposit leaving you with a nominal profit of $100000 and $120000 in total. However whether you have actually profited or not depends on the average rate of inflation over that ten year time period because the purchasing power of that $120000 at the end of the period could be less than that of the $20000 at the beginning of the period.
So if the inflation was 10% on average per year then the purchasing power of that asset ($220000 in nominal terms) in inflation adjusted terms is now only $69735. So in actuality you lost money not gained it.
Related Articles
Nominal Value--Monid 09:19, 31 December 2007 (NZDT)
