What does an inflation rate of 4 percent mean?

Answer 1

Interest and inflation are similar.

If it is compounded annually, then you multiply the value by 1.04 each year.

So...

If you start with $100.

At the end of the first year you have $104.

At the end of the second year, you have $104*1.04 = $108.16

At the end of the third year, you have $108.16*1.04 = $112.49

At the end of the fourth year, you have $112.49*1.04 = $116.99

At the end of the fifth year, you have $116.99*1.04 = $121.67

That means, after 5 years, on average, an item that had cost $100 the first year would now cost $121.67.

In general this is just averages, and nothing goes up at exactly the same rate.

If you had saved the $100 in a non interest bearing cash, or your wages had not increased over time, then your original $100 now has "buying power" equivalent to $100*(100/$121.67) = $82.19.