Why can price increases build on one another over several years?
Correct answer
Answer A: Because each new price increase applies to prices that have already risen.
Quick explanation
If something costs €100 and its price rises by 5%, it then costs €105. If it rises by another 5% the following year, the new increase is calculated on €105, not on the original €100.
Detailed explanation
Inflation rates are usually stated for a period, such as the change from the previous year. If the rate stays positive for several years, it is not reapplied to the original price each year. It acts on the already increased price level. Mathematically, this is a compounding effect.
At 2 percent annually, a price index of 100 rises to 102 after one year, 104.04 after two years and about 121.9 after ten years. The price level is then around 21.9 percent above its starting value, not just 20 percent. The purchasing power of an unchanged amount of money falls accordingly over time.
In reality, the inflation rate rarely stays exactly the same every year, and not every individual price follows the average. The calculation only shows the effect of a constant assumption. A lower inflation rate later also does not reverse earlier price increases: the price level simply rises more slowly. Only a negative general rate of price change would lower the price level again.
Example or everyday application
A basket costs 100 euros today. After ten years with prices rising 2 percent each year, it costs about 121.90 euros.
Key takeaway
Even low inflation has a cumulative long-term effect.