How can inflation be only a few percentage points and yet many goods and services are up over 50% since 2019?
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Imagine you have a magic piggy bank. At the end of each year, this magic piggy bank makes more of the coins you already have inside it.
Let’s say the magic piggy bank makes 2% more coins each year. So, if you start with 100 coins, after one year, you would have 102 coins because the piggy bank added 2 more coins (which is 2% of 100).
Now, here’s where the magic gets even more interesting. In the second year, the piggy bank doesn’t just add 2% of the original 100 coins. It adds 2% of the 102 coins you have now. So, you get a little bit more than before.
This is what we mean when we say inflation compounds. Each year, the amount added is a little bit more than the year before because it’s adding to a bigger and bigger number of coins.
So, if the piggy bank kept adding 2% more coins each year for 3 years, by the end of the third year, you would have more than 106 coins. Even though 2% of the original 100 coins is only 2 coins, the magic piggy bank added a little bit more each year because it was adding 2% of a bigger and bigger number of coins.
This is just like inflation. When people say inflation is 2%, they mean that things are getting 2% more expensive each year. But just like with the magic piggy bank, that 2% is added to a bigger and bigger number each year, so the actual amount things get more expensive by is a little bit more each year. That’s why we say inflation compounds, or grows, over time.
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