Inflation adjustment is the process of adjusting economic indicators and the prices of goods and services from different time periods to the same price level. To adjust for inflation, an indicator is divided by the inflation index. This adjustment process takes prices — generally for a given year (e.g., "1942 dollars") — in the original "nominal dollars" and renders them into "constant dollars" (also referred to as "today's dollars").
It is easy to show that 7% inflation, lasting 10 years, would nearly double the cost of living (1.07^10=1.96). For example, a gallon of milk costing $4, could cost nearly $8, 10 years later. Inflation discourages saving and encourages spending. This, in turn, leads to higher costs of investment. Suppose that a firm is now able to borrow one million dollars at the interest rate of 8%. This is possible before the inflationary period begins. People save money at the interest rate of 3% and the firm can borrow it from the bank at 8%. The profit to the bank is 5% each year. Counting for 7% inflation, however, the bank is likely to increase the cost of borrowing from 8% to 15%.[1]