Because inflation in simple terms is defined as the increase in prices or the purchasing power of money the most common way to calculate the
inflation rate is by recording the prices of goods and services over the years (called a Price Index), take a base year and then determine the percentage rate
changes of those prices over the years. There are different Price Indices that can be used, the most popular are:
- Consumer Price Index (CPI) – measure the price of a selection of goods and services for a typical consumer.
- Commodity Price Index – measure the price of a selection of commodities with. It is a weighted index (in other words, some commodities are more important than others in determining price changes).
- Cost of Living Index (COLI) – measure the cost to maintain a constant standard of living. In other words, what would it cost you from year to year to live exactly the same.
- Producer Price Index (PPI) – measures the prices for all goods and services at the wholesale level. It is like the consumer price index but it is measuring the prices the producers have to pay.
- GDP Deflator – measures the prices of all goods and services (GDP).
The price index on its own does not give the inflation rate but it can be used to calculate the inflation rate. Let's use the Consumer Price Index as an example as
is the most often used index to calculate the inflation rate. An example of how this works is below. Keep in mind that although I have simplified the process by
using only 1 item in the basket of goods the process of calculating the inflation rate is the same.
What you need to know first
- The CPI has a base year that everything gets compared to. Let’s say it is the year 2000 for our example.
- Every month a basket of goods that is typical of many consumers is "purchased". For our example let's pretend that there is only 1 item in the basket, a loaf
of bread. In reality it contains many more items.
Calculating the CPI Index
- Let's say that in 2000 the basket of goods (which is 1 loaf of bread in our example) costs $1.00. This becomes our base year and our index now has the year 2000 with an index value of 100.
- In 2001 the same basket of goods now costs $1.25. Now in our Price Index we have the year 2001 with a value of 125.
- In 2002 the same basket of goods now costs $1.31. Now in our Price Index we have the year 2002 with a value of 131.
- We do this every year and come up with a Consumer Price Index that looks something like:
- Year - Value
- 2000 – 100
- 2001 – 125
- 2002 – 131
- 2003 – 133
- 2004 – 137
Calculating the Inflation Rate
Now in order to calculate the inflation between any 2 years we simply calculate the percentage rate change. To calculate a percentage rate change the formula is:
where F is the final value and I is the initial value.
Inflation rate from 2003 to 2004: In this case the Final value is the index value for 2004 which is 137. The initial value is the index value for 2003. Therefore we plug
in the values into the percentage rate change formula to get:
this gives an inflation rate of approximately 3%.
Keep in mind that this is simply an example with numbers that are not actual CPI values. However, the principles are the same.
Consumer Price Index (CPI)