How to calculate inflation rate
You’ve probably noticed that a few dollars don’t go as far as they did back in the day. A candy bar might seem way more expensive than it did in 2001, but this uptick in prices is actually the result of a healthy, functioning economy. As the general wealth in a country increases, so does the overall cost of living. This pattern brings down the value of the country’s currency in a phenomenon known as inflation.
As a constant force on markets and economic outcomes, the ability to track inflation and predict the inflation rate is an essential piece of the financial industry. Calculating how inflation will impact the value of the dollar, for example, is vital to maintaining sustainable markets and putting economic policies into place.
Calculating the inflation rate is also essential for individuals looking to predict how much their savings will be impacted over time. This becomes very important as you consider large financial decisions such as retirement, or finding an affordable mortgage.
What is inflation?
Inflation measures the declining value of currency throughout a period of time. In a healthy economy, as more money is printed, the money that is currently in circulation becomes less scarce. This increase in the money supply steadily drives down the value of the currency. Usually represented as a percentage, understanding the inflation rate allows economists and government authorities to make informed decisions surrounding economic policy and investments.
This means if you save cash in a shoe box rather than opening a savings account, the money you saved will lose value over time. As the price of goods and services steadily increases, the buying power of your shoebox savings dwindles. Soon, that cash will be outpaced by the rate of inflation, and without compounding interest on the savings, you’ll actually be losing money, rather than saving.
A steady rate of inflation is expected and necessary to sustain a functioning economy. Sometimes, however, the rate of inflation can run out of control. As the value of money decreases, and more cash is printed, the public finds itself with less and less purchasing power. This leads to a general inability for citizens to pay for basic goods and services. Businesses, as a result, are forced to spike their prices to make up for the loss in sales. This vicious cycle can occur when inflation goes unchecked and stalls an economy’s growth.
A stable rate of inflation is maintained by a government sustaining an appropriate supply of money and credit to the economy. Establishing a healthy rate of inflation allows investors to make accurate predictions about the economy’s future and have confidence in where they place their savings. As an individual, you’ll also benefit from calculating inflation by predicting your own purchasing power, allowing you to make informed financial decisions, such as choosing the right mortgage plan.
Calculating the inflation rate over a period of time is an essential step for savvy investors. This formula allows you to understand how your purchasing power is expected to change and helps you plan on getting the most out of your financial future.
Before calculating the inflation rate, you’ll need to learn a bit more about what contributes to the equation. Possibly the most important step to calculating inflation is understanding the consumer price index.
Consumer Price Index
Before you calculate an inflation rate, you’ll need to look up the consumer price index.
The consumer price index, or CPI, is an economic tool that is used to measure the change in prices over time. This value is released each month by the Bureau of Labor Statistics after reviewing prices throughout the economy and measuring their change.
Commonly used by governments to gauge financial policy, this indicator measures the rate of inflation and helps economists understand the direction a market is headed. The CPI also helps individuals make strategic investments by understanding inflation’s impact on retirement savings.
By providing a snapshot of the economy, the CPI represents price trends in certain markets and provides a vital component of calculating inflation. Measuring the change in prices for retail, housing, medical costs and other vital sectors of the economy, the CPI demonstrates the purchasing power of the dollar and how it has changed over time.
How to calculate inflation rate
- Calculate increase in consumer price index
- Divide by the original CPI value
- Convert to a percentage
Understanding the rate of inflation allows you to predict how your savings and investments, such as retirement accounts and future mortgage payments, will be impacted. Let’s take a look at how you can calculate the inflation rate and make these predictions on your own in three simple steps:
1. Calculate increase in consumer price index
Before you calculate the inflation rate, you’ll need to look up the Consumer Price Index. After you’ve found the CPI for the basket of goods you’ll be analyzing, you’re ready to start the equation.
If you’re calculating the rate of inflation over the course of one year, you would subtract last year’s CPI value from this year’s. If last year’s CPI is represented as ‘x’ and this year’s CPI is represented as ‘y,’ this step in the equation will look like this:
(y - x)
If one year ago, for example, the CPI was 172 and today’s CPI is 180, you would perform the below equation:
180-172 = 8
2. Divide by the original CPI value
After you’ve determined the change in CPI, you will now need to divide that number by the CPI’s original value. This helps us compare the change in prices from the original point in time. That step in the equation will look like this:
(y-x)/x = z
Using our example, the equation will look like this:
(180-172)/172 = .047
8/172 = .047
3. Convert to a percentage
Finally, you’ll want to convert that final value into a percentage. This will give you your rate of inflation. To convert to a percentage, simply multiply your result by 100. Our example equation now looks like this:
Using our example values, this is what converting to a percentage will look like:
((180-172)/172)*100 = 4.7
.04*100 = 4.7
This final value represents the inflation rate over the previous year as 4.7%.
What causes inflation?
Inflation is the rapid decrease in the value of a country’s currency, but an inflation problem can be brought on by a variety of scenarios. Let’s take a look at the three main causes of inflation and how they can affect an economy’s growth:
- Demand pull inflation
- Cost push inflation
- Built in inflation
Demand pull inflation
When there’s a shortage in supply of a certain good, the price of that good will increase. When all goods within an economy are in short supply, possibly due to international sanctions or environmental disasters, prices across the economy increase.
This type of inflation, known as demand pull inflation, happens as the average person is able to afford fewer goods and services. The value of their currency drops and the rate of inflation increases. To make up for the dip in sales, businesses increase the price of their goods, further increasing the cost of living and escalating the cycle of inflation.
Cost push inflation
When the cost of producing actual goods for an economy rapidly increases, it can cause cost push inflation. The high-cost of production restricts companies from producing certain goods that are still in high demand.
With unchanged demand and a declining market supply, the price of goods that do get produced skyrockets. As a result, the general cost of living goes up, and the buying power of the country’s currency gets diminished.
Built in inflation
The most common form of inflation is known as built in inflation. Rather than indicating that inflation rates are out of control, built in inflation is an expected economic pattern and is the sign of a healthy economy.
As an economy thrives, workers earn more and more. As a result, surrounding businesses might raise their prices. Because of the rising cost of living, those surrounding businesses will raise the wages of their workers. Over time, the inflation continues increasing, allowing for economists, lenders and governments to make accurate predictions about the state of the economy and any measures that might be needed.
Calculating the inflation rate not only helps governments develop economic policy, but it also helps individuals better predict their purchasing power over time.
Retirement savings, mortgage payments and student loans are all impacted by inflation, so understanding how the trend impacts your bottom line is essential in preparing for your fiscal future. To get an even clearer picture on your future buying power, try calculating your predicted mortgage payments and affordability.
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