What is Inflation?
Inflation is defined as an increase in the overall level of prices of goods and services in a particular location. This location could be as small as a town or city, or it could refer to the entire world.
The Long Definition
There are many different ways you can look at inflation. While most people define it as being an increase in the OVERALL cost of goods and services in an area, it is important to understand inflation can happen even if some prices are falling.
The key to understanding inflation is the word “overall.” Most households consume a wide range of goods and services every day. And every day, the prices of these things rise and fall by different amounts. Price changes in some of these items (like food or gasoline) are much more obvious than lesser consumed items (like home decor).
Also, different people have different needs and preferences. So, an item’s price change will affect various demographics in different ways.
Inflation can be calculated as a broad measure (such as the overall cost of groceries for a given year) or it can be broken down into narrower, more specific segments (like haircuts or car repair). No matter what the context, inflation represents how much more expensive goods and services become over time.
How is Inflation Measured?
Depending on the type of inflation being measured for a particular set of goods or services, economists will choose a price index and calculate accordingly.
A price index is a measure of relative price changes for a set of goods and services during a particular length of time. In other words, it is a calculation of the cost of buying a set of goods or services in a particular month or year.
There are different types of price indexes available depending on what type of inflation you’re trying to measure:
The Consumer Price Index
The Consumer Price Index (CPI) measures the weighted average of a basket of goods and services that are considered vital to consumers. This includes necessities like groceries, utilities, and medical care.
This is the most common price index used when you hear about inflation calculation. Generally, if someone has calculated inflation for a set of goods, they’ve used the CPI unless they mention otherwise.
CPI is calculated by first establishing a basket of goods. This basket will be composed of a set of closely related goods whose inflation needs to be measured. Once the basket is established, the economist will take the price changes for each item over a specified length of time and average those changes based on their weight in the overall basket. For this index, the prices of each item are the average retail prices as they are available to consumers.
Most of the time, the statistics you’ll hear as they relate to the Consumer Price Index have been calculated by the Bureau of Labor Statistics. This government branch reports CPI on a monthly basis and has done so since 1913.
The Wholesale Price Index
The Wholesale Price Index (WPI) is the second most commonly used index for measuring inflation. It measures the changes in the price of goods before the retail level.
The items included in the WPI vary from country to country, but the index generally includes items that are invaluable at the wholesale or producer level. For example, you’ll find metrics for cotton prices including subsets like raw cotton, cotton yarn, cotton fabric, and so on.
Although many countries including the United States use this index to calculate the inflation on wholesale goods, some countries do not. Instead, they base their calculations on a similar index called the Producer Price Index.
The Producer Price Index
Similar to the WPI, the Producer Price Index is a family of indexes that measure the change in the prices of goods for domestic producers over time. In other words, where the Consumer Price Index is calculated from the perspective of buyers, the Producer Price Index is calculated from the perspective of sellers.
Calculating the Inflation for a Specific Good or Service
As you may have guessed, each of these respective price indexes has its own unique way to calculate inflation for a given period of time. All of the above indexes can be used to calculate inflation value between any two months or years.
If you’re looking to calculate inflation yourself, there are tons of inflation calculators across the web that allow you to plug metrics in and get a quick answer. However, it is always best to be aware of the math that goes into those calculators to have a clearer understanding of how those answers are reached.
That said, the actual formula for calculating inflation looks like this:
Inflation Percentage = [(Updated Price – Original Price) ÷ Original Price] X 100
If you aren’t good at reading mathematical formulas, don’t worry. We’re going to break it down for you.
Let’s say that you’re calculating inflation on an average cup of coffee in 1992 and 2012.
Start by finding the average price in each respective year. In 1992, it was $1.60. In 2012, it was $2.62. Next, subtract the old price from the new one.
$2.62 – $1.60 = $1.02.
This makes $1.02 your difference. Once you have that number, you divide it by the original price ($1.60).
$1.02 ÷ $1.60 = 0.6375
Finally, multiply this number by 100 to get your final percentage.
0.6375 X 100 = 63.75%
So, the inflation of a cup of coffee between 1992 and 2012 is 63.75%.
Calculating Inflation Using an Index
As you may have guessed, calculating inflation for a specific item or service is much different than using an index to calculate average inflation for a large group of goods. In fact, there’s an entirely separate equation that’s used.
Let’s take the Consumer Price Index as an example.
For the CPI, the equation used to calculate inflation is as follows:
Inflation Percentage (I.P)= (Current Price ÷ Base Year Price) X 100
For example, let’s say a gallon of milk cost $2.62 in 2012 and costs $4.53 today. So, we plug those numbers into our formula:
I.P= ($4.53 ÷ $2.62) X 100.
It is important to note that $4.53 divided by $2.62 is technically 1.72. To find our inflation percentage, we ignore the 1 and only use the numbers past the decimal. If the number you see before the decimal is a zero, it means prices have gone down and your inflation value will be negative.
So, with all that said, let’s revisit our formula:
I.P= 0.72 X 100
Using this, you can say the price of a gallon of milk has gone up 72% in the last 11 years. Contrarily, if the current price divided by the base year price had been 0.72 instead of 1.72, you would say the price of milk has gone down 72%.
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