What Is Inflation Rate?

The Inflation Rate is a measurement of the rise of general price level over a period of time. It’s usually calculated for a year, quarter or month. That is to say the Inflation Rate is a decrease of a purchasing power of currency. The higher the Inflation Rate is, the fewer goods or services you can buy for a unit of currency. The process opposite to inflation is called deflation, which is a decrease of general price level.

How to Calculate the Inflation Rate?

The Inflation Rate is calculated by dividing the difference between CPI index for the ending period and CPI for the starting period by CPI index for the starting period. This number is to be multiplied by 100 to get the number reflected as a percentage.

Inflation\space Rate = \frac{CPI_{x} - CPI_{y}}{CPI_{y}} \times 100\%

Where y is the initial consumer price index for the calculated period/time, and x is the ending consumer price index for the period calculated.

Consumer Price Index (CPI) measures changes in price level of a market basket which consists of fixed list of goods and services offered on the market, such as food, housing, transportation, medical care, recreation, education, apparels etc. Consumer Price Index is the most commonly used price index applied to represent prices of goods and services.

To calculate Inflation Rate you can also use the GDP deflator (a measure of the level of prices of all new, domestically produced, final goods and services in an economy, comparing to the CPI index, GDP deflator isn’t based on the fixed basket of goods, but is allowed to change along with people consumption changes), PCEPI (Personal Consumption Expenditures Price Index), PPI (Producer Price Index) or other indexes.

GDP deflator is calculated by dividing nominal GDP by real GDP and multiplied by 100%. The nominal GDP is calculated by using this year’s prices, whereas the real GDP is calculated by using base years prices.

GDP\space deflator = \frac{nominal\space GDP}{real\space GDP} \times 100\%

Examples of Inflation Rate Calculation

Example 1. British Office for National Statistics

The British Office for National Statistics has published the following CPI values for 2015, 2016 and 2017:

  • In 2015 CPI was 100.0
  • In 2016 CPI was 100.7
  • In 2017 CPI was 103.4
2016\space Inflation\space Rate = \frac{100.7 - 100.0}{100.0} \times 100\% = 0.7\%2017\space Inflation\space Rate = \frac{103.4 - 100.7}{100.7} \times 100\% = 2.7\%

The inflation rate is 0.7% in 2016 and 2.7% in 2017.

Example 2. The Bureau of Economic Analysis

The Bureau of Economic Analysis (BEA) of the United States Department of Commerce published the values of GDP deflator.

In the 3rd quarter of 2018 GDP deflator was 1.5 percent. In the 2nd quarter of 2018 it was 3.3 percent. Therefore, the Inflation Rate for 3Q 2018 is calculated as:

Inflation\space Rate_{3Q\space 2018} = \frac{1.5\% - 3.3\%}{3.3\%} \times 100\% = -0.54\%

The inflation rate for 3Q of 2018 was -0.54%. This means that we are facing the so-called “negative inflation” or deflation. That means that in Q3 of 2018 the value of US dollar increased by 0.54%.

What Is Inflation Targeting?

Inflation Targeting is the policy of meeting targets for Inflation Rates. Although there is no ideal standard Inflation Rate, there are some target limits Central Banks should aim for. Not only are Inflation levels of 2-3% annually are acceptable, but they are even desirable for the economy. Higher Inflation Rates can be dangerous for the economy as it might lead to hyperinflation, lower rates can cause stagnation, inefficient financial system and unemployment.

What Are the Effects of Inflation?

  • Activates spending and deters saving. An inflation decreases the value of money, so savings lose their value. That stimulates consumers to spend their savings while the purchasing power of money remains relatively high.
  • Decreases unemployment. The Inflation Rate is a measurement of the rise of general price level over a period of time. It’s usually calculated for a year, quarter or month. That is to say the Inflation Rate is a decrease of a purchasing power of currency. The higher the Inflation Rate is, the fewer goods or services you can buy for a unit of currency. The process opposite to inflation is called deflation, which is a decrease of general price level.
  • Interest rates. Interest rates are likely to rise with increasing inflation. Banks adjust their rates to the diminishing value of currency. For example, if certain bank’s interest rate is 2% and expected inflation is 3%, they will add 3 percentage points to the rate in order to remain their profit on the same level.
  • Hyperinflation. Hyperinflation is a very high level of inflation. Due to hyperinflation, nominal prices of goods and services increase rapidly. It occurs when the “flat money” is printed, that means the amount of money increases and it’s not supported by growth in the output growth of goods and services.