Understanding the inflation rate formula is like understanding what’s under the hood of your car. You don’t want to rely on some no-name “expert” to tell you if you’re in good shape. You need to verify it for yourself.
No matter your age, your income, or even the country you live in, price increases affect all of us, making inflation a big deal. So today we’ll cover how to calculate inflation rate, we’ll learn about the CPI, and look at how it’s been changing over a period of time
Let’s backtrack a bit and start by defining inflation. Inflation is the progressive increase in the price of goods and services, which ultimately reduces the purchasing power of money. You’ll find that over time, the quantity of goods and services you can buy for X dollars becomes significantly less. Basically, your money is gradually losing value because of inflation.
Inflation can also occur if money supply is greater than economic output. I know what you’re thinking, “Does that mean decreasing money supply can counter inflation?” The simple answer is yes, to an extent. This is a strategy that governments do turn to in their monetary policy by decreasing bond prices and increasing interest rates.
The purpose of this article is to provide clarity on what inflation actually is, because a lot of people only kinda, sorta know what it is. BONUS – you’ll find out how to use the inflation rate formula as well.
Inflation rate formula
If you’re wondering how to calculate the inflation rate, you’ve come to the right place. The inflation rate formula has three core inputs; consumer price index (CPI), as well as inflation base year and target year, which we will refer to as (B) and (T) respectively. Let’s zoom in on each input just for clarity.
The CPI is a weighted average of consumer goods and services. This is one way of determining if you are paying too much for something. The base year is the comparative year, while the target year is usually the present year or the year that you’re calculating the rate of inflation for.
With that in mind, the inflation rate formula is simply (T-B)/B x 100.
Inflation Rate Formula
Inflation rate = (T-B)/B x 100
T – Target year pricing
B – Base year pricing
To paint a clearer picture for you, here’s an example of how to calculate the rate of inflation for a carton of milk over 20-years: Using the inflation rate formula, if a carton of milk cost $1 in 2000 and $3 in 2020, then the calculation would be (($3-$1)/1) x 100 = 200% (over 20 years).
So, based on this example, the inflation rate for a carton of milk over 20 years would be 200%.
Generally, inflation is targeted at about 2% per year, but bring in the unwanted cousin – hyperinflation. In such a case, the increase in the price of goods and services can be excessively high. How high? As high as you can imagine. But, back to the inflation rate formula.
The nuance in how it’s calculated
The CPI is calculated periodically using what is referred to as a basket of goods, comprising everyday goods that pretty much every person uses. Think bread, milk, education, housing, medical care – you know, all the important stuff that keeps you alive and breathing. Unfortunately, that trip to Dubai and that expensive sneaker are NOT included in this basket.
The overall cost of the basket of goods over a period of time can be compared to that of previous years to get a better understanding of where things stand.
|January of||CPI ($)||Inflation Rate (%)|
This is not to say that this is the most efficient way to calculate CPI, a lot of overthinkers and smart people are quick to highlight that it focuses on the urban population, for one, so there are several blind spots. Others argue that the quality of goods is also never compared – another shortfall of the basket of goods concept. But that’s a conversation for another day.
Example of how it affects your personal finances
If you can confidently say that you haven’t really seen the impact of inflation over a period of time on your personal finances, then you’re either a) hiding in a bunker or b) so rich you have a butler do all your shopping.
Over the past ten-ish years, the US inflation rate was always around that 2% target. (Yeah, I know the last two years jumped up like crazy!)
But sticking with that 2% inflation rate for simplicity, if ten years ago you spent $1000 per month on your living necessities, you’d need to spend around $1218 on the same things.
If your bank account gave you 2% interest per year, your $1000 would amount to $1218 in 10 years (depending on the compounding frequency) so you’d be able to buy basically the same types of things.
But let’s be honest, most banks did not give a 2% interest rate – it was closer to zero, which is about as useful as hiding your money under a mattress. So the thousand dollars from ten years ago could get you only about $820 worth of stuff now, and with a recent jump in prices, it’s even less.
Now let’s say you invested that $1000 in the stock market which has a historic 10%/year average growth. After ten years, that thousand dollars would grow to over $2500 on the stock market! So unless you’ve suffered from some lifestyle inflation too, that money would more than cover your living necessities.
So if you’re still not sure where to park your savings, ask: would I rather my money lose its value or gain its value?
Inflation Rate Formula In Action!
Let’s look at a quick inflation rate formula example
|January of||CPI ($)|
To find the inflation rate, we can look at the two CPI values from January 2021 to January 2022.
Inflation rate = (T-B)/B x 100
Inflation rate = (281.148-261.582)/261.582 x 100
So the inflation rate is 7.5%!
But bear in mind that sometimes people make this calculation over multiple years (which usually gives a huge number) or just a month (which makes the change look teeny). Also, sometimes people are sneaky and don’t use the CPI but another value just to make a point.
Living essentials such as fuel and food are the quickest indicators of inflation – even without having to do a calculation, the increase over a period of time is evident. If we take a look at gas in the US over a period of 30 years between December 1991 and December 2021, using the inflation rate formula, the calculation would be: (($3.505-$1.182)/$1.182) x 100 = 196.53% increase over 30 years!
So, keep the inflation rate formula in mind and do some quick calculations next time you find yourself wondering.