How To Calculate Inflation Rate and Why It's Useful
By Indeed Editorial Team
Updated 1 September 2022 | Published 29 September 2021
Updated 1 September 2022
Published 29 September 2021
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Inflation rate is a key topic when discussing the economy and the value of a currency. It has a role to play in the economy of a country and how people spend and save money. Understanding the basics of the inflation rate can be an important part of money management and preparing for the cost of services and goods in the near future. In this article, we explore what the inflation rate is, why inflation happens, the formula for calculating it and how to calculate inflation rate.
What is inflation rate?
Inflation rate is a measurement of how the rate of price for goods (such as food or electronics) and services (such as train tickets) has increased over time. For example, if the cost of a £1 jar of coffee rises by 5p, then the rate of inflation for coffee is 5%. Inflation is measured by comparing the cost of things today with how much they cost a year ago. Calculating the average increase in prices across all these items is what gives the rate of inflation. However, you can look at the inflation rate over any period of time.
Understanding the inflation rate is important because as the average cost of items increases, the currency loses value as it takes more and more funds to acquire the same goods and services as before. This fluctuation in the value of a currency has an impact on the cost of general living, which in turn affects the economy and leads to slower economic growth. While you may notice low levels of inflation from month to month, the long-term picture can actually show significant changes in just how much you can buy with your money.
Related: 14 of the Best-Paid Jobs in Finance
What is the formula for calculating inflation rate?
The formula to calculate inflation is ((T – B) / B) x 100. To better understand this concept, let's look at a hypothetical example. Say the cost of a tin of beans in 1990 (B) was 65p and today (T) it is £1.15. Based on this example, here is what it would look like when you apply the inflation calculation formula:
target year: T = £1.15
inflation base year: B = £0.65
rate of inflation = ((T – B)/B) x 100 = ((1.15 – 0.65)/0.65) x 100 = 76.92
Based on this example, the inflation rate from 1990 to today for the price of a tin of beans is 76.92%.
To truly understand the formula, however, it is important to understand some of the terminology used around this topic. The three key terms to learn are:
1. Consumer price index (CPI)
The consumer price index measures the average change in prices over time that consumers pay for a 'basket of goods' and services. The Office for National Statistics (ONS) measures CPI who monitor the prices of thousands of everyday items. Each month, the ONS releases its measure of inflation to show how much prices have risen since the same date from the previous year.
2. Inflation base year (B)
The inflation base year is the CPI for the year to which you are comparing the current inflation rate. You need to have this starting year for the data to be valid. For example, if you are looking at how much the price of bread has risen since 1990, the base year would be 1990.
3. Target year (T)
The target year is the CPI for the end date (typically the present date) you are using to calculate inflation. Your target cannot be further in the future than the current year. For example, if you're looking at how much the price of milk is today compared to what it was in 2000, the target year is the current year.
How to calculate the inflation rate for any period of time
You might be wondering how to calculate the inflation rate for a given period of time. The CPI, which measures variations in price for goods and services, is used to help calculate the inflation rate. The inflation rate represents the price increase or decrease of consumer purchased products over a period of time. In addition to the CPI, you may also use historical price records.
The following steps can be applied to calculate the inflation rate for any given or chosen period of time:
1. Gather information
Begin by deciding which goods and services to evaluate. You can then gather key information on prices across a period of time. The ONS website ('under-inflation and price indices') displays this data across defined time periods. Alternatively, you may wish to conduct your own research. Remember that the CPI is the average price of goods and services over a period of time. The number you find around this information represents an average cost, not a definitive total.
2. Complete a chart with CPI information
Use a chart to help you visualise your data and make it easier to read. It's a good idea to use a line chart that shows the date across the x-axis (horizontal line) and the percentage of average price increase on the y-axis (vertical line). This gives you a clear flow to follow, visualising the rises and drops of the CPI.
3. Determine the period of time
Now determine how far back you wish to go or how far into the future. You may also wish to calculate the information across any given number of months, years or even decades. The inflation rate depends on the time scales to provide useful data.
For example, you may be looking to determine what the rate of inflation may be for when you are looking to retire. This way, you have more understanding about how much you wish to save in your retirement and pension pots. Opposite to this, you may be interested to see the rate of inflation since you graduated from university and compare how different times are to back then.
4. Locate CPI for dates
Start putting in data for the inflation calculation formula. First is the inflation base year, represented as B in the formula. Remember, this is the starting point of the good or service you are analysing. Next is the target year, represented as T in the formula. This is the CPI for the later date (typically the current year or month) on the same good or service.
5. Use the inflation formula
With these two critical CPI figures identified, you can now use the formula to calculate inflation. The formula is ((T – B) / B) x 100. Let's use another example to break this down and make it easier to understand.
You are calculating the cost of petrol from 1980 to today. In 1980, the cost was 23p per litre. Today it is £1.32 per litre. Step-by-step, this would work out as:
Subtract B from T. Start by subtracting the earlier date CPI from the later date CPI (1.32 - 0.23 = 1.09)
Divide by B. Then divide this number by the earlier date CPI to get a decimal point answer (1.09 / 0.23 = 4.74)
Multiply by 100. Finally, multiply this new number by 100 to get the inflation rate as a percentage (4.74 x 100 = 474%)
The rate of inflation of the cost of petrol from 1980 to the current date is 474%. Seeing as the inflation rate indicates an increase in prices, when the average inflation rate reaches 100%, it means the goods and services in question have doubled in price. For the petrol example, the rate of inflation has more than quadrupled in price since 1980.
Why does inflation happen, and who benefits?
There are various factors that can drive prices or inflation within an economy. Generally speaking, inflation rates are directly impacted by the demand for particular products and services. If a product is no longer in demand, this typically drives a price down. If a product is in high demand, the price goes up.
There are two main categories for inflation:
Costs associated with production lead to this type of inflation. This typically means the rising cost of raw materials. Predicating cost-push inflation is possible by tracking the prices of fossil fuels and precious metals, two primary resources in manufacturing. Cost-push inflation generally has no outright beneficiaries. Suppliers raise prices because the cost of manufacturing, production, or just running a business has increased.
Demand-pull inflation, on the other hand, is what you see in everyday supply and demand in your homes and general life. For example, your broadband service has increased in price in recent years because there is a greater demand for the product. The rise and fall of house prices display the same principle in action. If demand for houses increases, then prices go up, and as demand decreases, they go down.
Demand-pull inflation can have significant gains for the service provider. Using the same example of a broadband service provider, the cost of producing modems and laying broadband wire has not increased, but because demand for their product has gone up, they can raise their prices.
Please note that none of the companies mentioned in this article are affiliated with Indeed.
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