Inflation is a ubiquitous economic concept that impacts the everyday lives of people around the world. It's a critical factor in understanding the rising prices of goods and services, affecting everything from the cost of groceries to the value of investments. But have you ever wondered how inflation is calculated?
Here, we’ll dive into the world of inflation calculations and show an example of how inflation is really calculated.
What Is Inflation?
Before we dive into the calculations, it's essential to understand what inflation is. According to the International Monetary Fund, inflation measures how much more expensive a set of goods and services has become over a certain period (usually a year).1 To track and measure this economic metric, economists rely on various indices and indicators.
Measuring Inflation: The Consumer Price Index (CPI)
The most common tool to measure inflation is the Consumer Price Index, or CPI. The CPI is a comprehensive measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.2 These goods and services include everything from food, clothing, and housing to healthcare, transportation, and entertainment.
How to Calculate Inflation
Now, let’s look at how to actually calculate inflation:
Step 1: Selection of the Basket of Goods
The first step in calculating inflation is to determine the basket of goods and services that will represent the average consumer's spending.3 The selection of these items is crucial and should be a fair representation of what an average person buys.
Step 2: Price Data Collection
After defining the basket of goods, the next step is to collect price data. This involves tracking the prices of every item in the basket over time. Price data collection is an extensive process that involves visits to retail stores, online marketplaces, and other sources.4 The Bureau of Labor Statistics (BLS) records both the price of goods and services and the price of housing.
Step 3: Calculate the Base Year Index
To calculate the CPI, a base year is chosen, and the prices of items in the basket are collected for that year. The CPI for the base year is always set to 100. All future CPI values will be calculated relative to this base year.
Step 4: Calculate the Current Year's Index
Once the base year’s index is established, the same items in the basket are priced in the current year. The formula used to calculate the CPI is as follows:
CPI = (Cost of Basket in Current Year / Cost of Basket in Base Year) x 100
This formula measures the percentage change in the cost of the basket of goods and services from the base year to the current year.
Step 5: Calculate Inflation
The final step in the process is to calculate the inflation rate using the CPI values of the base year and the current year. The formula for calculating the inflation rate is as follows:
Inflation Rate = ((CPI in Current Year - CPI in Base Year / CPI in Base Year) x 100
This formula calculates the percentage change in the CPI from the base year to the current year, which represents the inflation rate.
An Example of How Inflation is Calculated
Let's walk through a simplified example to illustrate the process. Suppose we have a base year (Year 1) and a current year (Year 2).
Cost of Basket in Year 1 = $100
Cost of Basket in Year 2 = $110
Using the CPI formula:
CPI in Year 2 = ($110 / $100) x 100 = 110
Now, the inflation rate is calculated:
Inflation Rate = ((CPI in Year 2 - CPI in Year 1) / CPI in Year 1) x 100
Inflation Rate = ((110 - 100) / 100) x 100 = 10%
This means that prices increased by 10% from Year 1 to Year 2, indicating an inflation rate of 10%.
Inflation is a complex economic concept that plays a significant role in our daily lives. Understanding how inflation is calculated, particularly through the Consumer Price Index, can provide insights into the dynamics of rising prices
As always, let us know if you have any questions.
CRA Investment Committee
Matt Reynolds CPA, CFP®
Tom Reynolds, CPA
Robert T. Martin, CFA, CFP®
Gordon Shearer Jr., CFP®
Jeff Hilliard, CFP®, CRPC®
Joe McCaffrey, CFP®
Phillip Tompkins, CFP®
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by CRA Financial, LLC [“CRA]), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CRA. Please remember to contact CRA, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. CRA is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. A copy of CRA’s current written Disclosure Brochure discussing our advisory services and fees continues to remain available upon request or at www.crafinancial.com. Please Note: If you are a CRA client, please advise us if you have not been receiving account statements (at least quarterly) from the account custodian.
Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your CRA account holdings correspond directly to any comparative indices or categories. Please Also Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your CRA accounts; and, (3) a description of each comparative benchmark/index is available upon request.
Please Note: Limitations: Neither rankings and/or recognitions by unaffiliated rating services, publications, media, or other organizations, nor the achievement of any professional designation, certification, degree, or license, or any amount of prior experience or success, should be construed by a client or prospective client as a guarantee that he/she will experience a certain level of results if CRA is engaged, or continues to be engaged, to provide investment advisory services. Rankings published by magazines, and others, generally base their selections exclusively on information prepared and/or submitted by the recognized adviser. Rankings are generally limited to participating advisers (to the extent applicable). Unless expressly indicated to the contrary, CRA did not pay a fee to be included on any such ranking. No ranking or recognition should be construed as a current or past endorsement of CRA by any of its clients. ANY QUESTIONS: CRA’s Chief Compliance Officer remains available to address any questions regarding rankings and/or recognitions, including the criteria used for any reflected ranking.