How Economists
CALCULATE THE INFLATION?
Inflation is a term we hear a lot in discussions
about the economy.
It affects everything from the price of groceries
to the interest rates on loans.
But what exactly is inflation, and how does it
work?
In this post, we’ll break down what inflation is,
what causes it, its effects on different aspects of
the economy.
What Is Inflation?
Inflation is the rate at which the general level of
prices for goods and services rises, eroding
purchasing power.
In simpler terms, it means that over time, the
money you have today will buy less than it could
in the past.
Inflation is measured as an annual percentage
increase, so if inflation is 2%, that means, on
average, prices for goods and services are 2%
higher than they were a year ago.
How Inflation Is Measured
Inflation is typically measured by indices like the
Consumer Price Index (CPI) and the Producer
Price Index (PPI):
Consumer Price Index (CPI): This measures
the average change over time in the prices
paid by consumers for a basket of goods and
services. It’s one of the most commonly used
indicators of inflation.
Producer Price Index (PPI): This measures
the average change over time in the selling
prices received by domestic producers for
their output. It tracks the prices businesses
pay for raw materials and production costs.
Steps in to calculate
inflation Using CPI
1. Select a Base Year: A base year is chosen as the
point of reference for price comparisons.
Prices in other years are compared to this base
year.
2. Create a Basket of Goods and Services: A
representative basket of goods and services is
defined based on what the average household
buys, such as food, transportation, housing,
clothing, and medical care.
The quantity of each item in the basket remains
constant over time.
3. Track Price Changes: The prices of the items
in the basket are recorded at regular intervals
(monthly, quarterly, etc.). This is done across
various sectors and locations to ensure
accuracy.
4. Calculate the Index: The CPI for a given period
is calculated by dividing the current cost of the
basket of goods and services by the cost of the
same basket in the base year, then multiplying
by 100.
CPI Calculations:
Cost of Basket in Current Year
CPI = × 100
Cost of Basket in Base Year
For example, if the basket cost Rs. 1,000 in the
base year and Rs. 1,050 in the current year, the
CPI would be:
1050
CPI = × 100 = 105
1000
Calculate the Inflation Rate:
The inflation rate is then calculated by finding the
percentage change in the CPI from one period to
the next. The formula for calculating inflation is:
Inflation CPI in Current Year−CPI in Previous Year
= ×100
Rate CPI in Previous Year
For example, if the CPI was 105 in the current year and
100 in the previous year, the inflation rate would be:
Inflation 105 - 100
= × 100 = 5%
Rate 100
This means that inflation for that year was 5%, indicating
that prices rose by 5% on average over the period.
Effects of Inflation
1. Purchasing Power
Inflation reduces the value of money. As prices
rise, the money you have buys less than it used
to. Over time, this can make it harder to afford
goods and services, especially if wages don’t keep
up with inflation.
2. Interest Rates
Central banks often raise interest rates to
control inflation. When interest rates go up,
borrowing money becomes more expensive. This
can slow down spending and investments, as
people and businesses may cut back due to
higher loan costs.
3. Savings and Investments
Inflation can erode the value of savings if the
interest earned on savings is less than the
inflation rate. However, inflation can be good for
certain investments like stocks or real estate,
which may increase in value as prices rise.
4. Wages and Employment
Moderate inflation can push wages higher, as
employers need to pay more to attract workers.
However, if inflation rises too fast, wages might
not keep pace with prices, reducing people’s
purchasing power. In extreme cases, this can lead
to a cycle where prices and wages chase each
other upwards.
4. Debt
Inflation lowers the real value of debt, which is
good for borrowers. This means that the money
they owe will be worth less in the future. On the
other hand, lenders lose out because the money
they get back is worth less than when they lent it.
5. Economic Uncertainty
When inflation is high or unpredictable, people
and businesses can become uncertain about the
future.
They may delay spending or investing, which
can slow down economic growth and create a
lack of confidence in the financial system.
