What is inflation
A dollar buying power today is different than twenty years ago. The general prices of goods and services are changing over time. The increase in the overall level of prices is called inflation; in contrast, a persistent decline in the average price level called deflation. These two phenomena are a prevalent feature of the capitalist economy, and it is a primary concern of economists and policymakers.
Inflation is a continuous increase in prices of goods and services. In case of inflation, the currency gradually loses its purchasing power, so its value decreases in time. Therefore, the expressions “inflation” and the “fall in the value of money” are often used synonymously.
In general, policymakers aim to maintain stable prices; that is, keeping inflation low and constant, defined as an annual rate of close to 2%.
How to calculate the inflation rate
Since inflation can be defined as a sustained rise in the general price level and not the price level of only one or two goods, calculating the accurate level of inflation rate in an economy involves a carefully applied data collection and sophisticated statistical methodologies.
There are several ways how to calculate inflation rate. For example, the most comprehensive way of measurement is the GDP deflator, which considers prices of all factors used during the computation of the Gross Domestic Product.
Still, one of the most common way to measure inflation is to utilize the Consumer Price Index (CPI), which records the prices paid by consumers for a large basket of goods and services. This basket of products and services contains around 80 thousands items, representing the average cost of living. In the United States, the Bureau of Labor Statistics collects the prices through calling and visiting retail stores, service enterprises (such as cable providers, airlines, car, and truck rental agencies), rental units and medical centers across the country.
Therefore, by focusing only on a single good, we represent a simple way of calculation, where the result may differ from the official inflation rate but surely gives you a better understanding on the concept.
- Let’s start with determining the time frame. Enter the start and end year into our inflation calculator. For example, you can calculate the inflation rate between 2015 and 2016.
- Determine the price of any product in the start year. For example, one liter of beer during Oktoberfest cost € 10.30.
- Determine the price of the same product in the end year. The price of Oktoberfest beer rose to € 10.60.
- Use the following formula:
inflation = (FP / IP) ^ (1/t), where
IP is the initial price,
FP is the final price,
t is the time elapsed (in years).
- You can use our inflation calculator to find the result, too. In the above case, the price increase is 2.91%, which might be a proxy for the inflation rate. For a more precise calculation you may use the office CPI index in your country.
Inflation in a financial context
We don’t normally keep money in a locked box. Rather, we prefer to keep our savings in bank accounts or invest them. With a given interest rate, our savings increase from some initial value to a higher future value. For example, if you hold $1000 on your saving account with a 3% interest rate, you will have $1030 on your account after a year. However, this is only a nominal value which is not necessarily equal its real value.
Most probably, the general price level will change during the year; thus it will affect the real value of your money. So even though you will have $1,030 in your account, each one of these dollars will be worth a bit less than it was a year earlier. If the inflation rate is, let’s say, 2 percent, then the real value of the money in your account is only $1,010. It follows that the nominal interest rate, which is offered by banks, is not the best basis for evaluating the real value of your gains. It is better to use an inflation-adjusted rate, that is, the real interest rate.
When you borrow money, though, inflation might be your friend, depending on the real interest rate. If the inflation rate is higher than the interest rate, the money you owe is less worth in real term eventually. However, when deflation happens, your debt burden might increase in real term. In this way, deflation may redistribute income from debtors to creditors, worsening the financial position of people in debt. In economic slumps, countries often experience deflation, which is particularly harmful when plenty of people are indebted, for example, as it happened after the 2008 financial crisis. In this situation, firstly stated by Irving Fisher after the Great Depression, the real values of loans increase what further hinders the economic recovery.
However, as Farrell (2004) argues, deflation might be an acceptable feature of a prosperous economy if it is relatively mild and caused be supply factors. The broad expansion of Internet usage and the unfolding globalization allows suppliers to continually reduce their costs and also consumers to find the lowest price, implying a constant downward pressure on prices.