How To Calculate Inflation Rate: A Step-By-Step Guide
Inflation has run rampant throughout the United States in 2023, and it will continue to do so in the future. While it’s not fun, we must deal with it for now.
However, knowing how to calculate the inflation rate can help you make important financial decisions, especially as it affects your ability to afford the daily cost of living.
Knowing the inflation rate can help you understand how much more money you must save or where to cut back on spending to reach your financial goals despite rising prices.
Here’s everything you must know about calculating inflation rates on your favorite goods and services.
What Is Inflation Rate?
The inflation rate is a measure of how the price of goods and services increases from one period to the next, usually one year, written as a percentage. The opposite is the deflation rate, or the percentage of the price of goods and services decreases over a year.
As inflation increases, consumers’ purchase power decreases, making it harder to afford the daily cost of living, especially large purchases, such as real estate. When prices increase much faster than income, it becomes harder to keep up.
No one can predict how prices will change, often increasing and decreasing. However, knowing how to calculate the change can help you make important financial decisions.
Rather than just saying, “Gosh, bread is more expensive today,” you can have exact numbers to know how much more you must spend to maintain your household and reach your financial goals.
This allows you to build larger emergency funds and have enough money in your rainy day funds to handle the higher costs of your family's needs.
Why Does Inflation Happen?
Inflation happens for many reasons, but the most recent inflation of 2023 was a result of four key factors:
- Increase in demand for goods: We went from an economy with 35% goods and 65% services to one with 40% goods and 60 % services. The instant higher demand for goods, yet steady prices for services despite their declining demand, forced inflation.
- Stressed supply chains: The higher demand for consumer goods created stressed supply chains, causing prices to increase just for them to attempt to keep up with the demand.
- Housing demand: The increase in employees working from home increased the housing demand, playing a part in the soaring housing prices and shortages to occur.
- Fight between Russia and Ukraine: Russia's invasion of Ukraine affected food and energy supply and prices, playing an important role in inflation.
Higher demand for goods and services is typically a big reason for inflation, as are issues with the supply chain.
They go hand-in-hand because higher demand means more supplies are necessary, and if there aren’t more supplies, prices must go up to accommodate the demand and to afford the limited supplies.
Measuring The Inflation Rate
Now that you know what caused the higher rate of inflation, here are two indexes for measuring the average inflation rate:
Consumer Price Index (CPI)
Every month, the Bureau of Labor Statistics (BLS) tracks the Consumer Price Index (CPI). The CPI measures spending on everyday goods, including food, gas, computers and prescription medications.
The exact categories the BLS includes in the CPI change annually based on common consumer spending.
The BLS uses urban consumers, who comprise most of the population, to measure the change in spending on the chosen basket of consumer goods to determine the rate of inflation.
Personal Consumption Expenditures Price Index
Unlike the CPI, the Personal Consumption Expenditures Price Index (PCE) measures the change in prices all consumers spend, not just urban consumers.
This includes goods and services provided by nonprofits. The PCE measures the percentage of income households spend on goods and services. The PCE relies on reporting from government agencies to create its index.
This index stands out as the most accurate measurement for determining the nation's typical inflation rate. It is published by the Bureau of Economic Analysis (BEA) and used by the Federal Reserve as a benchmark for its inflation rate target of 2%.
Calculating The Inflation Rate
When calculating the inflation rate, use this formula:
((B – A) / A) x 100
The “A” represents the starting cost, while the “B” represents the ending cost.
Once you use the formula, multiply the decimal number you receive by 100 and convert it into a percentage. Your end result will be the rate of inflation.
Here are the factors to consider when calculating inflation:
1. Determine Time Frame
First, determine the period you’re trying to calculate the inflation rate. For example, are you trying to find the inflation rate for the current year, a decade, or a few months?
The timeframe depends on what information you’re trying to obtain, whether it’s how much more you must spend today for the price of goods versus last year or whether you want to measure the inflation from when your parents were your age until now.
2. Gather Price Data
Next, you must find the price data for the goods or services you want when measuring inflation rates, such as household goods, food, or gas.
You can use the BLS CPI data to determine the average cost of most goods over time. Just search for the goods you want to calculate the inflation rate for and use the historical price data to get the two data points needed for your equation.
3. Record Information
Next, you must record the information to determine the starting and ending prices to plug into the inflation rate formula. Make sure your data is from the appropriate timeframe and written down so you can use the inflation calculation formula.
4. Use The Inflation Rate Formula
With the pricing information and timeline set, you can complete the inflation rate formula using B as the new cost and A as the original cost, as written down in the above step.
5. Calculate The Inflation Rate
The final step is calculating the inflation rate. After plugging in the numbers, you find the difference between B and A, divide that number by A, and multiply the answer by 100.
Inflation Calculation Formula Example
Here’s an example of how to find inflation rates using the calculation from above. Let’s say you want to calculate the inflation rate on gas prices from 2013 to 2023. You have your time frames: January 2013 and January 2023.
Next, determine the prices during those two times:
- August 2013: $3.60
- August 2023: $3.955
Using the inflation rate formula, the inflation rate for gas over the 10 years is:
(($3.955 - $3.60) / $3.60) x 100 = 9.86%
The Bottom Line
Knowing how to calculate inflation rates can help you make important personal finance decisions when you understand how much prices have increased compared to your income. Inflation rates affect many purchases, including consumer goods, services and real estate.
If you’re considering buying a home, consider starting the mortgage approval process today to see how much financing you can get. This way, you know what you can afford now if inflation rates increase in the near future.