Inflation is an inevitable consequence of a growing economy. However, like the porridge in the story of "Goldilocks and the Three Bears," it's important that inflation be not too hot and not too cold. For some investors, knowing how to calculate the inflation rate is important to understanding how the purchasing power of your money changes over time. In this article, we'll explain why the inflation rate is essential, how to calculate inflation rate and what index investors use to understand the inflation rate.
As a free service for all investors wanting to know how to calculate inflation, MarketBeat provides an online inflation rate calculator. MarketBeat's inflation rate calculator allows you to plug in the elements of the inflation formula to see how inflation may affect your investments over a period of time.
What is Inflation Rate?
Inflation measures how the price of goods and services has increased over time. The inflation rate is the expression of inflation as a percentage increase over a certain period of time. Typically the inflation rate is expressed as a month-over-month or year-over-year difference.
Why Inflation Happens
Although seen as a negative economic indicator, inflation is necessary for a growing economy. That's because the cost of goods and services will naturally rise over time. However, with inflation, like many things, moderation is the key.
When inflation rises too fast, it signals a problem in the economy. But the opposite is also true. Deflation, otherwise called negative inflation, can be an even bigger problem for businesses as it decreases earnings, which weighs on a company's stock price.
There are two basic types of inflation that we'll look at in the following sections:
One of the most common definitions of inflation is too much money chasing after too few goods, or demand-pull inflation, which the consumer typically leads.
According to Keynesian economic theory by John Maynard Keynes, when consumers spend more, businesses will increase hiring. An increase leads to more demand until demand outpaces supply and prices rise.
When this kind of inflation is prevalent in an economy, there is a rise in the cost of living. Simply put, consumers will know that a dollar won't buy as much as it used to.
But most economists say this supply-demand imbalance is more an effect of inflation than the root cause. There are several causes of demand-pull inflation. These include:
- An expanding economy: As mentioned above, a little bit of inflation is natural and healthy. That's because when consumers feel confident about their employment and the likelihood of rising wages, they're more likely to spend money and take on more debt in the form of a home mortgage or a car loan. The net effect of this spending is a rise in prices as demand increases and supply decreases.
- Currency fluctuations due to higher exports: When a country begins suddenly and significantly exporting more than it imports, it will undervalue the underlying currencies. For example, when the U.S. exports more to Europe, European goods' cost is generally cheaper than the strong dollar.
- Increased government spending: When government spending increases, prices will rise, particularly if the government is engaged in deficit spending (i.e., printing money). That's because it increases the money supply.
- Companies anticipate inflation: When they anticipate inflation, companies frequently raise the price as a preemptive measure to protect profit margins.
- Increase in the money supply: A nation's money supply refers to all the currency and other liquid instruments that are part of a country's economy. When the money supply increases, usually through a country's central bank or treasury, it will cause prices to rise.
Another kind of inflation is known as cost-push inflation. This kind of inflation occurs on the producer side of the economy. When a company's input costs rise (e.g., the cost of raw materials or wages), companies will frequently pass some of these costs along to the consumer.
These two types of inflation frequently play off each other. As demand increases, input costs rise. Those costs pass on, which increases prices, and if demand continues to grow, it can lead to an inflationary spiral.
The Consumer Price Index
The Consumer Price Index (CPI) is a commonly referenced inflation measure. It's also one of the best economic indicators of the Federal Reserve Board (the Fed) when considering changes in the nation's monetary policy.
The CPI measures the price change paid by U.S. consumers in a given month, expressed as a percentage. The Bureau of Labor Statistics (BLS) calculates the CPI.
Like an equity index, the CPI is a weighted average of prices for a basket of goods and services thought to represent aggregate U.S. consumer spending. For example, shelter costs account for approximately one-third of the CPI. The methodology of the CPI solicits 94,000 price quotes collected from 23,000 retail and service establishments and 43,000 rental housing units.
The CPI shows how prevalent demand-pull inflation is in the economy. By contrast, the producer price index (PPI) measures cost-push inflation by calculating the price change reported by U.S. manufacturers.
How to Calculate Inflation Rate
To understand the inflation rate equation, you'll need to know the timeframe you're comparing to calculate inflation rate. For example, if you're looking to calculate the inflation rate on a year-over-year basis, you should ensure you start with the same month each year.
Inflation Rate Formula
The inflation rate formula is expressed as follows:
((B – A)/B) x 100 = Inflation Rate
In this formula, B stand for a current measurement, and A stands for a past measurement. In this case, multiplying by 100 calculates the CPI. However, for individual calculations, you would use the measured item's price.
Using the exact measurement with CPI gives us this inflation equation:
((Current CPI – Past CPI) ÷ Current CPI) x 100 = Inflation Rate
Note: The Bureau of Labor Statistics provides current and past CPI data on its website.
How to Use the Inflation Calculator
Math may not be your thing. Or maybe you've come to love MarketBeat's online calculators, such as the MarketBeat retirement calculator. Either way, the MarketBeat inflation rate calculator is a super simple way to quickly calculate the purchasing power of your dollars by calculating the inflation rate over time.
Here are the steps you need to follow:
Step 1: Input a dollar amount.
For example, how much $100 would have been worth in 2022 as opposed to 1972? But you can input any amount, including cents, if you would like, such as $10.50.
Step 2: Choose your method for calculating the inflation rate.
Your options include using historical U.S. data meaning the CPI index reading for a specific period, or you can choose to use the forward flat rate or backward flat rate over that period. Your decision will impact the following two steps.
- If you're using historical U.S. data:
Step 3: Enter a starting year and an ending year.
If you want to know how the inflation rate affected purchasing power between 2000 and 2022, your starting year will be 2000, and your ending year will be 2022. The MarketBeat calculator will automatically pull in the CPI from the years you entered.
- If you're using forward flat rate or backward flat rate:
Step 3: Enter the inflation rate and time period.
The calculator will default to 3% and 10 years. Therefore, selecting a forward flat rate will calculate how much your dollar amount would be worth at that inflation rate in 10 years. Selecting a backward flat rate will show you how much that dollar amount would have been worth based on the inflation rate.
If you find this calculator helpful, check out other free calculators on MarketBeat, including the MarketBeat stock average calculator, the MarketBeat stock profit calculator and the MarketBeat options profit calculator.
Examples of Inflation Rate Calculations
Now, let's look at using the formula with real-world examples.
Let's say you paid $6.99 for your latest coffee fix. Assuming that the producer passed all the inflation on to you, what would that same cup of coffee cost the year before? We'll use a CPI of 297.711 for 2022 and 277.948 in 2021.
The inflation rate formula would be:
((297.711-277.948)/297.711) x 6.99
Which would be:
(19.763/297.711) x 6.99
.06 x 6.99 = 2.90
That means you paid 41 cents per cup more for coffee in 2022.
Now, let's say you wanted to see how much that same cup of coffee would have theoretically cost (assuming all producer costs passed on) in 2000. We'll use a CPI of 297.711 for 2022 and 174.1 for 2000.
The inflation rate formula would be:
((297.711-174.1)/297.711) x 6.99
Which would be:
(123.611//297.711) x 6.99
.41 x 6.99 = 2.90
Why is Calculating the Inflation Rate Important?
Indeed, a dollar today is not worth what a dollar was worth five years ago or 10 years ago. That's the natural effect of inflation, and it's healthy for a growing and functioning economy.
Of course, like any economic measure, inflation is only good if it occurs at a moderate pace. The Federal Reserve has a 2% annual rate as its benchmark for healthy inflation. When inflation exceeds that 2% target, it generally points to underlying economic problems. That’s why knowing how to calculate inflation is important for economies and individuals.