How To Calculate The Inflation Rate: Formulas And Examples

Inflation generally refers to an increase in prices of various goods and services over time. If you're wondering how to calculate the inflation rate, estimating the inflation rate involves some straightforward steps:

1. Subtract an item’s original cost from its present cost.
2. Divide the result by the original cost.
3. Multiply by 100.

This calculation should provide a general idea of how inflation impacts your spending power. Below, we'll explore some finer points of understanding the inflation rate and provide another formula.

What Is Inflation?

Inflation refers to an increase in the price for the same amount of an item or service. You can measure inflation based on price changes for a single item like a cup of coffee, but more often, it’s calculated based on a standard market basket of goods and services. The opposite of inflation is deflation, when prices fall. Over time, prices tend to rise more than they drop.

Some of the effects of inflation are that it encourages spending sooner rather than later, helps control deflation, and in the long term could reduce unemployment. The U.S. Bureau of Labor Statistics generally calculates the overall inflation rate each month.

How To Measure Inflation – And Why It Matters

There are a few different ways to get a measure of the average inflation rate, and the exact ways that you measure it can produce slightly different results. The Federal Reserve considers a 2% percentage change a good benchmark. What this means for consumers is if the rate of inflation rises by 2%, then consumers' purchasing power reduces by 2%.

What Makes The Inflation Rate Change?

The inflation rate can change for a variety of reasons. When some goods are in short supply, that can cause an increase in the prices for those items. The rising cost of goods can increase the overall cost of living and degrade purchasing power. It is also important to understand that it is common for there to be fluctuations in the overall inflation rate over time.

How To Calculate Inflation Rate From The CPI And The PCE Index

The Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) Price Index are two different ways that economists use to calculate the inflation rate. Some economic experts may prefer one index over the other. The CPI, administered by the Bureau of Labor Statistics (BLS), asks consumers the average price that they’re paying on various items for a specific period of time. There are two different survey bases used when calculating CPI. The Consumer Price Index for All Urban Consumers (CPI-U) covers about 93% of the U.S. population because most people in the country live in urban areas.

The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) covers people who have clerical or wage-based earnings. Although it covers a smaller sample size, it is an acknowledgment of the reality that people in different financial situations buy different goods and services.

Another indicator of the economist's annualized inflation rate is called the Personal Consumption Expenditures (PCE) index, measured by the Bureau of Economic Analysis (BEA). As opposed to asking consumers about pricing increases, the PCE asks businesses for information about their expenditures.

Understanding Inflation Rate Formulas

There are a couple of different formulas that can be used to calculate inflation rate. While they’re suitable for different purposes, the one you pick may also depend on the information that you have available to you.

The first formula we’ll look at is best if you’re looking for the inflation rate for a specific product or service over a given period of time. In order to make this work, you’ll need the average price of the product during both years as your starting and ending point.

[ (Updated Price − Original Price) ÷ Original Price] × 100

Here are the steps to find the difference between the average price of a cup of coffee in 1992 and 2012:

1. Find the average price in both years: $1.60 in 1992 and $2.62 in 2012
2. Enter the data into the equation.
3. Subtract the 1992 price from the 2012 price ($1.02)
4. Divide the difference by the original price. ($1.02 ÷ $1.60 = 0.6375)
5. Multiply the previous answer by 100 to get a percentage. (0.6375 × 100 = 63.75%)

In contrast to the above inflation rate formula, the formula the CPI uses is good for comparing goods or services in a basket for the current year to a base year in order to determine inflation. Here’s the formula:

(Current Price ÷ Base Year Price) × 100

Let’s use this formula to find the inflation rate between a base year, 2002, and now for a loaf of white bread. Here’s how it works:

1. Find the average price of a loaf of white bread in 2002 ($1.02) and July 2022 ($1.72)
2. Divide the 2022 average price by the 2002 average price (1.68).
3. Subtract 1 (0.68)
4. Multiply the result by 100. (68%)

What Is Demand-Pull Inflation?

Demand-Pull inflation is classic supply and demand-related inflation. When one toy is the hit of the holiday season, prices rise until the level of demand matches the supply the manufacturer is able to provide. One example of this might be concert or sporting event tickets — when demand is high, the cost for a ticket rises. Less desirable tickets usually have lower prices.

What Is Cost-Push Inflation?

Cost-Push Inflation is when an increase in production costs increases the cost of products and/or services. A good example of this would be the shortage of specialized computer chips for automobiles. Because chips were in short supply, the prices of both new and used cars spiked.

What Is Built-In Inflation?

Built-in inflation occurs when inflation has been high enough because of demand-pull or cost-push inflation that people start demanding higher wages to keep up. Unfortunately, this can also be the most sinister type of inflation because if people have more money, they’ll be willing to pay higher prices, and prices will keep going up.

FAQs: How The Inflation Rate Affects Consumers

How does the inflation rate affect my personal finances?

Inflation affects your personal finances because things tend to cost more. If the rate of inflation rises by 3%, then you'll need to have your income increase by at least 3% just to have the same purchasing power you had before. Also, when inflation is high it can impact your overall investment strategy and make borrowing money more challenging.

Should I change my spending habits because of the inflation rate?

How you react to inflation will likely depend on the amount of resources you have. When inflation rises, your purchasing power decreases. The same $10 you had last year doesn't buy as much this year. When inflation rises, you will need to either increase your income or trim your spending habits to keep your budget intact.

Can I buy a home during a period of high inflation?

It is possible to buy a home when inflation is high, but it can become more difficult. Rising inflation can make the cost of buying a home more expensive, and inflation can also drive up the cost of other associated transactions, like your inspection, repairs or closing costs. Still, buying a home may be a possibility as long as you find one that fits your budget.

The Bottom Line: The Inflation Formula Helps You Measure Your Buying Power

The inflation rate is the rate at which prices increase over time. Inflation is typically measured by economists and makes everything more expensive, including homes and mortgages. Being aware of inflation can help you plan your overall financial strategy and make sure that you are taking the necessary steps to secure your financial future.

Need to maximize your buying power when inflation is high? Download the Rocket Money℠ app to find ways to trim your expenses and spend your money on what matters most!