Rate of Inflation = [ CPIx+1 – CPIx ] ÷ CPIx
CPIx = Initial consumer price index
Rate of inflation formula is utilized by investors and financial analyst to measure the probability of change in purchasing power of a particular currency. As the market prices of goods increases, the purchasing power of the currency goes down a simple inverse proportional relationship.
Bureau of Labor Statistics in U.S. released the Consumer Price Index and this Rate of Inflation formula uses that index to calculate inflation. Although different consultancy firms use some other indices at times where there are some special requirements. You can simply replace CPI in the rate of inflation formula with the respective Index.
On the other side in the formula above the subscript ‘x’ indicates the initial period OR time for consumer price index. While, the subscript ‘x+1’ refers to the initial time plus 1 OR subsequent year for consumer price index.
How rate of inflation formula is useful for investors
Typically economists, investors use rate of inflation formula for decision making. While companies use rate of inflation to compare the expenses, profit and revenues over full investment period. One point which can be confusing for some, especially not from economic background may confuse the terms rate of inflation and purchasing power of goods. Purchasing power is basically the ability of a person OR community to buy goods relative to their income.
An example will be a person whose salary increases to $100,000 from $70,000 annually. After a great moment of excitement, when the person goes to supermarket for shopping purpose he found that all basic kitchen use items including loaf, bread etc. have new prices with almost 30% increase. This is where the concept of inflation comes-in and individual realizes that things are almost same even after increase in salary. Here in this example the increase in prices of consumer goods is known as inflation while on the other side ability of person to buy an item based on his income is known as purchasing power.
Rate of inflation formula adjustment
If you want to annualize a monthly rate, first it’s not that’s simple to just multiply with 12 and second this method do not take in to account the compounding effect. On the other side if you are thinking to add all the monthly changes in consumer price index to find the annual percentage change in indices then this would also be a wrong approach and result will mislead. The precise way to calculate the annual rate for inflation is to use the initial CPI for a specific year and then the ending CPI of the same year in the formula above.