Inflation can boggle the mind. To many people, it doesn’t make sense that something you bought ten years ago could cost significantly more today. Why is that? If you want to know, then read on. We can explain what inflation is, how to calculate the inflation rate, and what can influence inflation and your financial situation.
What is Inflation?
The capitalist economy has two main components: inflation and deflation. Inflation is when you buy something for far more than you did, say two decades ago. Deflation is when there is a decline in the price you pay for something. These two things can be concerning to the average economist.
When the price of something is inflated, it increases over time to the point of the currency losing its value against the item. The item, in essence, becomes more valuable than the money with which you are buying it. Therefore, you have to pay more to get it.
It’s the job of policymakers to ensure that pricing stays as stable as possible, which means they have to ensure inflation is constant and low – This is also known as an annual rate.
How Do You Calculate the Inflation Rate?
Calculating the inflation rate is a complex process that involves applying data and statistical methodologies to ensure an accurate level of inflation. There is more than one way to go about it as well.
You can use a GDP deflator which considers all factors of price during the computing stage of the Gross Domestic Product (GDP).
Alternatively, you can use the Consumer Price Index (CPI), which records what people pay for a basket of goods and services to represent the cost of living. This “basket” typically contains around 80,000 items, and the data is collected by visiting stores and phoning service providers.
To understand and calculate the inflation rate, you can follow this process.
1. Identify the timeframe you wish to consider. For this example, focus on the year 2018 to 2019.
2. Think of an item and find the price for it at the beginning of the year. Let’s say a loaf of bread was $1 at the beginning of 2018, but it went up to $1.20 by the end of the year.
3. Use the formula
Inflation = (FP / IP) ^ (1/t)
IP = Initial Price
FP = Final Price
t = time period (in years)
4. You can also use this inflation calculator to work it out with no effort at all. However, in the example, the inflation rate was 20% for bread.
Putting Inflation into a Financial Situation
Most of us know that putting money under our mattress is unsafe. What’s worse, however is that it doesn’t allow you to earn any money on it. If you put it in a bank account, you have an interest rate and can receive money from the bank for holding it there. An example of this is if you put $10,000 in the bank with a 2% interest rate. In one year, you would have $10,200.
However, that $10,200 is not equal to its real value; it’s only a nominal value. The price of that figure would have changed during the year, affecting its value and what you could buy with it. If, for example, inflation was at two percent, then you still would only have $10,000 worth of money to account for that - not $10,200 with interest.
However, that’s not to say the system can’t work in your favor. If you borrow money with the inflation rate higher than interest, the money value of what you owe is less than the real figure. But, that’s when you have to consider deflation.
Deflation can cause economic slumps, such as with the 2008 financial crisis and the Great Depression. The real value of loans can end up causing significant harm to economic recovery.
What is Hyperinflation?
When price levels skyrocket, that’s what is known as hyperinflation. For hyperinflation to occur, prices have to increase by 50 percent or higher in one month.
An excellent example of hyperinflation was in Hungary in 1946. The price of money doubled every 15 hours, with daily inflation levels of 207%. Zimbabwe was no better. In 2008, their prices doubled every 25 hours with a daily inflation rate of 98%.
Hyperinflation can destroy an economy for many reasons. People will hoard goods because of the rising prices and won’t deposit their money into bank accounts. As a result, financial institutions can collapse. Even public services can collapse because taxes plummet.