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Words from our economics professor Ray Hill. He is correct in saying that and I also believe that everyone in business (not just MBAs) should know what inflation is and how to calculate the rate of inflation.

What is Inflation? Per Wikipedia, the definition is – inflation is a rise in the general level of prices of goods and services in an economy over a period of time. So far so good. We all understand this basic concept very well.

Now, how is the rate of inflation calculated? What measures should one use to calculate the rate?  Basically, there are some other measures (or indices) that should be known to you before you decide to calculate the rate. First is CPI or Consumer Price Index – an estimate of average price for goods and services purchased by households. Second is GDP deflator – a measure of level of prices of goods and services that are produced domestically. Third is PCEPI or Personal Consumption Expenditures Price Index – derived from the largest component of the GDP (personal consumption) and measures the change in prices of goods and services consumed by individuals. I will not go into the details of what each of these are and how they differ because lots of literature is already available on the internet.

Calculation of the rate of inflation is very simple indeed.

Rate of inflation (between time period t and T, T>t) = (Value of the index at time T)/(Value of Index at time t) – 1.0

For e.g. – Between December 2006 and 2007, the inflation rate was 4.08% (based on CPI)

But this is where the fun begins. Using these concepts how do you find out what is the real price of a good based on prices in a certain year in the past? Say Coca Cola, 6 pack 12Oz., used to cost 50 cents in 1974 and $1.50 in 2004 (illustrative figures). This $1.50 is the Nominal price of Coca Cola. What is the real price in 1974 dollars? Say the rate of inflation between these time period is 283% (2.83) (this is actually true). Then,

Real price (in 1974 dollars) = Price in 2004/Rate of inflation = 1.5/2.83 = 53 cents. Huh. Not bad is it!

There is another question that begs answering – What index should one use to calculate inflation rate? CPI is measured using a fixed basket..not a good idea because a typical household’s basket of goods purchased changes over time, new products are introduced, and quality of goods changed (for e.g computers, cars…). There have been some changes in the ‘algorithm’ used but still it tends to have an upward bias in the calculation. GDP deflator helps a little bit because it does not rely on a fixed basket but the actual consumption/expenditure patterns of individuals in a given year. This tends to eliminate the upward bias, but not by much.

Some products, specifically food and energy, tend to be affected by supply shocks and the price change may be temporary (we know about the oil prices, right?). So including these components in calculating true inflation may be misleading. If these are eliminated we may be able to see the real picture. This is where Core Inflation, calculated using PCEPI, comes into picture. In fact, Fed nowadays uses this measure to calculate inflation and take monetary decisions.

Note that inflation can be calculated for specific set of assets such as commodities, services, and wages.These set of values are just subsets of the net inflation but the rules of calculations remain the same.

Some important direct links:

CPI (unadjusted) Data Download

GDP Deflator Data Download

PCEPI (Less food and energy) Data Download

News Flash – September inflation data indicated that consumer prices declined 1.3% during the prior 12 months and that core annual inflation, which excludes volatile food and energy prices, rose just 1.5% — well within the Federal Reserve’s comfort range of between 1%-2%.

Hope you now understand what this means…