Definition of inflation

Inflation is defined as the measure by which the purchasing power of a currency witnesses a downfall over time. Needless to say, purchasing power decreases when there is an increase in price. Having said that, in simple terms, inflation measures how costlier goods and services get over time. Inflation hence explains the increase in the average price of goods and services in terms of percentage.

To further elaborate, the inflation rate in terms of percentage is a common value indicating the overall increase in price levels of goods and services. From an economic perspective, the inflation rate is crucial given its direct impact on the consumers’ cost of living which is directly dependent on how expensive or affordable goods and services are. The rate of inflation depicts the rate at which a currency’s purchasing power declines and subsequently, price levels shoot up.

The rate of inflation depicts the rate at which a currency’s purchasing power declines and subsequently, price levels shoot up. The current and previous price levels can be compared with the calculation of percentage to mark the difference between the two levels.

Therefore, a higher rate of inflation indicates a higher average price value of goods and services. Here, it is also notable that when inflation rates are too high, the purchasing power of consumers begins to decline swiftly and they resist making unnecessary purchases.

Furthermore, it is essential to note that the major factors responsible for a spike in the inflation rate include the following.

  • Increased printing of currency in a country

  • Deliberate reduction in the value of the legal currency tender (devaluation)

  • Increased lending through the banking system

  • Unprecedented pressure on supply or demand (supply shocks or demand shocks)

Proceeding further, the subsequent section explains the most common classifications of inflation. Before that, we’d like to tell you that you can compare the top economies of the world based on their inflation rates with the help of our meticulously compiled list of the Top 50 economies of the world.

Broader classifications of inflation

1. Cost-push inflation

Cost-push inflation occurs when there is an increase in production or supply costs hence pushing the overall costs to the higher end. To elaborate, cost-push inflation can be a direct consequence of an increase in labor wages, the cost of raw materials, or capital goods. Alternatively, cost-push inflation can also be a result of a decline in supply levels or labor shortages. In the ultimate sense, these factors lead to an increase in the price levels of the finished goods and services.

To continue, cost inflation is not seen very commonly in economies. Cost-inflation is more likely to occur in monopolistic economies or during the times when exchange rates change too frequently. Besides, it is more likely to exist in times of natural calamities leading to adverse economic impacts.

2. Demand-pull inflation

The demand-pull effect of inflation exists when there is stimulation of demand for goods and services driven by increased lending or circulation of money in an economy. The demand-pull inflation is high when demand increases beyond the production capacity of an economy. Simply put, demand-pull inflation occurs when the aggregate demand for goods and services is in excess of the aggregate supply.

In case sellers are not able to meet the demand by raising the production capacity, they resort to price hikes to manage the gap between the demand and the supply.

3. Built-in inflation

The concept of built-in inflation is linked to the expectations of people. To explain, it is linked to a scenario wherein people anticipate the current inflation rate to sustain in the future. When there is an increase in the prices of goods and services, consumers expect that the trend of increase in average prices will continue at a familiar rate in the future.

Moving forward, the ensuing section talks about the Cost Price Index, one of the most imperative and commonly used price indexes.

Consumer Price Index (CPI)

It is vital to understand that when it comes to measuring inflation, it is done with the help of price indices. To explain, the price index measures how prices change over time. Among price indices, the consumer price index is the most commonly used measure of inflation.

With respect to primary consumer needs, CPI gives a measure of the weighted average of the prices of goods and services. The primary consumer needs include healthcare, transportation, food, and other essential needs of consumers. For measuring the CPI, retail prices of the goods and services are taken into account.

The changes in the value of the cost price index have a direct impact on the cost of living for consumers in an economy. Hence, the consumer price index is one of the most vital economic indicators given its repercussions on other economic parameters.

Given below is the formula for calculating CPI

Consumer Price Index =Cost of basket in the current year )X 100
(Cost of the basket in the base year)

Where the cost of basket refers to the basket of goods and services as per the primary consumer demands. Further, the basket of goods and services represents the purchasing patterns of consumers. The base year is used as a benchmark for the calculation of CPI in the current fiscal period.

In most countries, the consumer price index is measured either on a monthly basis or a quarterly basis.

How to Calculate the inflation rate using CPI?

The formula for calculating the inflation rate using CPI is given below

Inflation Rate =CPI (current year) - CPI (base year) x 100
CPI (base year)

As per the above formula

The inflation rate can be calculated with the difference in the value of CPI between two years

An Alternative formula for calculating the inflation rate

In the generic sense, the value of the inflation rate can be calculated using the following formula

Inflation Rate =(B-A) x 100
A

Where

A is the starting cost

B is the ending cost