To determine the rate of inflation, you need a base year from which to anchor your measurements and a product or collection of products to price in that and subsequent years. In theory, calculating the inflation rate is easy -- designate the base year as 100, then measure how prices change each year. With a simple formula you can generate an index for other years, and the percentage change between them will give you the rate of inflation.
The Consumer Price Index
The Consumer Price Index (CPI) is the most widely used measure of inflation and is determined by measuring price changes from a base year.. Computed monthly by the Bureau of Labor Statistics (BLS), the CPI measures inflation on a national level and in selected major cities across the country. Its significance is broad-reaching, as it is used to determine cost of living adjustments for Social Security recipients and many workers. The Internal Revenue Service also uses the CPI to adjust tax brackets for inflation.
The Market Basket
The market basket is the collection of goods and services that the BLS believes the typical American consumer buys. All items are weighted according to how much of the consumer's budget they comprise. Housing is the largest component, constituting 41.5 percent of the budget, followed by transportation at 17.3 percent and food and beverages with 14.8 percent. The balance of the market basket consists of apparel, medical, recreation and others miscellaneous categories. The market basket is revised periodically to reflect the introduction of new products and changing patterns in consumer behavior.
The Base Year
Once the market basket is determined, the BLS selects a base year from which all changes are calculated. This base year is assigned a value on 100. From that base, the BLS can calculate the index moving either forward of backward to measure inflation in different years. As of March 2015, the base year used by the BLS was 1982.
The CPI and the Rate of Inflation
The CPI for any year is determined by a simple formula -- market basket value in the current year divided by the market basket value in the base year multiplied by 100. If prices are rising, the numerator will be greater than the denominator and the equation will yield a value greater than 100. During an inflationary period, each year's CPI will be greater than the year before it. To determine the rate of inflation, find the difference between this year's index and last year's index, divide that number by last year's index and multiply the quotient by 100. For example, if the indices for the last two years are 110 and 112, then the rate of inflation is (112 – 110)/110 = 0.018 x 100, or 1.8 percent.
Alternative Inflation Measures
While the CPI is the most commonly cited inflation measure, whether on the national or city basis, an alternative inflation measure is the Core CPI. The core CPI omits the food and energy segments since these tend to be more volatile and may contribute to monthly swings in the general index. Two other measures of inflation are the Producer Price Index and the GDP Deflator. The PPI measures price changes at the producer level, while the GDP Deflator is a much broader index, including government expenditures and business investment, and also includes "substitution effects." Substitution of goods and services occurs as prices change. For example, if the price of beef goes up, you may decide to eat more chicken. The CPI, because it uses a fixed basket of goods, does not capture these substitution effects.