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Inflation is the surge in prices of goods and services in an economy. More precisely, it is the rate at which prices of goods and services increase. While it may seem like inflation would hurt your pockets, it is typical for prices to increase over time. The inflation rate might be high or low depending on a plethora of political, economic, and other factors.
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Change is the only constant. If you take the time to examine how much everyday items were worth 50 years ago, you will realise that prices now are vastly different from that time. For instance, things such as a cup of coffee or a given quantity of fruits and vegetables were much cheaper a few decades ago than in modern times.
Now, one might think- what exactly causes inflation?
Primarily, the root cause is an increase supply of money. This can happen in various ways-
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Printing and offering more money to citizens
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Lowering the value of the legally recognized money within a given political jurisdiction.
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Circulating fresh money into actuality as reserve account credits.
Methods of calculating Inflation
Consumer Price Index or CPI is the most widespread method of measuring inflation. However, CPI is just one of the methods used to calculate inflation. Another popular method of calculating inflation is known as Wholesale Price Index (WPI), which includes the wholesale price of goods instead of the retail price. Inflation can also be computed using personal consumption expenditure or PCE, which uses the same inputs as CPI.
What is the base year?
An important step across various inflation calculation methods is choosing the base year. Base year refers to a chosen year in which the inflation calculation is done. Most metrics used to calculate inflation use a base year. CPI is one such metric that utilises the base year in its calculation.
Since CPI is a relative change in the prices, it is calculated as a percentage change. This percentage helps us understand how much prices have moved since a fixed time frame. This fixed time frame is known as the base year and is used to realise how much prices have changed from a fixed standpoint. The prices in this base year can be understood as the benchmark for CPI calculations.
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For instance, an inflation rate of 5%, calculated in 2020 with 2010 as the base year would indicate that prices have increased by 5% over a decade. However, the same calculation for 2020, with 2005 as the base year would yield a different inflation rate, which greatly changes the value of the obtained value.
This is why CPI calculations may be available for different base years, making the overall process more comprehensive. The authority responsible for maintaining the CPI is also in charge of monitoring the base year.
Monitoring the base year refers to deciding which year would be chosen as the reference point. For example, the authority might decide that 2012 would be considered the base year for CPI calculations from 2015 onwards.
Key Takeaways
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Inflation is change in prices of goods and services used for household purpose.
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Inflation can be calculated in many ways, most common 3 ways are CPI, WPI, and PCE.
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Base year and its importance.
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