Inflation:

The inflation rate is the rate at which prices for goods and services increase over a period of
time. If the cost of goods and services decrease over a period of time, then it is known as
deflation, which is just negative inflation. The base year for inflation is the year you want to
compare the inflation rate from. For example, if you want to know the inflation rate since 1998,
then the base year is 1998.
Because inflation in simple terms is defined as the increase in prices or the purchasing power of
money, the most common way to calculate the inflation rate is by recording the prices of goods
and services over the years (called a Price Index).There are different Price Indices that can be
used, the most popular are:

Consumer Price Index (CPI) measure the price of a selection of goods and services for a
typical consumer.
Commodity Price Index measure the price of a selection of commodities with. It is a
weighted index (in other words, some commodities are more important than others in
determining price changes).
Cost of Living Index (COLI) measure the cost to maintain a constant standard of living. In
other words, what would it cost you from year to year to live exactly the same.
Producer Price Index (PPI) A family of indexes that measures the average change in
selling prices received by domestic producers of goods and services over time. PPIs
measure price change from the perspective of the seller.
GDP Deflator The GDP deflator is a measure of price inflation. It is calculated by dividing
nominal GDP by real GDP and then multiplying by 100. Nominal GDP is the market value
of goods and services produced in an economy, unadjusted for inflation. Real GDP is
nominal GDP, adjusted for inflation to reflect changes in real output.

The price index on its own does not give the inflation rate but it can be used to calculate the
inflation rate. Let's use the Consumer Price Index as an example as is the most often used index
to calculate the inflation rate. An example of how this works is below. Keep in mind that
although I have simplified the process by using only 1 item in the basket of goods, the process of
calculating the inflation rate is the same.

What you need to know first

The CPI has a base year that everything gets compared to. Lets say it is the year 2000 for
our example.
Every year a basket of goods that is typical of many consumers is "purchased". For our
example let's pretend that there is only 1 item in the basket, a loaf of bread. In reality it
contains many more items.
An index of 110, for example, means there has been a 10-percent increase in price since
the reference period; similarly, an index of 90 means a 10-percent decrease. Movements
of the index from one date to another can be expressed as changes in index points
(simply, the difference between index levels).

Calculating the CPI Index

Let's say that in 2000 the basket of goods (which is 1 loaf of bread in our example) costs
$1.00. This becomes our base year and our index now has the year 2000 with an index
value of 100.
In 2001 the same basket of goods now costs $1.25. Now in our Price Index we have the
year 2001 with a value of 125.
In 2002 the same basket of goods now costs $1.31. Now in our Price Index we have the
year 2002 with a value of 131.
We do this every year and come up with a Consumer Price Index that looks something
like:
o Year - Value
o 2000 100
o 2001 125
o 2002 131
o 2003 133
o 2004 137

Calculating the Inflation Rate

Now in order to calculate the inflation between any 2 years we simply calculate the percentage
rate change. To calculate a percentage rate change the formula is:

Where F is the final value and I is the initial value.

Example
Inflation rate from 2003 to 2004: In this case the Final value is the index value for 2004 which is
137. The initial value is the index value for 2003. Therefore we plug in the values into the
percentage rate change formula to get:

This gives an inflation rate of approximately 3%.

Keep in mind that this is simply an example with numbers that are not actual CPI values.
However, the principles are the same.
Note: Any of several statistics can be presented in the media as the Official CPI.
Calculating Total Cost & Inflation Factor for Estimates
Inflation is not always as simple as saying theres 3% inflation every year. To be correct, that
inflation must be compounded in order to reflect new inflation prices from each previous value
calculated instead of just using what 3% reflects for the base year you are calculating. This will be
shown in detail below.
For example, 3% inflation rate factored into $100,000 gives you $103,000 (100,000 + (100,000
*0.03)) for the next year, which is accurate in both the simplified and compounding equations.
But, what if you use 3% inflation over the next 5 years?

Using simple inflation techniques, the new value is (100,000 + (100,000 * 0.03 * 5 years)),
which equals $115,000.
But, when compounding the inflation factor you get a value of $115,927, which is a
difference of $927 from using simple inflation rates. Why the difference? Well, instead of
just adding $3,000 for every year of inflation, we take the previous value that was
calculated ($103,000) and multiply by 3%. Then take that new value ($106,090) and
multiply by 3% again. This is the longhand version and you continue this process up to
however many years you are calculating, in our example, 5 times. The simple way to do
this is shown in the equation below.

Pn = P(1+i)n
Where:
Pn = Total Inflated Estimated Cost
P = Base estimated Cost
i = Inflation Rate
n = Difference between Base Year and Selected
Year. Ex 2010 - 2005 = 5 years, therefore n = 5
(1+i)n = Inflation Factor
Example: The current (2005) estimated cost of a project is$100,000. Calculate the expected cost
of the project in2010. Assume a 3% inflation rate.
Base Year: 2005
Future Year: 2010
Initial Cost (P): $100,000
Inflation Rate (i): 3%
Pn = $100,000(1+0.03)5= $115,927

Use of Rate of Inflation Formula

The formula for the rate of inflation is primarily used by economists. On the financial side, the
rate of inflation may be used by corporations to compare expenses, revenues, and profit across
multiple years.
The rate of inflation formula shown is not to be confused with the purchasing power of goods
relative to income.
An example, albeit an extreme example, would be an individual who recently discovers that their
income will increase to $1,000,000 from $20,000 per year--a 5,000% increase. The individual,
unable to hold back excitement, decides to go shopping only to discover that a loaf of bread
suddenly increased to $300 from $3--a 10,000% increase. The same result occurs as the
individual purchases more products. Soon the individual realizes that they are worse off than
prior to the income change. The rate of inflation formula measures only inflation, the 10,000%
price increase in the example, and does not consider income, the 5,000% income increase in the
example, or standard of living.
Annualizing the Rate of Inflation Formula
As with annualizing any monthly rate, the monthly rate of inflation cannot be annualized by
simply multiplying it by 12, as this does not consider compounding. The same concept can be
applied to adding each monthly percentage change in the consumer price index as an attempt to
find the annual percentage change in the consumer price index. The proper way to calculate the
annual rate of inflation is to use the year's initial and ending CPI in the formula.

How inflation or deflation is calculated:

What does $100 in 1980 dollars equal today?
Step 1:
2014 Anchorage CPI
divided by
1980 Anchorage CPI

215.805
-------------85.5

=2.52

Step 2:
Multiply 2.52 by any number of 1980 dollars and you will have the 2014 equivalent.
($100 x 2.52= $252)
So, $252 in 2014 would have the same purchasing power as $100 did in 1980