Question

What is the method used to calculate inflation?

Answer 1

Inflation is calculated using the consumer price index or the GDP deflator method. The consumer price index method compares the cost of purchasing a market basket of goods and services in the current year with the cost of purchasing the same market basket of goods and services in the previous year.

The inflation rate is then calculated using the following formula

CPI in current year - CPI in previous year Inflation rate = - x 100 CPI in previous year

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The GDP deflator method measures the price level by calculating the ratio of nominal GDP to real GDP. It takes into account all the goods and services produced in an economy within a year such as industrial goods, consumer goods, government services etc. Hence GDP deflator method is a broad measure of calculating the inflation rate than consumer price index method which only considers the prices of consumer goods and services.

Nominal GDP is the value of all final goods and services produced in an economy at current prices.

Real GDP is the value of all final goods and services produced in an economy at base year prices. To calculate the real we have to designate a particular year as base year and take into account the prices of the goods in base year.

Nominal GDP GDP deflator = Real GDP X 100

The inflation rate is calculated as

GDP deflator in year 2 - GDP deflator in year 1 Inflation rate in year 2 = x 100 GDP deflator in year 1