Inflation rate is the percentage change in the purchasing power of a currency. As the general prices of consumer goods increases the currency purchase power is falling. One of the most commonly accepted reasons for rising inflation is the increase in money supply (know as money printing) and in crease in the velocity of money.
The most common way of measuring inflation is to track prices of basket of consumer goods and services. The basket usually contains predeterminated goods prices on things like food, medications, transportation, housing, education etc. The most popular measurement of inflation rate is the Consumer Price Index (CPI) that is made and publish by the U.S. Bureau of Labor Statistics (BLS). The CPI index is calculated and reported on a monthly bases and it’s one of the most frequently used index for calculating the state of inflation.
The change in price over time (in CPI terms) is measured by the inflation rate. In essence, the inflation rate formula is telling us the rate at which money loses its value when compared to previous period. To calculate the inflation rate we need to know the inflation for the two periods. The formula is as follows:
Inflation Rate = (Current Period CPI−Prior Period CPI)/Prior Period CPI
Most governments set the inflation rate target at around 2-3%. The reasoning is that if inflation is too high it will deteriorate the purchasing power of the currency. But if inflation is too low, or negative, then some people may put off spending because they expect prices to fall which can lead to slowing down growth.
The inflation rate is important as it determinate the future value of money also known as time value of money. The time value of money is the concept that money you have now is (generally) worth more than the identical sum in the future due to its potential earning capacity (investing) and effect of inflation. If the inflation rate is high then the present value of money today is significantly larger that the future value of money and vice versa. Inflation rate also should be considered when calculating potential investment returns and it’s an important part of calculating present value of future investment returns.