# Financial questions: What is an annual inflation rate?

## How the annual inflation rate is calculated along with what it is.

Inflation is the process by which a dollar is worth a little less each year. An inflation rate of 1%, roughly what we have now, would mean that a dollar today would be worth 99 cents in a year’s time, a 5 % rate would mean that dollar would be worth 95 cents. Economists are still having large arguments over exactly what causes this but we can still work out what is an annual rate without having to worry too much about those academic problems. Let’s just use the simplest of the possible explanations, that inflation is when the supply of money grows faster than the supply of goods, thus, each of the goods costs more in dollars.

The most difficult concept to understand is that there is a different inflation rate for every different item. We all know that computers have been getting cheaper for the last twenty years: we can buy now for \$ 200 a box that will do far more than a \$ 2,000 box did in 1992, if you could even find a computer for that price then. Gas is more expensive now than it was then, so we can see that computers and gasoline have different inflation rates.

Houses are another thing that have risen in value over the past few decades: most of us think this is great as it has raised the value of our investments. Yet think of it from the point of view of someone who doesn’t own a house. For them houses have gone up in dollars, that is that there has been inflation in the price of houses.
In order for us to calculate an annual inflation rate, we have to add up all of the price increases of all the tens of thousands of different items that can be bought. We also need to work out which of those things have actually fallen in price that year. Fortunately, we don’t actually have to do that ourselves, there are a number of groups that do this for us, including several different parts of the Federal Government. This is literally what some people do for their entire working lives, work out how the prices of strawberries have changed last month, think about the impact of gasoline prices on transport costs and how good or bad weather might change the price of food crops. These are all worked out on a monthly basis, and then averaged out to give us the annual, or yearly, inflation rate.

To make their job a little easier they tend to specialize in certain areas. One group will look at a basket of food prices, another at wholesale prices, a third at raw materials prices. One of the problems with the whole system is that house prices are usually not included in inflation statistics, although changes in interest rates and thus mortgages are. The other problem these groups face is that many goods actually get better but do not change their price. A \$ 2,000 computer today is very very different from a \$ 2,000 computer from ten years ago and these changes are accounted for by making what are called hedonic pricing adjustments. No, we don’t have to worry about that detail here.

After all of these different groups have made their estimates of those different inflation rates, and made them into annual figures, then they themselves are averaged to give us the main annual number. The one thing we know about this number is that it is wrong. There is no single product anywhere in the country that has had exactly this inflation rate, all we can say is that to the best of our knowledge and calculations, this is the average for everything that we can measure.