Inflation Calculator: Definition, Usage, Calculation Process, Benefits, and Challenges

Inflation can be defined as a process by which overall price of various goods and services rises with time. This continuous rise in prices leads to a reduction in the purchasing power of money as time passes. So, with rising prices, costs increase with time as one has to spend more to purchase the same goods or services.

The rate at which inflation rises for a specific basket or wide range of goods and/or services is termed as inflation rate. In India common types of inflation rates that are tracked by the government include WPI or Wholesale Price Inflation and CPI or Consumer Price Inflation. These inflation rates tend to play a crucial role in determining fiscal decisions of the government as well as the direction of central bank monetary policy.

Under a typical scenario, inflation rises at a relatively constant rate, however, there are some situation where there are sudden changes in the inflation rate. These can include the following:

Inflation is usually calculated in two ways. They are as follows:

● Consumer Price Index (CPI): As the name suggests, CPI tracks the prices of consumers for food, apparel, healthcare, and other goods and services. You can calculate CPI by considering price changes for each good and service in the predetermined segment’s basket.

● GDP Deflator: It uses the comparison of nominal GDP with real GDP. Nominal GDP is not inflation-adjusted, while real GDP is inflation-adjusted. Deflators help identify the inflation that arises in any specific sector of the economy.

The most common formula for inflation calculation using the CPI data is shown below:

Inflation Rate = [(CPI in Current Time Period – CPI in Previous Time Period) / CPI in Previous Time Period ] X 100

In the above formula, the time period can be weekly, monthly, quarterly or longer, depending on the time period over which CPI is being considered.

For instance, the above formula, the current CPI is 180 and the CPI in the previous period was 160. In this case,

Inflation Rate = [(180-160) / 160] x 100 = 12.5%

Note: The above calculation is for illustration only and does not represent a real-world scenario.

The inflation calculator does not help calculate inflation, instead it is designed to provide insight into how inflation will impact current costs at a future time. This is done using the Future Value formula that is in-built into this calculator.

The formula to calculate future value from current value based on the inflation rate looks like this:

FV = PV × (1 + r)^n

Here,

FV = Future Value, ,

PV = Present Value,

PV = Present Value,

n = Number of years

To, get a clearer understanding how this formula works, let’s consider an example. Suppose current value is ₹50,000, inflation rate is 5%, so to calculate the future value of this after 30 years, the formula will look like this:

FV = 50000 x (1+5)^30 = 2.16 lakh

This indicates that if something can be bought for ₹50,000 today, 30 years later, the same good or service will cost ₹2.16 lakh if an inflation rate of 5% is applicable. This is how an inflation calculator helps you estimate the future impact of inflation.

The online free inflation calculator is an easy to use tool that requires you to provide 3 key bits of data to provide instantaneous results. The 3 bits of data user needs to provide are:

• ● Current Cost: This is the current cost or expense of the user

• ● Expected Rate of Inflation: In percentage per annum basis this represents the rate by which inflation is expected to increase

• ● Number of Years: This is the number of years over which the user plans to calculate the impact of inflation. .

Once these three key information have been provided, the inflation calculator shows how high the future price will be.

Here are some of the ways in which inflation can affect your savings over time:

● Reduces Purchasing Power

The purchasing power of money reduces over time due to inflation. This means you cannot buy the same amount of goods or services with the same amount of money in the future. This happens due to the rising prices of goods and services.

Therefore, the real value of your savings also declines if the investment returns cannot outpace the inflation rate. For instance, suppose your savings account holds ₹2 lakh at an annual interest rate of 4% and the inflation rate is 7% p.a. In this situation, due to inflation outpacing returns, the money in your account will lose value over time.

● Enhances the Need for a Larger Retirement Corpus

Since a decrease in puchasing power of money translates into higher future costs, you will need to accumulate a larger retirement corpus. This holds true even if you as part of your retirement planning you assume that you will maintain a similar lifestyle in the future.

For instance, suppose your monthly expenses are currently ₹1 lakh. Due to inflation, you will need to spend ₹2.65 lakh monthly to maintain the same lifestyle 20 years from now, assuming an inflation rate of 5% p.a. So, to cover your post retirement expenses you will an extra ₹1.65 lakh per month due to inflation.

● Long-Term Impact

Inflation reduces the real value of accumulated wealth over extended periods of time. Thus, long-term savings plans to fulfil life goals or provide financial independence during retirement are highly influenced by inflation.

This is especially relevant for fixed savings and investment plans which may find it difficult to keep pace with rising living expenses in the future. Thus, many experts suggest allocating a portion of savings and investible assets towards market-linked instruments such as equities. These have the potential to provide inflation-beating long-term returns.

Here are some of the best strategies to follow for protecting your money from inflation:

● Focus on Investment Diversification

Invest in a variety of commodities, stocks, and real estate, all of which have historically outperformed inflation over time. Risk exposure to any one asset class that is susceptible to price hikes is decreased through diversification.

You can diversify your investment portfolio by including different market-linked asset classes like equities, real estate, commodities, etc. that increase in value as prices rise due to inflation. This can help control the potential wealth erosion that might happen to savings held in popular fixed-return instruments such as PPF, FD, etc .

● Investment in Market-Linked Options

Invest in financial products such as stocks and equity funds for long-term returns that outperform inflation benchmarks. The pricing power and earnings of growth assets allow them to prosper even in inflationary environments. Despite brief market fluctuations, these investments guarantee patient investors real gains because they compound wealth more quickly than rising prices.

Additionally, investing in such assets is highly recommended to beat inflation when retirement planning or saving for specific milestones.

● Examine Your Portfolio Frequently

For best results, keep an eye on and adjust allocations based on current and anticipated inflation trends. Regular reviews can help in portfolio rebalancing to favour holdings that are resistant to inflation by identifying changes early.

This proactive strategy protects wealth from unforeseen price accelerations or slowdowns while maintaining alignment with economic conditions. Using an online inflation calculator in this regard is essential, as it helps you stay aligned and calculative for informed decisions.

The notable benefits of an inflation calculator are explained below:

● Helps in Budget Planning

You can plan your budget more accurately with an inflation calculator, as you can factor in the impact of price rises. So, you can allocate funds with respect to the rising prices.

● Helps in Making Purchase Decisions

It helps assess whether an individual can afford big-ticket purchases like home in the future by considering the inflation rate.

● Helps in Price Comparison

With an inflation calculator, you can compare the current and historical prices of goods and services. This helps in making informed purchasing decisions.

● Helps Set a Savings Goal

An inflation calculator helps in determining the future worth of present savings for objectives like retirement and a child's education based on inflation.

Despite its wide list of advantages, the inflation rate calculator also has some limitations. Here are a few to consider:

● Dependence on User Inputs

Like every tool, the effectiveness of the inflation calculator depends on user inputs. If user inputs are incorrect, the results too will be incorrect.

● Does Not Consider the Impact of Taxes

The inflation calculator can provide insight into the impact of inflation on future costs, however, it does not take into account how taxes may impact the final result.

● Uncertainty of Future

The inflation calculator is designed to provide insight into future value, however, it cannot account for uncertainty. This uncertainty regarding how inflation will change over time. So there is no assurance that the results will actually be representative of the future.