Introduction

Inflation is one of the most critical economic indicators, affecting everything from consumer purchasing power to interest rates and investments. Understanding how inflation is calculated and the measures used to control it can help individuals and businesses make informed financial decisions. In this blog, we’ll break down how inflation is measured and the tools used by governments and central banks to manage it.

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1. How Inflation is Calculated

Inflation is the rate at which the general level of prices for goods and services rises, eroding the purchasing power of money. Economists use several methods to calculate inflation, with the most common being the Consumer Price Index (CPI) and Producer Price Index (PPI).

A. Consumer Price Index (CPI)

✔️ CPI measures the average change in prices paid by consumers for a fixed basket of goods and services over time.
✔️ The basket includes categories like food, housing, transportation, healthcare, and entertainment.
✔️ The formula used to calculate CPI:

✔️ Example: If the CPI was 100 last year and is 105 this year, inflation is 5%.

B. Producer Price Index (PPI)

✔️ PPI measures the average change in selling prices received by domestic producers for their goods and services.
✔️ Unlike CPI, which tracks prices consumers pay, PPI focuses on wholesale prices and can signal future consumer price changes.
✔️ Rising PPI suggests businesses may pass higher costs to consumers, leading to higher CPI inflation.

✔️ The formula used to calculate PPI:

where,

–> Price of Basket in Current Year: The total price of a fixed set of goods and services produced by businesses.

–> Price of Basket in Base Year: The price of the same set of goods and services in the base year (used for comparison).

C. Other Inflation Measures

Some of the other inflation measures are GDP deflator and core inflation. I have explained them below

GDP Deflator

It is a measure of inflation. It tells us how much the prices of all goods and services produced in a country have changed over time.

Where,

–> Nominal GDP: The total value of goods and services produced in a country at current market prices

–> Real GDP: The total value of goods and services produced, adjusted for inflation (uses constant prices)

Real-Life Example of GDP Deflator

Let’s take an example of a country, say India, to understand the GDP deflator in action.

Scenario:

Imagine in 2020 (Base Year), India produced goods and services worth ₹220 lakh crore (₹220 trillion) at 2020 prices. This is the Real GDP (inflation removed).

In 2025, India’s total output (Nominal GDP) is ₹260 lakh crore, but prices have increased due to inflation.

Applying the Formula:

Given:

• Nominal GDP (2025) = ₹260 lakh crore
• Real GDP (2025) = ₹220 lakh crore

The GDP Deflator = 118.18, meaning prices have increased by 18.18% since 2020.

• This tells us that part of the increase in GDP is due to inflation, not just real economic growth.

Why is this Useful?

• Governments and economists use it to adjust economic policies based on inflation trends.
• It helps in distinguishing between actual growth and inflation-driven growth.

Core Inflation

Core inflation is a refined measure of inflation that excludes highly volatile items like food and energy (fuel, electricity, gas). Why? Because these prices tend to fluctuate due to short-term factors like weather conditions or global oil price changes.

By removing these elements, core inflation gives us a clearer picture of long-term price trends in the economy.

Core inflation does not have a single universal formula like the GDP deflator, but it is typically calculated by removing food and energy prices from the overall inflation rate.

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2. How Inflation is Controlled

Governments and central banks use several tools to keep inflation within a healthy range (typically 2-3%). Here’s how they do it:

A. Monetary Policy (Central Banks)

Central banks like the Federal Reserve (USA), European Central Bank (ECB), and Reserve Bank of India (RBI) control inflation mainly through interest rates and money supply.

✔️ Raising Interest Rates – Higher rates make borrowing expensive, reducing consumer and business spending, which helps lower inflation.
✔️ Open Market Operations – Central banks buy/sell government securities to influence liquidity in the economy.
✔️ Reserve Requirements – Increasing the amount banks must hold in reserves reduces excess money circulation, controlling inflation.

B. Fiscal Policy (Government Actions)

Governments can also control inflation through taxation and spending policies.

✔️ Reducing Government Spending – Less spending slows economic activity, easing inflationary pressures.
✔️ Increasing Taxes – Higher taxes reduce disposable income, lowering demand and slowing price increases.
✔️ Subsidies & Price Controls – Governments may regulate the prices of essential goods like fuel and food to prevent excessive inflation.

C. Supply-Side Measures

Since inflation often results from supply shortages, governments may take steps to increase production and efficiency.

✔️ Improving Infrastructure – Better transportation and logistics reduce supply chain bottlenecks.
✔️ Encouraging Investment in Key Sectors – Supporting agriculture, energy, and manufacturing can stabilize prices.
✔️ Regulating Import & Export Policies – Adjusting tariffs and trade policies to ensure a stable supply of goods.

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3. Real-World Example of Inflation Control

Let’s take a look at how a major economy responded to high inflation:

–> USA (2022-2024): When inflation soared past 8%, the Federal Reserve aggressively increased interest rates from near 0% to over 5%. This helped cool down excessive consumer spending and stabilized inflation to around 3% by 2024.

–> India (2013-2016): India faced inflation above 10%, leading the RBI to tighten monetary policy by raising interest rates and controlling liquidity. Over time, inflation dropped to manageable levels below 5%.

These examples show how central banks adjust policies based on economic conditions to stabilize inflation and economic growth.

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Final Thoughts

Inflation is a natural part of economic cycles, but controlling it is essential to ensure stable growth. By understanding how inflation is calculated and managed, individuals and businesses can better plan their financial strategies.

What do you think about current inflation trends? Should central banks take more action? Share your thoughts in the comments!

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