Inflation: measurement and impact on your personal finances
Measuring individual prices is quite easy. But measuring changes in a country’s general price level is complicated. Many factors need to be considered.
After all, there are many millions of goods and services in the market, provided by a wide range of suppliers. So how can we measure overall price developments? By using price indices. Read on to learn what price indices are, how they work and how to deal with inflation.
Using price indices to measure price levels
Obviously, when calculating price changes, we cannot take into account the prices of all goods and services on the market. Instead, we have to select a few. To get good results, we should not choose any random goods and services but rather a representative selection (a so-called basket of goods and services). Using price indices helps our calculation.
A price index is a measure that indicates how the prices of selected goods and services change over time. This is how a price index works: First, we sum up the prices of the items in our basket at a certain point in time (e.g. EUR 10,000) and attribute an index value of 100 to the total. Then we take a look at what the same items cost one year later. If their total price is EUR 10,200, for example, we calculate the index value for the second year as follows: (10,000/10,000) x 100 = 102. This is a 2% increase. So the average price of the items in our basket has gone up by 2%.
Using the price of a weekly breakfast at a bakery, the following example shows how a price index works.
What is a price index? – Example: a weekly breakfast at the bakery
Once a week, Sabine and her husband Malik have breakfast at their favorite bakery. For one year (year 1), they write down everything they had for breakfast (130 cups of cappuccino, 30 cups of tea, etc.) and what each item cost. Year 1 is referred to the base year. In the following years (year 2 and 3), they do the same. Based on the collected price data, we can calculate the value of their basket of goods, the price index and the average price increase (%) for their weekly breakfast at the bakery.
| Basket of goods | Year 1, EUR per unit | Year 1, Total, EUR | Year 2, EUR per unit | Year 2, Total, EUR | Year 3, EUR per Unit | Year 3, Total, EUR |
|---|---|---|---|---|---|---|
| 130 cups of cappuccino | 3.40 | 442 | 3.50 | 455.00 | 3.60 | 468.00 |
| 30 cups of tea | 2.80 | 84 | 3.00 | 90 | 3.10 | 93.00 |
| 75 glasses of orange juice | 2.00 | 150 | 2.50 | 187.50 | 2.30 | 172.50 |
| 80 bread rolls | 1.30 | 104 | 1.35 | 108.00 | 1.40 | 112.00 |
| 90 white rolls | 1.00 | 90.00 | 1.10 | 99.00 | 1.20 | 108.00 |
| 60 brioche croissants | 1.00 | 60.00 | 1.05 | 63.00 | 1.10 | 66.00 |
| 50 jam servings | 0.40 | 20.00 | 0.50 | 25.00 | 0.60 | 30.00 |
| 100 butter servings | 0.60 | 60.00 | 0.70 | 70.00 | 0.80 | 80.00 |
| 60 ham/cheese servings | 2.20 | 132.00 | 2.50 | 150.00 | 3.00 | 180.00 |
| 50 soft-boiled eggs | 1.50 | 75.00 | 1.60 | 80.00 | 1.80 | 90.00 |
| Basket of goods, total | 1,217.00 | 1,327.50 | 1,399.50 | |||
| Price index | 100 | 109.08 | 115.00 | |||
| Annual price increase, % | 9.08% | 5.43% |
Of course, this index only refers to the price one specific couple, Sabine and Malik, paid for their typical weekly breakfast at their local bakery. To calculate the average change of all the prices in a country, we must of course use a far more comprehensive index that covers prices at different locations and in different stores across the country.
The consumer price index (CPI)
The consumer price index (CPI) is a comprehensive price index that is used in many countries. Statistics Austria, Austria’s national statistical institute, is responsible for calculating the CPI for Austria.
The following figure shows the different steps that are necessary to calculate Austria’s CPI.
A major challenge is deciding which goods and services should go into our representative basket. After all, all Austrian households have their own preferences, and people’s consumption habits differ. For our calculation, however, we need to know what and how much a typical Austrian household buys, for example, within a year. So as a first step, several thousand Austrian households are invited to participate in a consumer survey and keep a detailed money diary for two weeks. In the money diary, they record everything they spend and consume. Then, they are asked to provide information about their general consumption habits. This step makes sure that less frequent expenditures are also covered. The survey is repeated every five years because consumer habits change over time.
Based on the survey results, a typical basket of goods and services is compiled. It is basically a list of the goods and services an average Austrian household consumes per year. The prices of the items on this list are then considered in the CPI. The CPI for 2020, for example, includes 757 items, which are categorized into 12 groups of goods and services.
In general, goods and services the average household spends more money on (e.g. housing and energy) need to have more weight in calculating price changes or inflation. Items households spend less money on (e.g. socks or mobile phone charges) are given less weight. The following chart shows how the individual groups of items in Austria’s CPI basket are weighted (%).
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The inflation rate
Many other price indices are calculated regularly in Austria in addition to the CPI. The Harmonised Index of Consumer Prices (HICP) is an index that is calculated using the same method in all European countries. On the basis of the HICP, you can draw comparisons between European countries. The HICP plays a key role in the ECB's monetary policy. There are a number of other price indices, such as the micro basket of goods which contains everyday consumer goods (especially food), the property price index and the construction input prices index.
Tip
- For an overview of the price indices calculated by Statistics Austria, see their website. You might come across price indices in contracts like rental agreements or rental offers, which often include price clauses based on the CPI. → https://www.statistik.at/en/statistics/national-economy-and-public-finance/prices-and-price-indices
Personal inflation rate
Inflation is calculated based on the basket of goods and services of an average household. Since your expenses might differ from those of an average Austrian household, the impact of inflation on your personal finances (your personal inflation rate) might differ from the average rate of inflation. Inflation does not affect everyone equally. Rather, its effect depends on people’s living conditions and consumption habits as well as on their general financial situation.
The following examples illustrate that different people can be affected by inflation in very different ways. We assume that prices for food, rents and energy have gone up, driving up inflation.
Example
Sebastian, aged 12, student at a secondary school
Sebastian spends most of his pocket money on video games, clothes and fast food. Rising food prices, rents and energy prices affect his parents more strongly than him because they pay for groceries and housing.
Example:
Gertrude, aged 67, retired secretary
Gertrude always worked part-time to be able to look after her two children. She therefore has a very low pension. Since she spends most of her money on groceries and housing, inflation affects her strongly. There are many things she cannot afford and she can hardly put any money aside.
Example:
Erkan, aged 31, freelance management consultant
Erkan started to work as a freelancer right after completing his studies. He often eats at restaurants and can afford to do so even if food prices are rising. This is because he owns his apartment (his parents gave him money to pay it off) and does not pay rent, so higher rents do not affect him. The only higher housing costs he has to pay are increased operating costs.
High inflation has a particularly negative impact on people with low incomes because most of their money goes into consumption (housing, food and other everyday necessities). People with higher incomes, on the other hand, can use their savings to cover higher costs in times of high inflation. Inflation has particularly negative effects for savers because it reduces the real purchasing power of their savings (unless they invested in inflation-protected investment instruments).
But inflation does not have negative effects on everyone. Borrowers, especially those who agreed on a fixed interest rate, even benefit from high inflation. Fixed-rate loans become more affordable in times of inflation as wages are usually raised in such times. Owners of nonfinancial assets (such as real estate) also benefit from inflation as the prices of nonfinancial assets usually rise faster than inflation. Last but not least, the government also benefits from high inflation with tax revenues rising on the one hand and the repayment of government debt becoming cheaper on the other. At the same time, however, inflation also has negative effects for the government as measures to cushion the impact of inflation as well as rising costs (e.g. for construction projects or the salaries of public sector employees) drive up government expenditure.
Strategies for dealing with inflation
So what can you do, in times of higher inflation, to avoid financial difficulties and reduce negative effects on your personal finances? Unfortunately, there are not many ways for individuals to protect themselves against high inflation. In times of high inflation, people with high incomes or large assets can largely maintain their lifestyle thanks to their savings. For people with low incomes, however, high inflation often means existential problems: They have difficulties paying their rent and maintaining their standard of living.
Calculate your personal inflation rate
To find out to what extent you and your household are affected by inflation, you could keep a precise record (money diary) of your expenses over a certain period of time, e.g. one month (see also Tracking your finances). You can use an app, for example, to list and categorize your expenses (eating out, leisure activities, housing costs, transportation, etc.). This money diary will help you find out how your own consumption habits differ from the Austrian average. A money diary will help you find out how you could potentially save money. To this end, you could also use the financial manager feature many banks offer on their online platforms. If you often pay with your debit card, this feature will give you a rough breakdown of your expenses. Ask your bank whether they offer this kind of service.
Tip
- Calculate your personal inflation rate with PIA, the personal inflation app provided by the Oesterreichische Nationalbank (OeNB) (in German). It is easy to use and very helpful. → https://finanzbildung.oenb.at/inhalte/PIA.html
Rethink your consumption habits
If your income is high enough to pay higher prices, you may not have to change your consumption habits in times of high inflation. However, if this is not the case, you need to look for opportunities to save money. For example, if Erkan ate out less often and did his own cooking, he could save a lot of money. If Erkan were to travel to work by public transport or bicycle more often, instead of by car, he would be able to reduce his fuel costs. It might also make sense for Erkan to switch to another energy provider that offers better conditions.
Tip
- Find out which of the products and services you regularly consume have recently become more expensive. As a next step, try to find cheaper alternatives.
People with low incomes, like Gertrude, do not have many options in dealing with rising prices. Because Gertrude worked part-time, she only has a small pension. Even in times of moderate inflation, she can hardly make ends meet. Cutting he expenses any further is difficult, especially when it comes to large items such as housing, energy and mobility. In the event of excessive inflation, it would be a good idea for Gertrude to find out how to get state aid. There are various options (e.g. one-off payments, subsidies and grants).
Tip
- If you face financial difficulties because of rising prices, find out more about state aid. If you live in Vienna, for instance, see the website of the City of Vienna for guidance about social and financial support. If you do not live in Vienna, ask your local authority or social welfare office about possible subsidies and grants and get help with filling out the necessary applications. → https://www.wien.gv.at/gesundheit/leistungen/index.html
Protect your savings against inflation
In times of high inflation, the value of your savings decreases. For example, if Erkan saved EUR 12,000 in year 1, it would already have lost purchasing power in year 2. Although there are still EUR 12,000 in his bank account, Erkan could have bought more for it a year earlier. To ensure that the money we save does not lose in value, we need to invest it in such a way that the interest (on bank deposits) or the returns (on securities) are greater than inflation. The savings book (Sparbuch), for example, which is a very popular form of investment in Austria, usually does not offer interest rates that cover inflation. Investments on the capital market (such as investments in shares or bonds) are, in general, much better suited to protect your savings against inflation. However, the higher returns they yield usually also mean higher risks (for more information, see Saving and investing).
Nochmals in Kürze
What is a price index?
A price index is a measure that indicates how the prices of selected goods and services change over time. For this purpose, the sum of the prices of these goods and services at a certain point in time is equated with an index value of 100. The summed-up prices for the same goods and services at later points in time can then be easily compared to this index value, indicating average price changes. The consumer price index (CPI) is the most important price index used in Austria. It considers the average expenses of a typical Austrian household. Statistics Austria, Austria’s national statistical institute, is responsible for calculating the CPI for Austria.
What is the Harmonised Index of Consumer Prices?
The Harmonised Index of Consumer Prices (HICP) is an index that is calculated using the same method in all European countries. Therefore, it can be used to draw comparisons across Europe. The HICP plays a key role in the ECB's monetary policy.
How do we measure inflation in Austria?
We measure inflation using the consumer price index (CPI). Every five years, a consumer survey of several thousand Austrian households collects data on households’ average expenses on various groups of goods and services. The collected data are summarized in a basket of goods and services. The prices of the items in this basket are surveyed monthly. Statistics Austria uses these data to calculate the inflation rate, which reflects the average price increase between two points in time (usually the same month in the previous year).
What is the personal inflation rate?
The CPI reflects average household expenses, and the inflation rate calculated using the CPI is an average rate. Your personal inflation rate will differ from the average depending on how much your consumption habits and housing situation, for instance, differ from the average.
What strategies can private individuals use to deal with inflation?
You could start by getting a detailed overview of your income and expenses, for example by keeping a money diary. On this basis, you can review your budget on a regular basis, identify ways to save money and rethink your consumption habits. If you have money to invest, it makes sense to adjust your investment strategy so as to protect your assets against inflation in the best possible way. High inflation is often a serious problem for people with very low incomes. It is a good idea for low-income earners to seek advice and find out more about state aid.
