Inflation is an economy-wide increase in prices and, in turn, an economy-wide decrease in purchasing power. It is the phenomenon of the same goods’ prices going up. Economy-wide price increases may indicate an increase in general consumer demand, and inflation for a single good could be a symptom of increased good-specific demand, or a shortage.
The concept of inflation is tied to purchasing power. Purchasing power is the value of a currency in terms of the ability to purchase goods. It is the real value of money within a given economy. For example, suppose at time A one loaf of bread costs $1. From time A to time B, there is 5% inflation, which means that nominal prices across the board go up 5%. However, if the price of a loaf of bread at time B remains $1, then bread consumers’ purchasing power has increased for that good. Purchasing power is also determined by income. If there is 2% inflation for all goods and services over a year, one’s purchasing power would decrease by 2% over that year. However, if you achieved a 2.5% raise that year, your purchasing power would increase. Moreover, the real value of one’s assets might also fluctuate with inflation (link to Rachel’s brief about protecting assets during inflation).
Measuring Inflation: The Consumer Price Index
Measuring inflation is not always straightforward. Inflation can’t be measured based on the price of a single good, since the relative price of a given good could fluctuate and not be representative of general price trends (television prices are an example of this; the relative price of televisions has plummeted in the past 25 years). Instead, the Bureau of Labor Statistics (BLS), the same government agency that collects data on employment, (link to my previous context brief on unemployment) collects data on the change of prices of a market basket—a group of commonly purchased items. The result of this survey is the Consumer Price Index (CPI). The data can also show the nominal and relative change in prices for individual goods, as we saw in the example about TVs. Because the actual measurement (CPI) is a level, not a percentage change, a single month’s CPI value is of little use when understanding how prices are changing. Instead, you must measure an annualized rate of inflation (or a month over month rate) to see how prices are changing. An annualized rate, much like GDP, is how the media and government agencies tend to report on inflation, as well as the measurement economists analyze.
There is more than one way to measure CPI. Most economic reports focus on headline CPI, but sometimes it can be useful to look at median CPI or core CPI. These measurements trim out outliers and/or central goods whose prices fluctuate unlike the rest of the economy. Housing is an example of such a good. Not all countries calculate CPI in a uniform manner. For instance, some countries exclude housing from their CPI calculations (the US does not make this exclusion). International organizations like the OECD and economists standardize their CPI measurements for the purpose of comparing inflation over international borders.
Measuring Inflation: The Personal Consumption Expenditure Index
CPI is also not the only method for calculating change in prices over time. This measurement is derived from a consumer survey, but indices that measure inflation do not necessarily have to be consumer focused. The quintessential example of such an alternative measurement is the Personal Consumption Expenditure index (PCE). Rather than relying on a consumer survey like the Bureau of Labor Statistics does with CPI, the Bureau of Economic Analysis (BEA) calculates PCE by surveying business. One can also eliminate outlier goods in a PCE calculation, as is done with the trimmed mean PCE index.
Figure 1 Source: Federal Reserve Bank of St. Louis
As we can observe in Figure 1, measurements like median CPI and trimmed PCE remain much more stable than their unadjusted counterparts as they remove individual goods that are particularly volatile at a given time.
High Inflation
Inflation can be a major issue for a country’s economy if it is too high, because workers’ purchasing power will decrease at a rate higher than their wage growth, meaning they are effectively worse off. Asset-holders, which constitute anyone with a retirement, college, or savings account, will lose personal wealth as the relative value of their savings decreases. (Link to other brief about how to maintain assets’ values during inflation).
Recent reports on inflation have suggested that inflation—despite initially being driven by temporary price hikes in major goods like cars—is likely here to stay. In June 2021, the annualized inflation rate rose to 5.4%. The International Monetary Fund warned that inflation might remain high for the rest of the year in developed countries that are beginning to rebound from the COVID-19 crisis. You can read about more warning signs of an overheating economy here (link to Allie & Rachel’s brief).
Ideal Inflation Rates and the Fed
However, because of the mechanism of wage increases, ideal inflation is not 0%. Inflation ideally stays around 2% because wages are “sticky”—stuck at their baseline rate and can only go up. Since firms generally do not cut wages, underperforming firms will overpay their workers to avoid hiring more people. With inflation rates comfortably above 0% but not too high, the economy effectively creates real wage cuts, and employers can then reward higher productivity workers with raises to keep up with inflation. When inflation rests at 0%, there is also a higher probability for deflation, which brings with it a host of macroeconomic problems.
One of the Fed’s jobs (link to my other brief on Fed policy) is to ensure that inflation stays around 2%. Inflation can also happen because of more direct policies from the Fed. Quantitative easing (QE), which is when the Fed buys assets (primarily treasury bonds) en masse to increase the money supply. (link to previous briefs or my brief on the Fed). Because this action technically constitutes an increase in the money supply, it is possible for inflation to be a result of QE. However, past instances of aggressive QE policies—particularly in the aftermath of the Financial Crisis of 2007-2008—did not cause inflation like some critics feared.
Although the Federal Reserve has been successful at staving off inflation recently, that has not always been the case. From 1962-1980, inflation was a central macroeconomic problem in the US. This occurred for a few reasons:
- Because of the explosion in international trade, US dollar reserves became increasingly in demand, spiking up their price.
- The expansion of national government spending meant the Fed had to keep interest rates relatively low in order to support more deficit spending in the US.
These two causes of inflation were primarily demand-based: an increased demand for US dollar reserves increased its relative value. Oil shocks in 1973 and 1979—results of conflicts in the Middle East and decisions by the Organization of the Petroleum Exporting Countries’ (OPEC)—decreased the supply of all oil in the US. The drastic increase in the price of oil thus increased inflation because oil is a core good in a developed economy.
Going back further, before the Fed existed in its current form—when the value of the US dollar was tied to gold and silver—inflationary and deflationary episodes were much more severe in magnitude and length. For instance, during the Civil War and World War I, the government disconnected the value of the dollar from gold and silver to finance the war effort—effectively increasing the money supply. After each war, the national government allowed the dollar to reconvert to gold and silver, which meant prices fell. After World War II, a similar phenomenon occurred, except by then the dollar was no longer tied to gold or silver. Rather, the government spent an unprecedented amount of money on the war effort, which caused inflation. Like previous examples, the government’s efforts to pay off postwar debt brought the country into a deflationary period. These monetary cycles do not occur anymore because the dollar is not indexed based on any commodity’s value and because the national government does not swing rapidly between deficit spending and deficit reduction policies.
