Inflation and its measurement
Inflation is a sustained rise in the general level of prices. Falling prices overall is deflation. Disinflation is a fall in the inflation rate, with prices still rising but more slowly.
The consumer price index (CPI) tracks the cost of a fixed basket of goods and services typical households buy.
CPI = (cost of basket in current year ÷ cost of basket in base year) × 100.
The inflation rate is the percentage change in the price index between two periods.
Worked example
A tiny basket costs 400 dollars in year 1 (the base year) and 420 dollars in year 2.
- CPI in year 1 = 100; CPI in year 2 = 420 ÷ 400 × 100 = 105.
- Inflation = (105 − 100) ÷ 100 = 5%.
If the CPI then rises from 105 to 108.15, inflation in year 3 is 3.15 ÷ 105 = 3%.
Real versus nominal
A nominal value is in current money. A real value is adjusted for inflation. Approximately:
- Real wage growth ≈ nominal wage growth − inflation. A 4% pay rise with 6% inflation is a real pay cut of about 2%.
- Real interest rate ≈ nominal interest rate − inflation. A 7% loan rate with 3% inflation is a real rate of about 4%.
Problems with price indices
The CPI can overstate inflation because of substitution bias (people switch away from goods that get expensive), quality changes and new products. Statistical agencies try to adjust for these.
Causes
- Demand-pull inflation: too much total spending chasing limited output.
- Cost-push inflation: a rise in production costs, such as an oil price rise, shifts supply left.
- Money supply growth: over the long run, rapid money growth is associated with high inflation. The quantity equation MV = PY states this link, where M is money, V is velocity, P the price level, and Y real output. If M = 500, V = 4 and Y = 1,000, then P = (500 × 4) ÷ 1,000 = 2.
Winners and losers
Unexpected inflation moves wealth from lenders to borrowers, because debts are repaid in cheaper money. It hurts people on fixed incomes and savers whose interest rate lags prices. Expected inflation causes smaller costs, such as "menu costs" of repricing and the time spent avoiding holding cash. Very high inflation, hyperinflation, can wreck an economy's functioning.