Inflation
What is Inflation?
Inflation is a sustained rise in the general price level of an economy, measured as the annual percent change in a price index such as the CPI.
Inflation is a complex and multifaceted phenomenon that occurs when there is a sustained increase in the general price level of goods and services in an economy over a period of time. It is measured as an annual percentage increase in the CPI. Inflation can be caused by various factors, including an increase in the money supply, economic growth, and supply chain disruptions. High inflation can have negative effects on the economy, such as reducing the purchasing power of consumers and increasing the cost of living.
Inflation: a worked example
A teacher's nominal salary rises from $50,000 to $52,500, a raise of 5 percent. Over the same span the price level rises 8 percent, so the price index goes from 100 to 108. To find the real salary in base period dollars, divide the new nominal salary by the price index in decimal form: $52,500 divided by 1.08 equals $48,611 when rounded to the nearest dollar. Measured in the earlier year's dollars, the teacher can now buy about 2.8 percent less than the original $50,000 bought, so the raise is a pay cut in real terms. The quick approximation, nominal growth minus inflation, gives 5 minus 8, or negative 3 percent, close to the exact figure. A raise that looks generous on the pay stub disappears once inflation is netted out.
The mistake students make with inflation
Calling a single price increase inflation is the error that shows up most often in written answers. A 20 percent jump in the price of gasoline is a relative price change, not inflation, because inflation is a weighted average movement of the entire basket. If gasoline climbs 20 percent while clothing and electronics fall enough to offset it, the price index barely moves and there is no inflation at all. Check whether the price level as a whole rose before using the word, and save relative price change for one good getting more expensive against everything else.
Inflation questions
Who is hurt and who is helped by unexpected inflation?
Unexpected inflation transfers purchasing power from lenders to borrowers, because loans are repaid in dollars worth less than the ones lent. Workers on fixed nominal contracts and savers holding cash lose, since their incomes and balances buy fewer goods. Borrowers with fixed rate debt gain, and so do holders of real assets whose prices rise with the general level. If inflation is anticipated, lenders build it into the nominal interest rate ahead of time and the transfer largely disappears.
Why do central banks target a small positive inflation rate instead of zero?
A small positive target leaves room to cut real interest rates in a downturn. Suppose inflation sits at 2 percent and the central bank pushes nominal rates to zero; the real rate is then about negative 2 percent, which encourages borrowing. A zero inflation target offers no such cushion and risks tipping into deflation after a bad shock. Mild inflation also lets relative wages adjust downward without any employer cutting nominal pay, a change workers resist strongly.
How is inflation measured?
Statisticians price a fixed basket of goods and services that a typical household buys, then track what that basket costs from period to period. The cost is converted into an index number, with the base period set at 100, and inflation is the percentage change in that index. The consumer price index is the headline measure, the GDP deflator covers everything an economy produces, and the producer price index tracks prices firms pay. Different baskets can give different inflation figures for the same span.
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Related terms
The same idea in another course
What inflation does to money you holdThe same rise in the price level, viewed from the side of a saver rather than the economy. On FinanceLearn, a sister site.
Common comparisons
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