What Is Inflation? How It's Measured and Managed

Causes, Types and How It's Measured

determinants of demand
Inflation is when the prices of everyday items keep creeping up. Photo: peter zelei P/ Getty Images

Definition: Inflation is the rising price of goods and services over time. It's an economics term that means you have to spend more to fill your gas tank, buy a gallon of milk, or get a haircut. That increases your cost of living.

Inflation reduces the purchasing power of each unit of currency. U.S. inflation has reduced the value of the dollar. Compare the Dollar's Value Today with that in the past.

 

As prices rise, your money buys less. That's how inflation reduces your standard of living over time. That's why President Reagan said, "Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man."  See How Does Inflation Impact My Life?

The inflation rate is the percent increase or decrease of prices during a specified period. It's usually over a month or a year.  The percentage tells you how quickly prices rose during the period. For example, if the inflation rate for a gallon of gas is 2.0% a year, then gas prices will be two percent higher next year. That means a gallon that costs $2.00 this year will cost $2.04 next year.  

If the inflation rate is more than 50% a week, that's hyperinflation. If it occurs at the same time as a recession, that's  stagflation. Rising prices in assets like housing, gold, or stocks are called asset inflation.

A common, but inaccurate, definition of inflation is an increase in the money supply.

  That's a misinterpretation of the theory of monetarism. It says the primary cause of inflation is when the government prints too much money. As a result, too much capital chases too few goods. 

An increase in the money supply is one of the three causes of inflation. It's not a definition in itself.

The most common cause is demand-pull inflation is the most common cause. That's when demand outpaces supply for goods or services. As a result, buyers are willing to pay higher prices. Cost-push inflation is another reason. That's when supply is restricted but demand is not. That happened after Hurricane Katrina damaged gas supply lines. 

This misinterpretation goes on to say that there is a difference between inflation and CPI. The Consumer Price Index is the most commonly-used tool to measure inflation. 

Inflation and the CPI

The U.S. Bureau of Labor Statistics (BLS) uses the Consumer Price Index (CPI) to measure inflation. The Index gets its information from a survey of 23,000 businesses. It records the prices of 80,000 consumer items each month. The CPI will tell you the general rate of inflation. Check out the current inflation rate.

The Personal Consumption Expenditures price index (PCE price index) also measures inflation. It includes more business goods and services than the CPI. For instance, it includes health care services paid for by health insurance.

The CPI only includes medical bills paid for directly by consumers.

How Central Banks Manage Inflation

Central banks throughout the world use monetary policy to avoid inflation and its opposite deflation. In the United States, the Federal Reserve aims for a target inflation rate of 2% year-over-year. It uses the core inflation rate that removes energy and food prices. Those prices are set by commodities traders and are too volatile to take into consideration. In January 2012, the Fed started using the core PCE price index as its measurement of inflation. 

If inflation is above the target rate, the central bank raises interest rates to reduce the velocity of money and slow economic growth. If that doesn't work, it has other tools of contractionary monetary policy

If deflation is a threat, then the central bank uses expansionary monetary policy. It often lowers interest rates. For more, see What Is the Fed Doing to Control Inflation? 

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