What Is Inflation? How It Is Measured and Managed

Why Inflation Is as Violent as a Mugger

determinants of demand
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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. Inflation 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."  Here's more on how inflation impacts your 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 percent a year, then gas prices will be 2 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 percent a week, that's hyperinflation. If inflation 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 the printing out of too much money by the government. 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. That's when demand outpaces supply for goods or services. Buyers want the product so much they are willing to pay higher prices. Cost-push inflation is another cause. That's when supply is restricted but demand is not. That happened after Hurricane Katrina damaged gas supply lines. Demand for gasoline didn't change but supply constraints raised prices to $5 a gallon.

The inflation rate is a critical component of the misery index. The other component is the unemployment rate.  When the misery index is higher than 10 percent, it means people are either suffering from a recession, galloping inflation, or both. 

Inflation and the CPI

The U.S. Bureau of Labor Statistics uses the Consumer Price Index 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 misunderstanding about the money supply goes on to say that there is a difference between inflation and CPI. But there is no difference. That's because the CPI is a measurement tool, not a different form of inflation. 

The Personal Consumption Expenditures 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. In 2012, the Federal Reserve prefers using the PCE price index as its inflation measure.

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 Fed aims for a target inflation rate of 2 percent 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. 

How to Protect Yourself 

The most powerful way to protect yourself from inflation is to increase your earning ability and income. A 5 percent annual raise, or a promotion that nets you a 20 percent gain, will make inflation irrelevant. But if that's not an option, or you are on a fixed income, then you'll need to explore other options.

The best way to protect your savings is to invest in the stock market. It has returned around 10 percent over time. Whether it will do so in the future is unknown, and there's the risk. As always, consult with your financial planner before making any financial decision to be sure this fits within your goals.

If you are looking for a safer way to protect yourself from inflation, consider two instruments you can purchase from the U.S. Treasury

The first is Treasury Inflated Protected Securities. These pay a fixed rate of interest. Twice a year the government re-adjusts the principal in response to changes in the Consumer Price Index, as published monthly by the Bureau of Labor Statistics. This means that, as inflation increases, the value of the bond increases. Although the interest rate doesn't increase, holders get a larger cash payment because the percent is applied to a larger principal.

TIPS do well during inflation, but do worse during times of non-inflation or stability. But over the long haul, they do not do as well as a well-diversified portfolio that includes stocks.

The second is Series I Bonds. They offer a guaranteed fixed rate of return which it keeps for the life of the bond. It is also affected by a variable rate that is indexed to the CPI, and is reset in November and May. The return you get for the bond is a composite of its fixed rate and the variable rate in effect at that time. To find out each bond's return, go to the Treasury Department's Savings Bond Calculator.