This episode of our Economic Lowdown Podcast Series discusses three aspects of inflation: what it is, what causes it and how it is measured. The episode also addresses related topics such as deflation, disinflation and the role of the Federal Reserve in monitoring inflation.
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In 1964, you could get a McDonald's hamburger for 15 cents and go to the movies for under a buck. You would spend 27 cents a gallon for the gas to get there, and, the best part is, you could arrive at the cinema in your brand new 1964 Mustang for which you paid $2,320. Now that's a night out!
It may be hard to believe that the prices of some of our favorite things were that low at one time. It's sad to see those low prices give way to the prices we pay for those items today. However, it's important to understand that while prices have risen, so has income. That high school student in 1964 probably wasn't driving a 1964 Mustang because, even though the price of the Mustang was only $2,320, the student earned $1.25 an hour - probably not enough to purchase a new car. Prices of goods, services and resources, including labor, have increased over the years. Economists pay particular attention to the changes in prices, especially the changes in the price of goods and services typically purchased by the urban consumer. A sustained increase in the average price level of goods and services is referred to as inflation.
Each month, data collectors from the Bureau of Labor Statistics visit or call stores, hair stylists, doctors offices, airlines and every type of establishment selling everything from breakfast cereal to jewelry to train tickets to hospital stays. In fact, the prices of 80,000 goods and services are checked each month. This collection of goods and services is referred to as the "market basket." Some prices in the market basket increase, while others stay the same or even decrease. It isn't necessary for every price to be increasing to have inflation. Remember the definition of inflation is a sustained increase in the AVERAGE price level of goods and services.
The most common measure of inflation is the Consumer Price Index - or CPI for short. The CPI measures changes in price level using prices of the market basket of goods and services collected each month. Imagine the market basket of goods and services could be purchased last year for $100, but it took $103 to purchase the basket this year. To get the inflation rate we simply calculate the percentage change in price level - in this case the inflation rate would be 3 percent.
Is inflation good or bad? It depends. Economists believe that a little inflation is healthy as long as the inflation rate remains relatively constant - they refer to this as "stable prices." On the other hand, HIGH inflation can be damaging to savers, people on fixed incomes, or for people whose incomes simply have not risen at the rate of inflation. For example, let's say your entire income for last year was $100, and you spent the entire $100 on goods and services. With the 3 percent increase in inflation, the same stuff you bought last year for $100 will now cost you $103. Sadly, your income remained at $100. The outcome is that you can't have all the stuff you had last year. You've lost purchasing power. And, if you have been saving, inflation could make your saved money worth less-meaning you won't be able to buy as much with it as you had planned.
Also, your purchasing decisions would likely change if you came to EXPECT high inflation. If you noticed that the mp3 player that you had been planning to buy had increased in price by $10 a day for three consecutive days, what would you do? You would likely expect prices to keep rising and run out to buy it before the price increased again. So you can see that inflation could make spending and saving decisions very difficult.
So, what causes inflation? Economists explain that inflation occurs when the overall quantity of goods and services demanded by consumers exceeds the overall quantity of goods and services supplied by producers. What might cause this increase in the demand for goods and services? Very simply stated, consumers have more money and want to spend it.
So, where does all of this money come from? When consumers are feeling pretty good about the economy, for instance they have jobs and expect to keep them, they expect they will get annual raises in their wages, or they see their investments going up, they become confident that they can borrow money and have the ability to pay it back. So, they borrow money and spend it on goods and services.
However, if people demand more goods and services than producers can produce, the store shelves will empty quickly, and there won't be enough of the goods and services consumers want. There is a solution to this problem. If producers were to raise the price of those goods and services, some consumers would buy less, and products would remain on the shelves for the people who were willing to pay the higher prices. If this were to happen on a broad scale we would label the result inflation. The amount of money people have available to spend is called the money supply. When the money supply increases, people respond by increasing their spending. This is sometimes described as too much money chasing too few goods.
While inflation usually gets most of the attention, we must mention two related events: disinflation and deflation. Disinflation is a decreasing inflation rate. The average price level is still going up, but not as much as it did in an earlier period. For example, if the inflation rate were to decrease from 3 percent in one year to 2 percent in the next year - prices would still be increasing, but at a slower rate. Disinflation becomes a concern when the inflation rate nears zero because of concerns about deflation.
Deflation is a decrease in the average level of prices, or a negative inflation rate. It may seem like deflation is a good thing - who wouldn't want to pay less for their favorite things? However, deflation can be very damaging to an economy. Like high or volatile inflation, deflation makes planning for the future very difficult. Also, because not all prices drop at the same rate, businesses may find that the price of the product they are selling has dropped, but the costs of their rent, utilities and other inputs have not - so these businesses must cut production or close entirely. In either case, there are fewer jobs. Expectations about deflation can also change your purchasing decisions. Imagine that you have saved $4,000 which is exactly the price of the car you want. You could buy it today, but you've noticed that every time you pass the dealership on your way home from school the car is $100 less than the day before. What would you do? You would likely wait to see if the price keeps dropping. Tomorrow, the car could be $3,900. Other consumers will act the same way. They will hold off on their purchases waiting for further price reductions. If consumers keep waiting, and nobody is buying, businesses will have to cut prices even more, produce less and maybe even close. You can see how this becomes a downward cycle.
Central banks - such as the Federal Reserve System in the United States - have the task of monitoring the money supply and inflation rate. As you now know, the two are linked. So, what is a good inflation rate? The Federal Reserve judges that inflation at the rate of 2 percent is most consistent over the longer run with the Federal Reserves's mandate for price stability and maximum employment. So, if the inflation rate drops too low the Federal Reserve will take actions that will increase the growth of the money supply - and if the inflation rate is too high the Federal Reserve will take actions that will decrease the growth of the money supply to bring inflation back to an acceptable level.
To recap, inflation is measured by calculating the percentage price change of a basket of goods and services over time. If inflation is increasing at a decreasing rate we call it disinflation, if it is negative we call it deflation. Economists explain that inflation results from too much money chasing too few goods. Finally, the Federal Reserve attempts to control inflation by influencing the growth of the money supply.