Inflation - The Economic Lowdown Video Series

Below is the full transcript of this video presentation. It has not been edited for readability, and there may be slight differences between the text and the video.

Let’s say it’s 1964 and you’re in high school. The price of a hamburger is 15 cents, and you can go to the movies for under a buck. Gas to get you there is 27 cents a gallon, and the best part? You get to drive there in your brand-new 1964 Mustang you bought for $2,320.

It may be hard to believe, but prices really were that low at one time.

The increase in the price of hamburgers, movies, gas, and cars is due, in part, to inflation. Inflation is a general, sustained upward movement of prices for goods and services in an economy.

Prices have tended to rise over time. And, as prices rise, the quantity of goods and services that each dollar can buy diminishes.

A 2 percent annual inflation rate means that—on average—a dollar buys 2 percent fewer goods and services than it did the year before. However, it's important to understand that even though prices have risen over time, so have incomes.

In reality, most high school students in 1964 didn’t drive a 1964 Mustang because, even though the $2,320 price sounds low, students earned only $1.25 an hour—probably not enough to purchase a new car.

The most widely reported measure of inflation is the consumer price index, or CPI. The CPI measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The current basket includes about 80,000 items consumers buy on a regular basis.

Data collectors visit businesses to collect and record the prices of the items in the basket. The prices of these goods and services are then “indexed” to make it easier to compare changes in the price of the basket over time.

To do this, the Bureau of Labor Statistics sets the price of the market basket during a particular time period equal to “100.” Changes in the index value are used to measure inflation and calculate the inflation rate. For example, if the index rises from 100 to 104 over 12 months, the inflation rate for that 1-year period is 4 percent.

Economists say that inflation is caused by “too much money chasing too few goods.” What does this mean?

Well, when people have money, they tend to spend it. And the more money people have, the more they tend to spend. As a result, if the money supply increases too quickly, the supply of good and services might not keep up with what people want to buy. So, prices are pushed higher as people compete to buy goods and services.

As such, how much money is available for spending—the money supply—affects the level of spending—and inflation—in the economy. That is what “too much money chasing too few goods” means.

Inflation itself is not necessarily a bad thing. In fact, a little inflation is considered healthy for an economy. But is there a “Goldilocks” inflation rate? An inflation rate that is “just right?”

In modern economies, the central bank influences the nation’s money supply. The Federal Reserve System is the central bank in the United States.

Congress has given the Federal Reserve a dual mandate. That is, the Fed is to achieve two economic goals—one, price stability and, two, maximum employment.

Let’s think about price stability first.

Price stability is a low and stable rate of inflation maintained over an extended period of time. When this is the case, the inflation rate stays relatively low. You can expect that the stuff you can buy for a dollar today, will be about the same amount of stuff you can buy tomorrow or in the near future.

But, how low is low?

The Federal Reserve has determined that a 2 percent inflation rate is the best way to achieve the “price stability” part of the dual mandate. As a bonus, when the Federal Reserve achieves the “price stability” part of its dual mandate, it helps with the other part of its mandate—maximum employment.

How?

High and volatile inflation can make it difficult for businesses and consumers to plan their future spending. In contrast, when there is price stability, businesses and consumers can invest and spend with confidence. And when they spend and invest more, more goods and services are produced and more workers hired. The increase in hiring moves the economy toward maximum employment.

Overall, the dual mandate supports a healthy economy. The Federal Reserve tries to make sure the inflation rate stays just right.