Inflation Explained
What inflation is, how it is measured, and how to calculate it.
Inflation is a sustained rise in the general level of prices, which reduces the purchasing power of money. A single price rising is not inflation; the general price level must be rising.
Measuring inflation
Statistical agencies track the cost of a representative "basket" of goods and services. The consumer price index (CPI) compares the cost of that basket over time.
Inflation rate = (new price index − old price index) ÷ old price index × 100.
Example. The CPI rises from 200 to 210 over a year.
- Change: 10.
- 10 ÷ 200 = 0.05.
- Inflation rate = 5%.
Purchasing power
If prices rise 5%, an item that cost 100 now costs 105. Money buys less than before.
Possible causes
Economists often distinguish:
- Demand-pull: total demand in the economy rises faster than supply.
- Cost-push: production costs, such as wages or energy prices, rise.
- Expectations: if people expect rising prices, they may demand higher wages and set higher prices.
Real situations often involve a mix, and economists debate their relative importance.
Effects
Inflation can reduce the real value of savings, change who gains or loses on loans, and make planning harder. Low and stable inflation is generally considered less harmful than high or unpredictable inflation.
Real and nominal values
A nominal value is not adjusted for inflation. A real value is. If your wage rises 3% while prices rise 5%, your real wage has fallen about 2%.
Common mistakes
- Saying inflation means prices are rising on every item.
- Confusing inflation with the price level. If inflation falls from 5% to 2%, prices are still rising, only more slowly.
- Forgetting to divide by the old value.
Quick recap
Inflation is a sustained rise in general prices. It is measured by index changes, and real values adjust for it.