Inflation: the overall price level of goods and services. But how do we measure it?
The CPI (Consumer Price index): a price index computed every month by the Bureau of Labor Statistics (BLS) using a bundle representing purchases made monthly by a representative consumer. This bundle is typically called a “market basket”.
The CPI is a better tool for measuring inflation than the simple GDP deflator because the CPI attaches weights to certain items, meaning that an increase in housing prices affects more Americans than an increase in Tobacco prices.
The BLS collects prices every month of around 70,000 goods and services from around 20,000 different stores in 44 different geographic locations.
The United State’s CPI market basket in 2009.
The CPI market basket: Shows which goods and services a typical consumer spends their money on. As you can see, the majority of our income is spent on housing, food, and transportation (about 75%).
The base year CPI value is always 100. So if the BLS decided that the year 2000 was going to be the base year, then that means that the CPI in 2000 would be equal to 100.
This means that if the CPI in 2011 is 144.5, then prices in 2011 are 44.5 percent higher in 2011 than in 2000.
If the CPI is 123.4 in 2004, and 133.1 in 2005, then you take the difference between these two CPIs, and divide it by the initial CPI to get the percent change in CPI for the year (or inflation). In this case it would be (133.1-123.4)/123.4 or 7.9% inflation for the year (this is just an example).
How inflation affects the economy:
Just because prices are going up doesn’t mean that things are getting more expensive. Generally when inflation is high, we need to figure out what is driving the inflation. If the price of everything is going up, including wages, then there is no real effect going on in the economy. If the price of everything doubles, including people’s wages, then everyone can still buy everything they are used to buying.
Inflation can change how income is distributed.
Problems occur when the prices of only a few things go up, such as oil or food. Then those working outside of those industries don’t benefit from higher prices, but end up having to pay them. Especially for those living on fixed incomes, any positive inflation is bad.
Menu costs occur when inflation is particularly high. Menu costs are a form of administrative costs and inefficiencies. Imagine a restaurant owner having to print out new menus everyday to keep up with the rising prices of food. At some point it may not make sense to have nice menus anymore and just write the prices on chalk board. It is because of these costs that gas stations in America do not have permanent signs. Because the price of gasoline changes almost daily, they needed an easy and cheap way to keep up with price changes. But imagine a company that sends out sales catalogs. The prices they put in the catalog have to be good for at least a month, until they can update their catalog and send out new ones. This type of media would not be possible in a country with high inflation.
Inflation also plays a role in the interest rate. There are two interest rates present in the economy at any given moment, the real interest rate, and the nominal interest rate. The nominal interest rate is what you see in the news and on paper. The real interest rate is equal to the nominal interest rate minus inflation.
Because people can always find out what the inflation rate is, they know what the real interest is. The only time inflation hurts someone is when it is unexpected. Imagine if a contract was signed for 1 year to pay 9% interest. This contract was signed when inflation was 6%. Now imagine if inflation increased to 10%. Before the real interest rate was 3% (9-6) but now it is -1% (9-10) so the person who made this loan is actually losing money! And the person who borrowed the money has to pay back less (in real value) then they borrowed!
Subsidized loans from the government function in a similar way. Because you are paying a nominal interest rate of 0%, the real interest rate is 0 minus the inflation rate. So the government is losing out not only on the low interest rate they are charging you but also because inflation turns the real interest rate into a negative number. This means that when you pay back your loans after graduating, you are paying back less (in real terms) than you borrowed in the first place.