What is inflation and how is it measured?

In economic discourse, economists, government, and media often refer to the concept of inflation — general price increases in an economy.

Inflation measures a nation’s economic wellbeing, in part because it reflects consumer experience — rising inflation means an increase in cost of living.

What causes inflation?

Inflation is a byproduct of supply-and-demand economics. Prices rise when the demand for goods and services outpaces the production of those goods and services, or when raw materials used in production and other “input goods” are in limited supply.

As a result, the amount a dollar can buy is reduced over time. For example, imagine an item that cost $1.50 in 1920. After accounting for inflation, that same item would cost $9.80 in 1990 and $22.85 in 2023.

How is inflation measured?

There are many ways of measuring inflation, but one of the most common measures is the Consumer Price Index for Urban Consumers (CPI-U), which is produced by the Bureau of Labor Statistics. The CPI-U shows changes in the prices paid by urban consumers for a “representative basket of goods and services,” or the most common goods and services purchased on an average month based on detailed surveys of what Americans spend their money on. The urban consumer group represents about 93% of the US population.

There are eight major purchase categories covered in the CPI-U:

• Food and beverages
• Housing
• Apparel
• Transportation
• Medical care
• Recreation
• Education and communication
• Other

Not all categories are considered equally when generating the overall measure of inflation — each category is assigned a “relative importance” based on its proportion of all expenditures. In the most recent CPI calculations, housing was weighted the most heavily.

The overall CPI, also known as “headline” CPI, includes all items in more than 200 categories. Since food and energy categories are typically much more volatile than the other parts of the CPI, some choose to focus on a metric called the “core” CPI which excludes these two categories.

How is inflation managed?

The Federal Reserve (“Fed”) is the central bank of the US. The Fed is tasked with a dual mandate by Congress: to maximize employment while keeping prices stable.

In order to serve this mandate, the Fed attempts to influence the inflation rate by guiding economic activity through monetary policy. If demand is increasing, the Fed can pursue policies to raise interest rates to mitigate rising inflation. If demand is slowing, the Fed can ease rates to spur economic growth.

The Fed employs various tools to implement its monetary policy initiatives, including trading financial assets on the open market.

The Federal Reserve typically focuses on a different measure of inflation called the Personal Consumption Expenditures (PCE) price index. The PCE is designed to more quickly respond to changes in spending.

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