Understanding Inflation: Measures and Impact

• Inflation measures how much more expensive goods and services are over a period of time, usually a year.
• Inflation has caused instability in countries.
• Central bankers aim to be known as "inflation hawks".
• Politicians have won elections by promising to fight inflation but failed to do so.
• In 1974, President Gerald Ford declared inflation Public Enemy No. 1 in the United States.
• Inflation is the rate of increase in prices over a period of time.
• Inflation is usually a broad measure, like the overall increase in prices or the cost of living.
• Inflation can be narrowly calculated for certain goods such as food or services such as haircuts.

Measuring Inflation

• Consumers' cost of living depends on prices and their share in the household budget.
• Government agencies conduct household surveys to find a basket of commonly purchased goods and track their costs to measure the average consumer cost of living .
• Housing expenses are the largest component of the consumer basket in the United States.
• The cost of the basket relative to a base year is the Consumer Price Index (CPI).
• The percentage change in the CPI is consumer price inflation.
• The base year CPI is 100, the current CPI is 110, the inflation rate is 10 percent.
• Core consumer inflation focuses on inflation trends by excluding prices set by the government and volatile prices of products like food and energy.
• Core inflation is monitored by policymakers, since this does not include seasonal factors or temporary supply conditions.
• Calculating an overall inflation rate requires an index with broader coverage, such as the GDP deflator.
• The CPI basket is kept constant but tweaked to reflect changing consumption, like including new tech or replacing items no longer purchased.
• The GDP deflator varies yearly and is more current than the CPI basket because it shows prices for everything produced.
• The GDP deflator includes non-consumer items like military spending, so it is not a good measure of the cost of living.

The Good And The Bad

• If household nominal income does not increase as much as prices, their purchasing power decreases.
• Real-inflation-adjusted income falls with inflation.
• Real income is a proxy for the standard of living, and when real incomes rise, so does the standard of living.
• Prices change at different paces with some such as traded commodities changing daily and others such as wages established by contracts take longer to adjust.
• Unevenly rising prices reduce the purchasing power of some consumers, which is the biggest cost of inflation.
• Inflation distorts purchasing power over time for recipients and payers of fixed interest rates.
• Pensioners receiving a fixed 5% yearly increase lose purchasing power if inflation is higher than 5%.
• Borrowers who pay a fixed-rate mortgage of 5% benefit from 5% inflation because the real interest rate becomes zero.
• Inflation, where not factored into nominal interest rates, leads to some who gain and some who lose purchasing power.
• High inflation and hyperinflation, which is 1,000 percent or more a year, have been experienced in many countries.
• In 2008 Zimbabwe had hyperinflation with an estimated annual inflation of 500 billion percent.
• Countries take difficult policy measures to bring inflation back to reasonable levels, sometimes giving up their national currency, as Zimbabwe has.
• Deflation, or falling prices, is not desirable either.
• Consumers delay purchases when prices are falling, anticipating lower prices, which leads to less economic activity, less income for producers, and lower economic growth.
• Japan had a long period of nearly no economic growth because of deflation.
• The US Federal Reserve and other central banks kept interest rates low to prevent deflation during the global financial crisis that began in 2007.
• Most economists believe low, stable, and predictable inflation is good for an economy.
• Low and predictable inflation means it is easier to capture in price-adjustment contracts and interest rates, which reduces its distortionary impact.
• Knowing prices will be slightly higher in the future gives consumers an incentive to make purchases sooner, which boosts economic activity.
• Maintaining low and stable inflation, known as inflation targeting, has been made a primary policy objective by many central bankers.

What Creates Inflation?

• Long-lasting episodes of high inflation are often the result of lax monetary policy.
• If the money supply grows too big relative to the size of an economy, the unit value of currency diminishes, and purchasing power falls while prices rise.
• The relationship between the money supply and the size of the economy is called the quantity theory of money.
• Pressures on the supply or demand side of the economy can be inflationary.
• Supply shocks, like natural disasters or high oil prices, reduce supply and lead to "cost-push" inflation.
• The food and fuel inflation of 2008 was a case of sharply rising food and fuel prices.
• Demand shocks, like a stock market rally or expansionary policies, boost overall demand and economic growth.
• If the increase in demand exceeds an economy production capacity, the resulting strain on resources is reflected in "demand-pull" inflation.
• The balance between boosting demand and growth when needed without overstimulating the economy and causing inflation has to be maintained by policymakers .
• Expectations determine inflation.
• Expectations are built into wage negotiations and contractual price adjustments.
• Inflation is a behavior that determines the next period's inflation.
• Expectations become self-fulfilling once contracts are exercised and wages or prices rise.
• Inflation follows similar patterns over time when people base their expectations on the recent past, resulting in inflation inertia.

How Policymakers Deal With Inflation

• The right set of disinflationary policies, those aimed at reducing inflation, depends on the causes of inflation.
• Central banks implement contractionary policies that reinforce aggregate demand by raising interest rates, if the economy has overheated and if they are committed to ensuring price stability.
• Some central bankers impose monetary discipline by fixing the exchange rate, tying the value of its currency to that of another currency, and thereby its monetary policy to that of another country.
• Global inflation is driven by global developments rather than domestic which make such policies unhelpful.
• In 2008, countries allowed the high global prices to pass through to the domestic economy, when inflation rose across the globe because of high food and fuel prices.
• In some cases the government may directly set prices.
• Administrative price-setting measures result in government accruing large subsidy bills to compensate producers for income lost.
• Central bankers rely on their ability to influence inflation expectations as an inflation-reduction tool.
• Policymakers influence expectations and contracts' built-in inflation component by announcing their intention to keep economic activity low to bring down inflation.
• The more credibility central banks have, the greater the influence of their pronouncements on inflation expectations, because confidence matters.