What is Inflation and How is It Measured?

December 19, 2013

Every time I talk about economics – at a bar, among friends, wherever – most people seem to only have the vaguest idea of what inflation is, but worse, more often than not they have no idea how it is measured. It’s one thing to understand that inflation is “that economics thing that makes your dollar buy less”, but how do you have any relative big picture idea of what’s occurring in the economy without some tool of measurement?

A History Lesson

The word inflation stems from the latin “inflare”, in which “in” literally translates as “in” and “flare” translates as “to blow up”. Clearly, the word was originally used to refer to filling an object with a gas, however between the mid-1830’s and the Civil War the word inflation began to appear in financial and economic literature. At that time, due to a rapid increase in banks (referred to as the “free banking era”), the word inflation became associated with the money supply, due to a wide circulation of “bank notes” (a private form of currency) – not in reference to price levels. [1]

So if it originally had something only to do with specifically money supply, how did it pick up its meaning today? Former Vice President and Economist at the Federal Reserve Bank of Cleveland, Michael F. Bryan wrote in On the Origin and Meaning of the Word Inflation, “What was once a word that described a monetary cause now describes a price outcome.” And furthermore, as a result of several contextual meanings, the word has come to complicate understanding and debate.

When did the shift occur away from exclusively dealing with monetary supply to today becoming most commonly used in connection with prices?

According to Bryan, John Maynard Keynes’ General Theory, published in 1936 and which dominated macroeconomic thought for the next 40 years, is mostly to blame. Among other things, Keynes’ theory “challenged the necessary connection between the quantity of money and the general price level. Moreover, it suggested that aggregate price increases could originate from factors other than money. In addition to separating the price level from the money [supply], the Keynesian revolution in economics appears to have separated the word inflation from a conditionof money and redefined it as a description of prices. In this way, inflation became synonymous with any price increase.”

Today, the easiest way I can think of to explain the meaning, would be that of this excerpt from Investopedia:

“The value of a dollar does not stay constant when there is inflation. The value of a dollar is observed in terms of purchasing power, which is the real, tangible goods that money can buy. When inflation goes up, there is a decline in the purchasing power of money. For example, if the inflation rate is 2% annually, then theoretically a $1 pack of gum will cost $1.02 in a year. After inflation, your dollar can’t buy the same goods it could beforehand. “

End of history lesson and definitions.

Now that we know what inflation is, how do we measure it?

Thankfully, we have plenty of statistics available from the U.S. Bureau of Labor Statistics (BLS) to measure inflation. If you would want to measure it on your own nationally, it would take an extremely large data set and a serious amount of surveys.

Here are the two primary measurement systems used:

Consumer Price Index (CPI) – A measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles, which measures price change from a consumer’s perspective.
Producer Price Indexes (PPI) – A family of indexes that measure the average change over time in selling prices by domestic producers of goods and services, which measure price change from the seller’s perspective.

*Both of these can be found at http://www.bls.gov/bls/inflation.htm.

Conclusion

One last note – inflation is neither good nor bad. It presents challenges and opportunities for multiple parties: too little inflation can be seen as a sign of a weakening economy, too high inflation can be detrimental to the average person’s ability to buy necessities. Moderate inflation increases tend to be aligned with moderate wage increases. And as a fringe benefit, increased inflation makes it easier for the government to pay their debt’s, which to the tax payer, is great.

I hope that clears up any confusion regarding what inflation is and how we measure it.

Image: Hot Air Balloon Sunset by Al Cooper

http://www.flickr.com/photos/alwyncooper/5841660718/

Cited Source

1. http://www.clevelandfed.org/research/commentary/1997/1015.pdf