Definitions and Basics
Inflation is the loss in purchasing power of a currency unit such as the dollar, usually expressed as a general rise in the prices of goods and services….
We have many measures of inflation, but none provides a truly reliable gauge of inflation at any specific time. The most widely watched measure is the consumer price index (CPI), published monthly by the Bureau of Labor Statistics. Subindexes are available for different cities and for many different classes of goods and services….
What is Inflation? from Khan Academy
A little inflation may not be bad for the economy. Is there a “Goldilocks” rate of inflation? Inflation, from the St. Louis Fed’s Economic Lowdown Video Series.
Let’s say it’s 1964 and you’re in high school. The price of a hamburger is 15 cents, and you can go to the movies for under a buck. Gas to get you there is 27 cents a gallon, and the best part? You get to drive there in your brand-new 1964 Mustang you bought for $2,320.
It may be hard to believe, but prices really were that low at one time.
How is the rate of inflation determined? Measuring Inflation, at Marginal Revolution University.
Consumer Price Index, from the American Heritage Dictionary at Dictionary.com
Definition: To adjust for inflation means to remove the effects of inflation from nominal prices or values so that their real changes can be compared over time. (See also Real vs. Nominal.)
Example. Suppose when you were 10 years old, a Sunday newspaper cost $2.00, but now that you are 20, it costs $3.00. The $1.00 price change is not all because newspapers now cost more relative to other goods like books, college education, etc., but partly because inflation has increased the cost of everything over time. That is, the nominal price increase of $1.00 is partly due to inflation.
If inflation has caused prices to rise by 20% in those ten years, then inflation alone would have caused the newspaper price to increase to $2.40. Thus the remaining $.60 price increase (=$3.00-$2.40) is the real economic increase in the price of the newspaper. An economist would say that the price of the newspaper, adjusted for inflation, has increased by 60 cents [or by 30%=($3.00-$2.40)/$2.00].
Adjusting for inflation, also called adjusting for the cost of living, is most often done by dividing by the consumer price index, published by the Bureau of Labor Statistics, a division of the U.S. Department of Labor.
Inflation is a sustained increase in the aggregate price level. Hyperinflation is very high inflation. Although the threshold is arbitrary, economists generally reserve the term hyperinflation to describe episodes where the monthly inflation rate is greater than 50 percent. At a monthly rate of 50 percent, an item that cost $1 on January 1 would cost $130 on January 1 of the following year….
In the News and Examples
Measuring economic progress requires an accurate measure of inflation. But measuring inflation is harder than you might think because rapid changes in quality often aren’t taken into account. When goods and services improve rapidly over time, it is more likely that inflation will be overestimated and changes in the standard of living will be underestimated. Watch Let’s Party Like It’s 1973 with EconTalk host Russ Roberts at PolicyEd.org.
…Capital gains have been taxable in the United States since the enactment of the federal income tax in 1913. Several features of the tax on capital gains have remained constant throughout this period. Only capital gains and losses realized through the sale of an asset, not unrealized “paper” gains and losses, are recognized for tax purposes. The dollar amount of a taxable capital gain or loss is not adjusted for inflation. This means that some of the apparent capital gains that are taxed are actually phantom gains: they do not represent real gains in purchasing power….
How harmful is inflation? Deflation? What role do expectations play with regard to both? Don Boudreaux on Monetary Misunderstandings at EconTalk, January 2011.
Understanding why money was invented can explain why it is not useful for the government to print money to give away. Why Not Print More Money? at LearnLiberty
Hanke on Hyperinflation, Monetary Policy, and Debt at EconTalk, October 2012.
Hanke argues that despite the seemingly aggressive policies of the Federal Reserve over the last four years, there is currently little or no risk of serious inflation in the United States. His argument is that broad measures of the money supply lag well below their trend level. While high-powered reserves have indeed expanded dramatically, they have not increased sufficiently to offset reductions in bank money, in part because of requirements imposed by Basel III. So, the overall money supply, broadly defined, has fallen. Hanke does argue that the current fiscal path of the United States poses a serious threat to economic stability. The conversation closes with a discussion of hyperinflation in Iran–its causes and what might eventually happen as a result.
Anne Bradley, Suffering is Venezuela’s new normal, at LearnLiberty.
The economy is collapsing in front of our eyes, but the real tragedy is not the macro indicators that we read about daily: soaring inflation rates, increasing unemployment numbers, nonexistent consumer goods, and crashing oil prices. The real tragedy is that the innocent citizens of Venezuela suffer and that suffering is the new normal.
A Little History: Primary Sources and References
Widespread dissatisfaction with high inflation in the late seventies and early eighties brought renewed interest in the gold standard. Although that interest is not strong today, it strengthens every time inflation moves much above 6 percent. This makes sense. Whatever other problems there were with the gold standard, persistent inflation was not one of them. Between 1880 and 1914, the period when the United States was on the “classical gold standard,” inflation averaged only 0.1 percent per year….
Fisher was a pioneer in the construction and use of price indexes. James Tobin of Yale has called Fisher “the greatest expert of all time on index numbers.” Indeed, from 1923 to 1936, his own Index Number Institute computed price indexes from all over the world.
Fisher was also the first economist to distinguish clearly between real and nominal interest rates. He pointed out that the real interest rate is equal to the nominal interest rate (the one we observe) minus the expected inflation rate. If the nominal interest rate is 12 percent, for example, but people expect inflation of 7 percent, then the real interest rate is only 5 percent. Again, this is still the basic understanding of modern economists….
What are the underlying factors that lead to inflation? The quantity theory of money can help to explain. Causes of Inflation, at Marginal Revolution University.
Is there a policy trade-off between inflation and unemployment? Economist A. W. H. Phillips conducted a milestone study that resulted in what’s now known as the Phillips Curve (from the Concise Encyclopedia of Economics)
Phillips found a consistent inverse relationship: when unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly.
Phillips conjectured that the lower the unemployment rate, the tighter the labor market and, therefore, the faster firms must raise wages to attract scarce labor. At higher rates of unemployment, the pressure abated. Phillips’s “curve” represented the average relationship between unemployment and wage behavior over the business cycle. It showed the rate of wage inflation that would result if a particular level of unemployment persisted for some time.
Can inflation actually be created on purpose? Why Governments Create Inflation, at Marginal Revolution University.
Allan Meltzer on Inflation at EconTalk, February 2009.
Milton Friedman on Money at EconTalk, August 2006.