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What Is Inflation?
Inflation is the overall increase in prices within a fixed economy. Inflation is the reason that a dollar in 2019 can only buy a tiny fraction of what a dollar could buy in 1950. As inflation increases, individual denominations of currency become less valuable. When you hear a person using phrases like “in today’s dollars,” they are referring to long-term changes in the rate of inflation.
What Is The Inflation Rate?
The inflation rate is represented as a percentage increase in prices over a set period of time.
- When those prices go up, currency devalues because you need more of it to buy the same amount of goods.
- The opposite of inflation is deflation, where the price of goods goes down and an individual unit of currency becomes more valuable.
- Deflation is good for those who have a large amount of saved money, but it’s bad for the overall economy, which thrives when goods and services increase in value.
Inflation Rate and Economics
It’s the job of the Federal Reserve, the central banking system of the United States, to keep the economy healthy.
- Technically, the Fed’s mandate from Congress is to achieve full employment and price stability.
- Economists have long debated what the terms “full employment” and “price stability” mean in practice. The understanding today is that price stability means keeping the inflation rate around 2% per year. Full employment means getting unemployment as low as it can go without driving up inflation.
- An economy that produces too little will suffer from high unemployment since the low rate of employment opportunities will be inversely proportional to the high number of able-bodied workers. An economy that produces too much will see widespread increases in the prices of nearly all goods and services as the demand for them outpaces production capabilities. This general increase in prices is known as inflation.
How to Calculate Inflation Rate
Economists calculate the rate of inflation by examining data from the consumer price index (CPI), provided by the Bureau of Labor Statistics (BLS). The CPI is a tool that economic observers use to track inflation. It represents the average change in prices over time for all components of an economy. These may include:
- Physical goods (such as food, electronics, vehicles, and clothing)
- Professional services (such as those performed by hairstylists, tour guides, gardeners, and tutors)
- Entertainment (such as live music, sporting event tickets, and cable subscriptions)
- Health care (such as doctor’s appointments, medical procedures, and pharmaceuticals)
The consumer price index uses what’s known as a fixed “market basket” of goods and services from these categories in order to extrapolate a complete picture of the economy.
Once the CPI of two different periods is ascertained, one can compare the current CPI to the prior CPI to calculate the rate of inflation, using this formula:
Inflation Rate = Current CPI − Prior CPI / Prior CPI
3 Ways Inflation Is Related to GDP
Gross domestic product (GDP) is one of the most important statistics in economics. It represents three separate conceptions of the strength of an economy:
- The value of everything that is produced within the country
- The value of everything that is purchased within the country plus that country’s net exports to other countries
- The income of all the individuals and businesses within the country.
These three values are the same because everything that we purchase must be first produced and then sold. Then, through the selling of products and services, we earn our income. Therefore, total production, total purchases, and total income for the whole country are the same. Measuring GDP tells us an enormous amount about how we are doing as a nation. If the GDP is rising, it signifies that incomes are rising, and consumers are purchasing more. All of this means a stronger economy.
How Can the Fed Control Inflation?
Although the Fed can increase the strength of the economy by printing money, that comes at the cost of a higher rate of inflation. Higher inflation causes interest rates to rise and the economy to slow.
If the Fed is not careful, its actions can backfire and lead to an economy with high rates of inflation but not very high GDP growth. In the 1970s, the U.S. experienced precisely that outcome. Inflation rose throughout the 1970s while economic growth slowed. That experience left a mark on many Americans—so much so that there are people who believe that trying to increase GDP by printing money is so dangerous that it borders on evil.
Economists understand that while high inflation is a real danger, low inflation is dangerous as well. Just as high inflation can lead to permanently high interest rates, low inflation can lead to permanently low interest rates. Permanently low interest rates limits the Fed’s ability to increase the strength of the economy in very bad times, which can lead to long, deep recessions.
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