"When prices are stable, people can hold money for transactions and other purposes without having to worry that inflation will eat away at the real value of their money balances."
Did you know National Tooth Fairy Day is observed twice each year on February 28 and August 22? It's based on the tradition that when a child loses a tooth and puts it under their pillow, the magical Tooth Fairy visits during the night and leaves money in exchange for the lost tooth. The amount of money the Tooth Fairy leaves varies and has changed over time. A few generations ago, a child might have found 10 cents under their pillow. But over the years, the Tooth Fairy started leaving 25 cents, and then 50 cents. It wasn't long before the Tooth Fairy started leaving $1, and then $2, and even more. Today the Tooth Fairy pays an average of almost $4 for one tooth!2 Even in a fantasy world, inflation is real!
In one way or another, inflation affects everyone. News reporters anxiously await the monthly release of the inflation rate, which becomes headline news. And when interviewers ask consumers what inflation means, their answers carry the same message: Inflation means the same amount of money buys fewer goods and services, or "inflation means prices go up"!
Inflation is a general, sustained upward movement of prices for goods and services in an economy. It affects purchasing power or the amount of goods and services that a unit of currency can buy; more specifically, inflation reduces purchasing power. Data show the changing value of the dollar and its purchasing power. Figure 1 shows the value of the dollar set at 100 (representing full value) in 1983. The value of the dollar is 37 in 2021. This means that since 1983, the purchasing power of a dollar has been reduced by 63 percent. Put another way, if you lived in 1983 and took a time machine to 2021, a dollar would buy 37 cents worth of 2021 goods and services.
One type of inflation is cost-push inflation. This occurs when the costs of production (including wages and raw materials) increase and those higher costs are passed on to consumers. For example, if the minimum wage increases from $9 an hour to $15 an hour, firms may raise prices of their products because of the higher cost of wages. If firms raise prices, consumers will pay more.
Inflation also occurs when the overall quantity of goods and services demanded by consumers exceeds the overall quantity of goods and services supplied by producers. This is called demand-pull inflation, and it occurs when consumers have more money and want to spend it. This is often referred to as "too much money chasing too few goods." In this case, spending increases at a rate that outpaces production and usually occurs in an expanding economy.
What's Not Inflation
Prices tend to rise over time. But increases in the price of a single good or service, or even a few goods or services, do not indicate that the economy is experiencing inflation. For example, postage rates have increased over the years (Table 1). By itself, this would not indicate inflation.
Technological improvements and more competition in the marketplace for specific items can also affect prices. In these instances, the price of some individual goods and services may remain the same or even decrease in price over time. For example, the price of a computer is much less today than 20 years ago. Some of this is an actual decrease in price, but part of the decrease is due to quality adjustment.3 For example, imagine a computer model that is the same price in year 1 and year 2, but the year 2 version of the computer has a faster processor and larger hard drive. In reality you are getting more computer for the same amount of money; in "real" (inflation adjusted) terms, the price of the computer has decreased from year 1 to year 2, even if the price you pay at the cash register is exactly the same.
Inflation is the increase in the average price of many goods and services, and the most widely reported measure of inflation is the consumer price index, or CPI. The CPI measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Urban consumers represent about 93 percent of the total U.S. population.4 The CPI does not measure inflation for people living in rural areas, serving in the Armed Forces, or living in institutions. Since 1913, a federal agency, the Bureau of Labor Statistics (BLS), has gathered this information by contacting businesses to collect and record the prices of items. The BLS releases this information monthly, and researchers can use the data to compare the prices of goods and services in a month, in a quarter, or over a span of years.
The Market Basket
Although the CPI does not literally include all items, it is quite representative of the goods and services consumers buy on a regular basis. It includes a market basket of about 80,000 items that are sorted into more than 200 categories and arranged into eight major groups (Table 2).5
Some items are weighted more heavily than others. For example, housing makes up a significant part of consumers' budgets, so it is weighted more heavily. CPI includes some taxes, such as sales and excise taxes, that are directly associated with the prices of specific goods and services. However, the CPI excludes other taxes, such as income and Social Security taxes, because they are not directly associated with the purchase of consumer goods and services. Financial products like stocks and bonds are not included in the market basket. Essentially, the market basket attempts to represent the goods and services purchased by the population represented by the CPI.6
Figure 2 shows the average annual change in the prices paid by urban consumers for a market basket of consumer goods and services since 1983. From the graph we can determine that a market basket of goods or services is set at 100 in 1983 and that the CPI increased to 200 in 2005. This means the cost of the market basket doubled from 1983 to 2005.
The Inflation Rate
The inflation rate is the percentage increase in the average price level of goods and services over a period of time. To figure the rate, the BLS sets the price of the market basket during a particular time period equal to "100" and calculates the increase in the price of goods in another time. For example, if the value in year 1 is 100 and it rises to 103 in year 2, the percentage increase in the price of goods and services from year 1 to year 2 is equal to a 3 percent annual inflation rate. A 3 percent annual inflation rate means that, on average, a dollar buys 3 percent fewer goods and services than it did the year before.
CPI versus Core CPI
Core CPI is the CPI excluding food and energy. Core CPI removes food and energy from the market basket because these price categories are more subject to frequent and sudden changes. For example, weather events may disrupt crops, or fluctuations in oil supply can impact fuel prices. Looking at the core inflation rate can make it easier to see the long-term, underlying trends in other categories. In other words, by examining core inflation, economists can analyze what is happening to general prices without being distracted by sudden changes in food and energy prices.7 Figure 3 illustrates the difference in the measures, as it compares the percent change from year to year in the CPI and core CPI.
Inflation and Personal Finance
Inflation affects consumers in different ways. As long as personal incomes increase at the same rate as the inflation rate, purchasing power remains constant and inflation is hardly noticeable. However, if consumers' personal income does not increase, or it increases at a slower rate than the inflation rate, consumers aren't able to buy the same amount of goods and services as they could previously. This reduces purchasing power and is an important factor in making a budget. Inflation also reduces the value of people's savings if the interest rate at which their savings grows is less than the rate of inflation. For example, if a savings account is paying 1 percent annual interest and the inflation rate is 2 percent, the purchasing power of the money in that savings account is reduced by 1 percent.
Inflation is the average increase in prices for the typical urban consumer, but few people are exactly "typical." Individual consumers experience inflation differently because they buy different items. The price of some items may increase more rapidly than the price of others. Figure 4 illustrates the difference in the overall inflation rate and the rate for individual categories.
As "prices go up," consumers experience the obvious effects of inflation and learn to make adjustments in their budgets. But consumers are more sensitive to changes in price than to changes in quantity,8 and this tendency allows companies to benefit from shrinkflation. For example, companies might reduce the size or quantity of their products without reducing the price. Shoppers can easily find downsized product packing in grocery store aisles. For example, what used to be a 1 pound package of bacon may look the same and cost the same, but it may have been downsized to only 12 ounces. Or a box of cereal that used to be 18 ounces may have been downsized to 16 ounces. Shrinkflation is inflation that can go unnoticed, but it's real.
The Fed and Inflation
Inflation is a concern to the Federal Reserve (Fed), the central bank of the United States. Congress has given the Fed a dual mandate—the responsibility to promote maximum employment and price stability. Price stability means maintaining a low and stable rate of inflation. To meet its price stability goal, the Fed seeks to achieve inflation that averages 2 percent over time.9 Sometimes inflation may be a bit above 2 percent, while at other times it may be a bit below 2 percent; but, on average, it should be 2 percent. Economists generally agree that a low and stable inflation rate creates economic conditions that encourage economic growth and employment.10
When the inflation rate is less than 2 percent, the danger of deflation exists. Falling prices and deflation can signal a weak economic condition. An inflation rate greater than zero maintains an "inflation buffer"—that is, some "wiggle room"—which reduces the chances of deflation should the economy start to weaken. Fed policymakers see a 2 percent inflation target as a compromise—high enough to provide a buffer against deflation while low enough to minimize the distortions that arise from high inflation.11
Inflation affects the overall economy and individual consumers alike. The Fed is charged with addressing inflation for maintaining a healthy economy. A desirable goal for inflation and the economy may be described as the "Goldilocks Effect." This is another way of saying "not too hot and not too cold, but just right" as in the fairy tale The Three Bears.
Inflation is also embedded in personal finance and has effects in everyday decisions. It affects consumers based on different situations. When inflation increases, savers may lose purchasing power and spenders need more dollars for purchasing goods and services. Yes, everyone knows that inflation means "prices go up," but there's a lot to learn about inflation and the real effects on consumers.
So, what's a dollar worth? To answer this, the Tooth Fairy gives us a clue: Inflation is real and the value of a dollar changes with time.
Budget: An itemized summary of probable income and expenses for a given period. A budget is a plan for managing income, spending, and saving during a given period of time.
Bureau of Labor Statistics (BLS): A research agency of the U.S. Department of Labor that compiles statistics on employment, unemployment, and other economic data.
Deflation: A general, sustained downward movement of prices for goods and services in an economy.
Income: The payment people receive for providing resources in the marketplace. When people work, they provide human resources (labor) and in exchange receive income in the form of wages or salaries. People also earn income in the forms of rent, profit, and interest.
Interest: The price of using someone else's money. When people place their money in a bank, the bank uses the money to make loans to others. In return, the bank pays interest to the account holder. Those who borrow from banks or other organizations pay interest for the use of the money borrowed.
Interest rate: The percentage of the amount of a loan that is charged for a loan. Also, the percentage paid on a savings account.
Savings: The accumulation of money set aside for future spending.
Savings account: An account with a bank or credit union in which people can deposit their money for future use and earn interest.