Inflation
Contents
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the overall price level rises, each unit of currency buys fewer goods and services. This means that inflation reflects a reduction in the purchasing power per unit of money.
Causes of Inflation
Economists generally attribute inflation to a few key factors:
| • | Demand-Pull Inflation: This occurs when there's an increase in aggregate demand across the economy that outpaces the available supply of goods and services. Too much money is "chasing" too few goods. This can be caused by strong consumer spending, government spending, or an increase in the money supply. |
| • | Cost-Push Inflation: This happens when the costs of production for businesses increase. Rising costs for things like raw materials, wages, or energy can force businesses to raise their prices to maintain their profit margins. This can be caused by supply chain disruptions, a sharp increase in the price of a key resource, or a rise in wages. |
| • | Built-in Inflation: This type of inflation is often linked to people's expectations. If workers expect prices to rise, they may demand higher wages to maintain their standard of living. As a result, businesses might raise prices to cover the higher wage costs, leading to a cycle where higher wages push up prices, and higher prices, in turn, lead to demands for higher wages. |
Effects of Inflation
Inflation can have a range of effects on an economy and on individuals:
| • | Decreased Purchasing Power: This is the most significant effect. As prices rise, the same amount of money buys less than it did before. This erodes the value of savings and disproportionately affects people on fixed incomes, like retirees. |
| • | Reduced Value of Money: Inflation reduces the real value of money over time. For example, a dollar today will not buy the same amount of goods that it could a year ago. |
| • | Higher Interest Rates: Central banks often raise interest rates to combat high inflation. This makes borrowing more expensive for both consumers and businesses, which can slow down economic activity. |
| • | Uncertainty: High and unpredictable inflation can make it difficult for businesses and consumers to plan for the future, as they can't be sure what prices will be. This can discourage investment and saving. |
| • | Impact on Debtors and Creditors: Inflation can benefit debtors (those who owe money) because they can pay back their loans with money that is worth less than the money they borrowed. Conversely, it can harm creditors (those who are owed money) because the real value of the money they receive in repayment is lower. |
How Inflation is Measured
The Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) price index are both key measures of inflation in the United States, but they differ in several important ways. While both track changes in the prices of consumer goods and services, they use different methodologies and data sources, which can lead to different inflation readings.
Here's a breakdown of the key differences:
1. What They Measure (Scope)
| • | Consumer Price Index (CPI): The CPI measures the change in prices paid by urban households for a fixed "basket" of consumer goods and services. It focuses on out-of-pocket expenditures made directly by consumers. |
| • | Personal Consumption Expenditures (PCE) Price Index: The PCE price index measures the change in prices for all goods and services consumed by all households in the U.S., including rural households and nonprofit institutions serving households. Crucially, it includes not only out-of-pocket spending but also expenditures made on behalf of consumers by third parties, such as employer-provided health insurance, Medicare, and Medicaid. This gives the PCE a broader scope than the CPI. |
2. How They Are Calculated (Formula and Weights)
| • | Consumer Price Index (CPI): The CPI uses a modified Laspeyres formula and a fixed basket of goods that is updated annually. This means it's slower to account for changes in consumer behavior. |
| • | Personal Consumption Expenditures (PCE) Price Index: The PCE uses a Fisher-Ideal formula, which is a "chain-type" index. It uses data from both the current period and the preceding period, and its weights are updated more frequently. This allows the PCE to better reflect consumer substitution, where people switch from more expensive items to cheaper alternatives (e.g., buying chicken instead of beef when beef prices rise). Because of this, the PCE tends to show a lower inflation rate over time than the CPI. |
3. Data Sources
| • | Consumer Price Index (CPI): The CPI relies on data primarily from a household survey (the Consumer Expenditure Survey) to determine the weight of different items in its basket. Prices are collected by the Bureau of Labor Statistics (BLS). |
| • | Personal Consumption Expenditures (PCE) Price Index: The PCE is based on data from business surveys, such as the Census Bureau's retail trade and service surveys. It's a component of the national income and product accounts, which are used to calculate the Gross Domestic Product (GDP). |
4. Who Uses Them
| • | Consumer Price Index (CPI): The CPI is the measure most often cited in the media and is widely used for things like adjusting Social Security payments and other "cost-of-living" adjustments in contracts. It's the most common inflation measure for the general public. |
| • | Personal Consumption Expenditures (PCE) Price Index: The PCE is the Federal Reserve's preferred measure of inflation. The Fed uses the PCE, particularly the "core" PCE (which excludes volatile food and energy prices), to guide its monetary policy decisions, including setting interest rates. The Fed believes the PCE is a more comprehensive and accurate reflection of overall price pressures in the economy. |
Summary Table
Feature |
Consumer Price Index (CPI) |
Personal Consumption Expenditures (PCE) Price Index |
Publisher |
Bureau of Labor Statistics (BLS) |
Bureau of Economic Analysis (BEA) |
Scope |
Out-of-pocket spending by urban households |
Spending by all households and nonprofits, including third-party payments (e.g., health care) |
Formula |
Modified Laspeyres (fixed weights, updated annually) |
Fisher-Ideal (chain-type, reflects consumer substitution) |
Data Source |
Household surveys |
Business surveys and national accounts data |
Use |
Cost-of-living adjustments, public-facing indicator |
Federal Reserve's primary inflation measure for monetary policy |
Typical Trend |
Generally shows a slightly higher inflation rate |
Generally shows a slightly lower inflation rate |