Over the past couple of months, the United States economy has been experiencing an increased level of inflation. The news and media talk about inflation numbers being above the “healthy” benchmark inflation rate suggested by the Federal Reserve.

Over the past year, most people around the world have experienced a rise in gasoline prices, partly due to the ongoing war between Russia and Ukraine but also due to inflation. So, what exactly is inflation, and how is inflation measured?

What is inflation?

According to Investopedia, “Inflation is the rate at which prices for goods and services rise”. One of the well-known inflation metrics is the price of a can of Campbell’s tomato soup between 1898 and 2015: the product remains essentially the same (a can of tomato soup), yet the price of the product rises.

Inflation: Price of goods over 40 years

A can of tomato soup used to cost $0.10. Now it’s almost a dollar.

When we experience inflation, our purchasing power per dollar decreases. The can of soup is the same, yet we need to pay more for it due to inflation.

There are three main types of inflation that exist: demand-pull inflation, cost-push inflation, and built-in inflation. Let’s explain these types of inflation in detail:

  • Demand-pull inflation: this is when the demand for a product is higher than the production capacity of said product. For example, let’s say a company sells a certain product for $10, and can only produce 100 items a week. If there are 400 people trying to purchase this product every week, then the company is incentivized to raise the prices of the product. Since the price of the product did rise, it has experienced inflation, demand-pull inflation specifically.
  • Cost-push inflation: this is when the production costs themselves increase the prices of a good or service. For example, let’s say someone makes scissors. In order to produce scissors, you need steel and plastic. If the price of steel goes up, then the scissor manufacturer will have no choice but to raise the price of the scissors that he is manufacturing. This is an example of cost-push inflation.
  • Built-in inflation: this is the idea that people expect prices to continue rising in the future, causing a rise in wages as well. This is considered built-in inflation.

The main idea of inflation is simple: it is the idea that the price of goods and services increase over time. If the price of the same good or service increases over time, then it has experienced inflation.

Related: The Fed Pulls Out Another 0.75% Hike, Suggesting It’s Not Ready to Slow Down Until Inflation Comes to Heel. 

How is inflation measured?

There are many ways to measure inflation, but the easy way to measure inflation is to measure the increase in prices of products, goods and services. If a bicycle cost $100 five years ago, and now it costs $150, then the bicycle has experienced inflation. However, the price of a bicycle may not be the best factor for showing inflation across an entire country.

Countries measure inflation through standardized inflation indexes. For example, the United States government likes to measure inflation through the CPI index. The CPI index serves as the official inflation metric of the country, and covers all industries. Let’s look at a recent CPI inflation index:

How is inflation measure: CPI

Via [BLS/CPI]

As we can see, the bar chart measures levels of inflation across all items, food, and energy. Some CPI indices go more in depth, measuring inflation levels across different industries.

The CPI index is used as the official rate of inflation, but many people believe that it is not the best indicator of inflation levels, considering it a very conservative measurement of inflation. Some people do not trust the CPI index.

Another indicator used to measure inflation is the Personal Consumption Expenditures Price Index (PCE). This indicator is less talked about in the news compared to the CPI, but it nevertheless provides a measure of the prices that people in the United States pay for their goods and services.

This is different from the CPI because, since it tracks consumers, it also tracks general consumer sentiment and if people are currently buying more (or less) compared to before. Below is a table of the most recent PCE numbers:

How is inflation measured: PCE

Via [BEA/PCE]

As we can see in the table, indeed the PCE has been increasing month over month, meaning that people are paying more for goods and services than they used to. This means that inflation has happened.

Furthermore, the Producer Price Index (PPI) measures the average change over time in the selling prices received by domestic producers for their output. In other words, it tracks how much producers are charging for a certain product or item, and how the price of this item has changed over time.

Basically, if someone makes glue, but the price of a certain chemical that is needed for the glue has gone up 10% in price, then the producer will need to raise the price. This would make the PPI go up. The PPI gives a more narrow, precise measure of the cost of goods, essentially, making it a valuable measure that is used to calculate inflation. Every month, the PPI delivers a detailed report explaining the fluctuation in prices over time.

Finally, another measurement of inflation that is still used in some countries is the Retail Price Index (RPI). Different from the CPI and the PPI, this time the RPI tracks changes in the cost of a fixed basket of goods over time. Since this fixed basket of goods never changes, the RPI measured is generally a little bit higher than the CPI.

Conclusion

No matter how inflation is measured, the simple idea of measuring inflation is to measure the rate of increase in prices over a certain amount of time.

Different firms and organizations measure inflation slightly differently, because they analyze the rise in prices across different products. Some people might check the price of a can of Coke at a store in Oregon, others might look at the price of that same can of coke at a store in Wisconsin.

We can imagine that some regions may have a rate of inflation that is faster than other regions, therefore the actual metric of inflation is difficult to measure accurately. Therefore, it may be wise to look at multiple inflation reports, in order to have a better idea about what the actual rate of inflation might be.

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