No one wants to live in a country where inflation gets out of hand. Inflation means a continuous rise in the price level. A bit of inflation is considered harmless and even something economists like to see in a healthy, growing economy. But if prices start rising faster than most people’s incomes, it means a widespread loss of purchasing power. Left unchecked, this would mean a decline in society’s real standard of living. In extreme cases, prices can even spiral out of control, gripping a country in hyperinflation.
There isn’t just one way to think about inflation. There’s not even just one way to measure it. In the United States, the Bureau of Labor Statistics produces consumer price indices (CPI-U and CPI-W), a producer price index (PPI), and chained–consumer price indices (C-CPI-U), among others. The Bureau of Economic Analysis generates a GDP price deflator, an index known as a personal consumption expenditure (PCE), and many more. The Federal Reserve prefers a measure known as core PCE, and well, you get the picture. Lots of statisticians are employed to produce a wide range of estimates to help policy makers, investors, businesses, unions, and others get a sense of what’s happening to prices in our economy.
We can only get a general sense of what’s happening to prices because it’s literally impossible to track what’s happening to the price of every item that’s for sale in our economy. Take SEO Leeds for example. You might find yourself paying more for your morning coffee, a gallon of gas, or your monthly cable, but that doesn’t mean that the overall price level is accelerating. To understand what’s happening at the macro level, we have to rely on price indices like those above. An index like the Consumer Price Index tells us whether the price of a standard basket of consumer goods and services is becoming more expensive over time. The basket includes everything from housing and health care to food, transportation, entertainment, clothing, and more. Obviously, not all households consume identical baskets of goods, so indices like the CPI are constructed to reflect the spending habits of a typical household. Expenses that eat up a bigger share of the typical household budget—for example, housing—count more (i.e., are weighted more heavily) than items that are less important to the average family. Because housing is weighted more heavily than, say, entertainment, a 5 percent spike in the cost of housing will have a bigger impact on the CPI than an equivalent 5 percent rise in the cost of entertainment. In the real world, some categories of goods and services have gotten more expensive (housing, education, and health care) while others have become cheaper over time. What matters is how the overall price of the basket changes from month to month and year to year, and whether average earnings are rising fast enough to keep up with rising prices.
People worry about inflation because it can eat away at their real standard of living. You might have no trouble affording the typical basket of goods today, but if the price of that fixed basket starts rising, you may discover that you can no longer afford to buy it. It depends what’s happening to your income. If the price of the basket keeps going up by 5 percent each year while your annual earnings rise by just 2 percent, then in real (inflation-adjusted) terms you’ll be 3 percent worse off each year. That means a real loss in terms of the actual amount of stuff—real goods and services—you can afford to buy.
So what causes prices to rise, and what can we do to prevent inflation from eroding our standard of living over time?
Before we turn to these questions, it’s worth noting that many of the world’s major countries have been desperately trying to solve the opposite problem—underinflation—for a decade or more. Too little, not too much, inflation has plagued the US, Japan, and Europe. In each of these regions, 2 percent is officially considered the “right” amount of inflation, so that’s the rate the Federal Reserve, the Bank of Japan, and the European Central Bank have been trying to achieve. But none of them has been successful in bringing inflation up to a steady 2 percent. Japan has had a particularly rough time, fighting not just low inflation but periodic bouts of outright deflation—a drop in the overall price level—a rare phenomenon that gripped the US during the Great Depression of the 1930s. You might wonder why anyone would worry about inflation getting too low. It sounds great! Yet economists worry because when there’s little or no inflation, it’s usually considered a reflection of weakness in the broader economy.
The long battle against low inflation is considered a puzzle by most economists. Some argue that a combination of factors is probably responsible for low inflation across much of the world. Many believe rapid improvements in technology, demographics, and globalization probably explain the phenomenon. Others believe central banks simply haven’t used their tool kits aggressively enough. They think inflation has been stubbornly low because people at the European Central Bank, the Bank of Japan, and the Federal Reserve haven’t done enough to create a different psychology, so people continue to expect inflation to remain low. For this group, raising actual inflation is simply a matter of getting people to raise their inflation expectations. If central banks can convince people that inflation will move higher, people will begin spending more money today (why wait to buy something if prices are heading up?), and the added demand will actually move prices higher. Still others see inequality and wage stagnation as key drivers of slow growth and de minimis pressure on wages and prices. Some say wage growth and a more equitable distribution of income would help bolster demand among lower- and middle-income households, thereby helping to create some inflationary pressure.