8.1 Tracking Inflation
The price level is measured by using a basket of goods and services and calculating how the total cost of buying that basket of goods will increase over time. The price level is often expressed in terms of index numbers, which transform the cost of buying the basket of goods and services into a series of numbers in the same proportion to each other, but with an arbitrary base year of 100. The rate of inflation is measured as the percentage change between price levels or index numbers over time.
8.2 How Changes in the Cost of Living Are Measured
Measuring price levels with a fixed basket of goods will always have two problems: the substitution bias, by which a fixed basket of goods does not allow for buying more of what is relatively less expensive and less of what is relatively more expensive; and the quality/new goods bias, by which a fixed basket cannot take into account improvements in quality and the advent of new goods. These problems can be reduced in degree—for example, by allowing the basket of goods to evolve over time—but they cannot be totally eliminated. The most commonly cited measure of inflation is the Consumer Price Index (CPI), which is based on a basket of goods representing what the typical consumer buys. The Core Inflation Index further breaks down the CPI by excluding volatile economic variables. Several price indices are not based on baskets of consumer goods. The GDP deflator is based on all the components of GDP. The Producer Price Index is based on prices of supplies and inputs bought by producers of goods and services. An Employment Cost Index measures wage inflation in the labor market. An International Price Index is based on the prices of merchandise that is exported or imported.
8.3 How the U.S. and Other Countries Experience Inflation
In the U.S. economy, the annual inflation rate in the last two decades has typically been around 2% to 4%. The periods of highest inflation in the United States in the twentieth century occurred during the years after World Wars I and II, and in the 1970s. The period of lowest inflation—actually, with deflation—was the Great Depression of the 1930s.
8.4 The Confusion Over Inflation
Unexpected inflation will tend to hurt those whose money received, in terms of wages and interest payments, does not rise with inflation. In contrast, inflation can help those who owe money that can be paid in less valuable, inflated dollars. Low rates of inflation have relatively little economic impact over the short term. Over the medium and the long term, even low rates of inflation can complicate future planning. High rates of inflation can muddle price signals in the short term and prevent market forces from operating efficiently, and can vastly complicate long-term savings and investment decisions.
8.5 Indexing and Its Limitations
A payment is said to be indexed if it is automatically adjusted for inflation. Examples of indexing in the private sector include wage contracts with cost-of-living adjustments (COLAs) and loan agreements like adjustable-rate mortgages (ARMs). Examples of indexing in the public sector include tax brackets and Social Security payments.