Inflation is commonly understood as an increase in the price level. Formally, it is defined as the rate of change in the price level. Thus, an inflation rate of 5 percent per annum means that the price level is increasing at the rate of 5 percent. Inflation, however, need not always be positive. It could be a negative number, in which case the price level would be declining. Of course, a negative inflation rate, termed deflation, is very uncommon. Most economies face positive rates of inflation year after year.
If the inflation rate is positive and an individual's income remains constant, his or her real standard of living will fall as the individual's income will be worth less and less in successive periods. Let us assume that a household earns $50,000 per year and the income remains fixed at this level in the future. If the inflation rate persists at 10 percent per year, the purchasing power of the household income will also keep declining at the rate of 10 percent per year. At the end of the five-year period, prices will be one and a half times greater. This will lead to the household being able to buy only two-thirds of the goods and services it was able to buy at the beginning of the period.
The inflation rate is derived by calculating the rate of change in a price index. A price index, in turn, measures the level of prices of goods and services at any point of time. The number of items included in a price index vary depending on the objective of the index. Usually three kinds of price indexes are periodically reported by government sources. They all have their particular advantages and uses. The first index is called the consumer price index (CPI), which measures the average retail prices paid by consumers for goods and services bought by them. Several thousand items are included in this index. The second price index used to measure the inflation rate is called the producer price index. It is a much broader measure than the CPI because it measures the wholesale prices of approximately 3,000 items. The items included in this index are those that are typically used by producers (manufacturers and businesses) and thus contain many raw materials and semifinished goods. The third measure of inflation is the called the implicit price deflator. This index measures the prices of all goods and services included in the calculation of the current output of goods and services in the economy, known as gross domestic product. It is the broadest measure of the price level.
The three measures of the inflation rate are most likely to move in the same direction, even though not to the same extent. Differences can arise due to the differing number of goods and services included for the purpose of compiling the three indexes. In general, if one hears about the inflation rate number in the popular media, it is most likely to be the one based on the CPI.
[ Anandi P. Sahu , Ph.D. ]
Froyen, Richard T. Macroeconomics: Theories and Policies. 6th ed. Upper Saddle River, NJ: Prentice Hall, 1998.
Gordon, Robert J. Macroeconomics. 7th ed. Reading, MA: Addison-Wesley, 1998.
Sommers, Albert T. The U.S. Economy Demystified. Lexington, MA: Lexington Books, 1988.
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