What is Inflation? Prices and Wages Go Up, Economy Grows

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Inflation is an important indication of the welfare of any given economy, but how is it calculated, and what exactly does it measure?

The basic function of inflation is to show if an economy is growing. Image credit: Wagner Magni.

What does Inflation Measure?

Inflation is the measure of the change in price of goods and services. Put simply, if inflation is calculated at 1%, it translates into us paying 1% more for products and services overall.

The benchmark for an ‘ideal’ inflation is often debated, but a target of 2% was set by the Federal Reserve earlier this year.

Inflation: Impacts on the Economy

Interest rates are significantly impacted by inflation reports. If the inflation rate is high, indicating high prices and possibly unattainable costs of living, interest rates may be raised in an attempt to curb public spending by indirectly reducing the amount of disposable income available to a population.

Adversely, rates may also be cut in response to low or negative inflation in order to encourage public spending. We have seen this latter measure implemented over the recession of the last few years, with many economies struggling with inflation.

Salaries are, ideally, linked with inflation, following the logic that if inflation is rising, pushing up the cost of living, then wages must rise, too. However, the gap between income and inflation has become more significant over the last decade, again due to the impact of floundering economies on both public and private sectors.

State pensions and benefit schemes also rely on inflation data so that payment levels can be set in accordance to a realistic level of expenditure.

Where Does Inflation Data Come From?

The primary source of data when calculating inflation rates is the Consumer Prices Index (CPI). CPI measures the rise or fall of costs of several different areas of expenditure, including food, energy, medical care, housing costs, and general commodities. Each category is broken down into specific reports (for example, food expenditure includes statistics for both food consumed in the home and food bought outside of the home).

Whilst data on each individual section is made available, all items are given a weighting, according to how frequently they are used/purchased, and to what level they are deemed essential to consumers, in order to calculate an overall figure.

In the UK, two separate reporting systems are in operation, with CPI taken into account with the Retail Price Index (RPI). The primary difference between the two is that CPI does not include housing costs, such as the cost of mortgages, whereas RPI does. In the US, the CPI covers all areas of reporting.

Inflation is one of the key factors in understanding the state of an economy. The basic function of inflation is to show if an economy is growing; if inflation is rising, the economy is growing.

Sources:

Spicer, J. In Historic Shift, Fed Sets Inflation Target. (2012). Reuters. Accessed November 10, 2012.

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