Measuring inflation
Inflation is a sustained rise in the general price level. Measuring it accurately matters for wages, pensions, interest rates, and policy.
What inflation is
Inflation is a rise in the overall level of prices over time, reducing the purchasing power of money. If inflation is 3% a year, a basket costing 100 dollars this year costs 103 next year. Deflation is a falling price level. Disinflation is a slowdown in the rate of inflation, with prices still rising.
The consumer price index
The consumer price index (CPI) tracks the cost of a fixed basket of goods and services bought by typical households, including food, housing, transport, healthcare, and entertainment. Statisticians collect thousands of prices each month. The index is set to 100 in a base period.
Calculating inflation
The inflation rate is the percentage change in the price index: \(\pi = \frac{CPI_t - CPI_{t-1}}{CPI_{t-1}} \times 100\%\). If the CPI rises from 250 to 260, inflation is 10/250 = 4%.
Core inflation
Food and energy prices swing a lot due to weather and global events. Core inflation excludes them to show the underlying trend. Central banks watch core measures closely, though households experience the full price changes.
Biases in the CPI
The CPI may overstate the cost of living because of substitution bias (people switch to cheaper goods when prices rise, but the fixed basket assumes they do not), quality improvements (a more expensive phone may also be much better), and new products entering the basket late. Agencies adjust for these, but measurement is imperfect.
Other price indices
The producer price index (PPI) measures prices received by producers, often an early signal of consumer price changes. The GDP deflator covers all goods in GDP. In the US, the Federal Reserve's preferred measure is the personal consumption expenditures (PCE) price index, which updates its basket more often than the CPI.
Real versus nominal values
Nominal values are in current dollars; real values adjust for inflation. To find a real wage, divide the nominal wage by the price index (times 100). If your pay rises 3% while prices rise 5%, your real wage has fallen about 2%.
Worked example
In 2015 a worker earned 40,000 dollars when the CPI was 237. In 2025 she earns 52,000 with the CPI at 320. Her 2025 wage in 2015 dollars is 52,000 x 237/320, about 38,500. Despite a higher nominal salary, her real purchasing power has fallen slightly.
Key takeaways
Inflation is a sustained rise in the price level; deflation is a fall; disinflation is slowing inflation. The CPI measures a typical household basket; inflation is its percentage change. Core inflation excludes food and energy. The CPI may overstate living costs through substitution and quality biases. Real values adjust nominal values for inflation.
Flashcard
Sustained rise in the general price level
Check your understanding
The CPI rises from 200 to 210. What is the inflation rate?