Inflation
The easiest way to describe inflation is that you have too much money chasing too few goods and services. People who wonder why the government doesn't just print more money to help those in need do not realize that printing more money will actually make an economy worse. This type of inflation is called Demand-Pull inflation.
Another cause of inflation is a general rise in the prices of inputs. In the 1970s, the nations that make up OPEC (Organization of Petroleum Exporting Countries) made an agreement to cut back on the production of oil, causing the price of oil to soar. Oil is such an important resource for every business and industry that the costs for all businesses increased, which resulted in higher price levels throughout the economy. This type of inflation is called Cost-Push inflation.
Extreme inflation is the worst type of inflation and has affected countries like Germany in the 1920s and Argentina around the 1980s.
View Inflation (2:10) to learn more about the concept.
Inflation (2:10)
Consumer Price Index (CPI)
As mentioned in the video, a market basket is used to determine the level of inflation. The Bureau of Labor Statistics (BLS) is tasked with determining what goods and services will go into a representative market basket. For instance, the price of a can of Coca Cola will be included but not a can of a generic brand. The BLS will also give a weight to certain items in the basket. This is done because an increase in the price of houses, for example, would tend to hurt the consumer more than a price increase in clothing. Since there is subjectivity in what is placed in the market basket, and there is importance assigned to each item, the CPI is often criticized for not being representative of the true price level.
To illustrate how the government determines CPI, we will use a simplified basket containing just a few items. While the BLS basket contains almost 80,000 items, for practical purposes our basket will only contain three items: shirts, gas and food. The price of each basket with the prices for 2010 and 2011 are listed below.
The image is a chart reflecting Market Basket Prices for 2010 and 2011. Item, Quantity, 2010 cost, Total Cost for 2010, 2011 cost, and total cost are listed for each item. Shirts: Quantity 5, 2010 $10, Total Cost 2010 $50, 2011 $12, Total Cost $60. Gas: Quantity 10, 2010 $20, Total Cost 2010 $200, 2011 $19, Total Cost $190. Food: Quantity 50, 2010 $3, Total Cost 2010 $150, 2011 $4.50, Total Cost $225. Total: Total Cost 2010 $400, Total Cost $475.
Calculating CPI
We can now determine the cost of the market basket for each year.
In 2010, the total basket cost:
$50 (5*10) + $200 (10*20) + $150 (5*30) = $400
The same basket, with the exact same items, in 2011 cost:
$60 (12*5) + $190 (19*10)+ $225(4.50*50) = $475
We will now choose our base year. In this case we will choose 2010. To determine the CPI we take the price of the basket, divided by the price of the basket in the base year and multiply by 100.
For 2010, CPI would be:
(400/400) * 100 = 100
This shows how the base year CPI is always 100.
To calculate the CPI for 2011 the equation would look like:
(475/400)*100 = 118.75
To calculate the increase in CPI, or the increase in the price level we will use the rate of change formula:
(New - Old) / Old * 100
In this case price level increased 475-400/400 *100 = 18.75 percent. This simply means the same basket of goods now costs 18.75 percent more.
Real GDP vs. Nominal GDP
Watch Real GDP vs. Nominal GDP (3:09) to learn the difference between nominal and real. Take the quiz at the end of the video for practice!
Real GDP vs. Nominal GDP (3:09)
Use the link below to see how the value of money has changed. U.S. Inflation Calculator