INFLATION
In economic terms, inflation is defined as the rate of increase in the level of general prices within the economy. However, while inflation is the most common, there are several terms describing how price levels are changing, with the most important being:
- Deflation: the rate of decrease in the level of general prices;
- Reflation: the rate of increase in the level of general prices from a deflated state;
- Disinflation: a reduction in the rate of increase in the level of general prices;
| MEASURING INFLATION | Although methods of calculation vary both within and between economics, inflation is measured by observing changes in the prices of many goods and services within the economy. While this is typically done by a single or number of government statistical agencies, labour unions and business organizations have also been known to construct their own measures of inflation. These prices are then aggregated into a price index which generates an average price level for a certain basket of goods and services, with the inflation rate representing the rate of increase in this index as a percentage. While simple in concept, the practical difficulty of calculating the general level of prices within the economy means there is no single true measure in inflation, since the value of inflation will depend on various factors such as the weight given to each good and service within the basket, the methodology of data collection, and which goods and services to include within the index. Another problem with measuring inflation is that there is no way to incorporate qualitative improvements in the standards of products over time. For example, what does the fact that the average car costs a certain percent more than it used to – does it imply that there has been the same percentage increase in prices, or is a certain proportion of that price increase down to higher quality and additional features? This also ignores the obvious difficulty of identifying what the average car is! |
| STOPPING INFLATION | There are many methods which have been suggested to stop inflation. Central Banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations (i.e., using monetary policy). High interest rates (and slow growth of the money supply) are the traditional way that Central Banks fight inflation, using unemployment and the decline of production to prevent price increases. |
Despite these difficulties, the most common measures of inflation are:
The Cost of Living Index (CLI)
The CLI measures changes in the cost of living, as approximated by Consumer Price Indexes. The CLI may also be adjusted for ‘Purchasing Power Parity’ to equalize inflation measures between two or more countries, where relative prices for the same goods and services may vary greatly.
The Consumer Price Index (CPI)
The most commonly reported measure for inflation among most industrial economies, the CPI measures price changes for a selection of goods purchased by a theoretical ‘typical consumer’. As the standard benchmark for price level changes, the CPI is often used in wage and salary negotiations, since workers will seek pay rises at least equal to the CPI in order to compensate for the year on year increase in the prices of goods and services within the economy.
The Producer Price Index (PPI)
Like the CPI, the PPI measures changes in prices received by the suppliers of goods and services within the economy. Due to government subsidies and taxation, this may differ from prices actually paid by consumers.
The Wholesale Price Index
Very like the PPI, the WPI measures changes in prices of a selection of goods at the wholesale level prior to the imposition of national and regional sales taxes.
The Commodity Price Index
The commodity price index measures the change in prices of a selection of commodity, based on the theory that commodities typically retain their value regardless of changes in price levels – thereby representing a stable benchmark against which to measure inflation.
The GDP Deflator
The GDP Deflator is the ratio of nominal (or gross) GDP to real (or inflation-adjusted) GDP to provide a more accurate representation of changes in economic activity while excluding the impact of changing prices. For example, if prices rise by 3%, nominal GDP would also rise by 3% even if the actual level of economic production and output hadn’t changed. More accurately therefore, would be to reduce nominal GDP by the level of inflation, thereby giving the real GDP.
Due to the difficulty of measuring general price level changes, economists often argue about the implicit bias inherent in many inflation measures. For example, in 1995 the Boskin Commission argued that the CPI produced by the US Bureau of Labour Statistics fundamentally overstated the level of inflation, mainly due to people substituting away from more expensive goods, and because of the quality of goods and services improving due to technological advances over time.