5 Things To Know About Inflation
Inflation is raging! It's reached the highest it's been in the past 40 years (for a full historical chart, check out usinflationchart.com). It's a buzzword being thrown around on the interwebs/news, the Federal Reserve is trying to rein it in, and we're ALL feeling it in our wallets.
Much of the content you'll find on the internet regarding inflation is flat out wrong. So I consulted my old CFA Institute (Chartered Financial Analyst) books to get to the bottom of it. Whether your dream is to work as an economist at a global financial institution or you just want to impress someone at your next Ace Virtual Event or happy hour, below are some insights into the mysterious "inflation".
1. Inflation Definitions
Inflation: a persistent increase in the price level over time. If the price level increases in a single jump but does not continue rising, the economy is not experiencing inflation. An increase in the price of a single good, or in relative prices of some goods, is not inflation. If inflation is present, the prices of almost all goods and services are increasing.
Hyperinflation: Inflation that accelerates out of control. Hyperinflation can potentially destroy a country's monetary system and bring about social and political upheavals.
Disinflation: An inflation rate that is decreasing over time but remains greater than zero.
Deflation: A persistently decreasing price level (i.e. negative inflation rate) is called deflation. Deflation is commonly associated with deep recessions. When most prices are decreasing, consumers delay purchases because they believe they can buy the same goods more cheaply in the future. For firms, deflation results in decreasing revenue and increasing real fixed costs.
2. Inflation favors borrowers at the expense of lenders
Inflation erodes the purchasing power of a currency. Inflation favors borrowers at the expense of lenders because when the borrower returns the principal to the lender, it is worth less in terms of goods and services (in real terms) than it was worth when it was borrowed.
3. Inflation Rate Defined
Inflation Rate: the percentage increase in the price level, typically compared to the prior year. Analysts can use the inflation rate as a business cycle indicator and to anticipate changes in central bank monetary policy. An objective of central banks is to keep inflation within a certain target range.
4. How To Calculate Inflation
To calculate a rate of inflation, we need to use a price index as a proxy for the price level. A price index measures the average price for a defined basket of goods and services. The consumer price index (CPI) is the best-known indicator of U.S. inflation. Many countries use indexes similar to the CPI.
The CPI basket represents the purchasing patterns of a typical urban household. Weights for the major categories in the CPI are shown in column CPI-W here.
To calculate the CPI, the Bureau of Labor Statistics compares the cost of the CPI basket today with the cost of the basket in an earlier base period. The value of the index is as follows:
CPI = cost of basket at current prices / cost of basket at base period prices * 100
5. Example: Calculating a Price Index
The following table shows price information for a simplified basket of goods.
Cheesburgers Quantity = 200 | Price in Base Period = 2.50 | Current Price = 3.00
Movie tickets Quantity = 50 | Price in Base Period = 8.97 | Current Price = 9.16
Gasoline (in gallons) Quantity = 300 Price in Base Period = 3.30 | Current Price = 5.50
Digital watches Quantity = 100 Price in Base Period = 12.00 | Current Price = 9.00
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Calculate the change in the price index for this basket from the base period to the current period.
Answer:
Reference base period:
Cheeseburgers 200 * 2.5 = 500
Movie tickets 50 * 8.97 = 448.50
Gasoline 300 * 3.3 = 990
Watch 100 * 12 = 1,200
Cost of Basket 3,138.50
Current period:
Cheeseburgers 200 * 3 = 600
Movie tickets 50 * 9.16 = 458
Gasoline 300 * 5.5 = 1,650
Watch 100 * 9 = 900
Cost of Basket 3,608.00
Price Index = 3,608 / 3,138.5 * 100 = 114.96
The Price Index is up 114.96 / 100 - 1 = 14.96% over the period
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