What Is Price Inflation?
Price inflation is an increase in the price of a standardized good/service or a basket of goods/services over a specific period, usually one year.
- Price inflation is an increase in the price of goods and services over a certain time period.
- Strong demand and supply shortages tend to cause price inflation.
- Price inflation can also be caused by an increase in the cost of inputs to the production process.
- Price inflation is a critical measure for central banks when setting monetary policy.
- The Consumer Price Index (CPI) is the most common measure of price inflation in the U.S. and is released monthly by the Bureau of Labor and Statistics (BLS).
How Price Inflation Works
The nominal amount of money available in an economy tends to grow larger every year relative to the supply of goods that are available for purchase. This overall demand-pull tends to cause some degree of price inflation. There’s not enough supply to satisfy demand so prices usually move upward.
Price inflation can also be caused by cost-push, which is when the cost of inputs to the production process increases. A large chunk of these extra expenses will likely be passed on to the customer in the form of higher prices if a company has to pay higher wages and more for the raw materials it uses to make the final product.
Price inflation can also be seen in a slightly different form where the price of a good is the same year-over-year (YOY) but the amount of the good received gradually decreases. You might notice this in low-cost snack foods such as potato chips and chocolate bars where the weight of the product gradually decreases while the price remains the same.
How to Measure Price Inflation
The Consumer Price Index (CPI) is the most common measure of price inflation in the U.S. It’s released monthly by the Bureau of Labor and Statistics (BLS). The calculation is complex but the BLS provides an inflation calculator that can tell you what $10 was worth in one compared to what it was worth in another. Ten dollars had the same buying power in December 2000 as $17.63 had in December 2023.
The CPI is based on day-to-day living expenses. It helps to determine individuals’ income eligibility for various types of government assistance and federal tax brackets.
The Consumer Price Index increased 1.0% on a seasonally adjusted basis in May 2022 after rising 0.3% in April. The index increased 8% between 2022 and 2023 according to a report published in December 2023.
Other measures for price inflation include the producer price index (PPI), which measures the increase in wholesale prices, and the employment cost index (ECI), which measures increases in wages in the labor market.
All can be vitally instrumental in measuring the state of the economy at any given point in time.
What Is the Difference Between the Price Level and the Inflation Rate?
The price level relates to the prices of various goods and services. The inflation rate is the percentage change in price levels.
How Do You Calculate the Inflation-Adjusted Price?
Prices are adjusted for inflation by dividing the price index for the current period by a previous period and then multiplying that ratio by the unadjusted price. For example, the Consumer Price Index of urban consumers (CPI-U) was 258.8 in 2020 and 271.0 in 2021. The price of the item you are adjusting for was $2,000 in 2020. The inflation-adjusted price of this item would be (271.0 / 258.8) * $2,000, or $2,094.
What Is Asset Price Inflation?
Asset price inflation is the rise in financial and capital assets such as stocks and real estate. The Consumer Price Index (CPI) excludes such assets. It measures day-to-day, necessary living expenses. You can survive without purchasing that hot stock everyone is talking about but that’s not the case with paying for your home’s heat or groceries.
The Bottom Line
Price inflation is a critical measure for central banks when setting monetary policy. A central bank will likely tighten monetary policy by increasing interest rates when price inflation is rising at a faster pace than desired. This would encourage savings through higher returns and slow spending in an ideal world, which would in turn slow price inflation.
On the other hand, a central bank will loosen monetary policy by reducing interest rates should inflation remain subdued over some time. Cheaper borrowing costs are intended to incentivize spending and investing activity, spurring demand and creating price inflation. A price inflation rate of 2% in the U.S. is generally considered desirable.