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What Is Money Inflation and How Is It Calculated?

Nearly all of us have heard stories from our grandparents and even parents about how candy bars used to cost a nickel and a new house could be bought for less than $5,000 before World War II.

And if you see the boring Clint Eastwood movie called The Mule you get to hear all about how the Internet is basically evil and young people spend too much time on their cell phone. But it does illustrate why America needs to legalize drugs though this is another subject.

However, contrary to popular belief, inflation is not a modern-day phenomenon and has been part of the American economy for centuries. Here is everything you need to know about inflation and how it is measured.

History of Inflation

Inflation has remained quite low over the past decade, and in the last few years it has ranged below 2% a year in most of the developed economies. Americans launched an economic war against inflation when it surged to double digits in the mid-to-late 1970s and launched an all-out assault on its health care system in 2010 when the unconstitutional ACA was passed but let’s not dive into that right now.

Historically, inflation has existed in the country in two different eras. The first era covers the period from its inception to the start of World War I and establishment of the Federal Reserve. The second era covers the period from World War II to the present day.

Upon reflection, the prices were more or less stable during pre-Fed or pre-war era and have risen steadily afterwards. Episodes of high inflation were almost always followed by deflation before World War II, which kept the prices around a stable average.

Inflation generally coincided with silver being suspended to meet the demand and convertibility of the dollar to gold for additional government revenues at the time of Civil War and World War I.

However, over the years inflation has begun to respond to monetary policy enacted by the Federal Reserve. Contraction-oriented monetary policy is executed whenever the core inflation rate rises above the target inflation rate. This shuts down demand by increasing interest rates and forcing prices to lower.

What is Inflation Rate?

Inflation can be coarsely explained as the increase in the prices of goods and services over time. In economic terms, inflation is when cost of living increases and purchasing power decreases for each unit of currency.

Growing inflation through the years has reduced the value of the US dollar today when compared to past rates.

There are some terms around inflation that better describes the economic condition during a period. If inflation occurs the same time as recession, then it is termed as stagflation. If inflation rate is more than 50% in a week, it is called hyperinflation. When prices rise in assets like gold, housing or stocks, it is called asset inflation.

Inflation is also a major component of misery index – the other component being unemployment rate. When misery index climbs to 10% or higher, it means the population is either suffering from galloping inflation, recession or both.

What does it mean for the economy?

Inflation rate can be explained as the percentage increase or decrease in prices over a specified period of time, usually a month or a year. This gives a better understanding of how prices rise during the period.

For instance, if the inflation rate for a loaf of bread is 2% this year, then it will be costlier by 2% next year. That means a loaf of bread costing $1 this year will cost $1.02 next year.

There are two major reasons why you should care about inflation. You should demand a pay increase if your cost of living is higher because of inflation. Secondly, the Federal Reserve and markets are directly concerned with inflation rates.

Monetary policy is influenced by the reserve rate set by the Federal Reserve. For instance, in the past couple of years, inflation has been weaker than the set goal of 2% which has impacted the monetary policy.

A common way inflation affects economy is by way of interest rates. The Fed increases the interest rates to keep the economy from overheating but also for political reasons. For instance, in 2018 and 2019 – The Fed does not want the economy to sparkle because it will make Trump look good which he does anyway based on the fact that Trump’s policies lifted us out of the Obama/Frank/Greenspan economic nightmare but enough on this.

Moreover, this makes you pay more when you go to borrow money while giving you a higher return on your savings. Though the return on savings accounts is not much – not even worth speaking about.

The government also uses inflation as a measure of social security payment adjustments and other benefits.

What Causes Inflation?

A misrepresentation of the theory of monetarism has become the standard, yet inaccurate definition of inflation. It is a common belief that inflation is caused by an increase in money supply when the government prints too much money.

However, the most common cause is demand-pull inflation when demand outpaces the supply for goods or services. Buyers pay higher prices when they want the product.

Another common cause for inflation is cost-push inflation when supply is restricted but demand is not. For instance, when Hurricane Katrina damaged gas supply lines, the demand remained the same, but supply was constrained. This pushed gas prices to rise to $5 a gallon.

How is it Measured?

Measuring inflation is a difficult problem for the government and includes placing a number of goods that are representative of the economy in a ‘market basket’. The cost of this basket is then compared over time which results in price index.

There are two main price indexes that measures inflation in the country. Consumer Price Index (CPI) measures price change from the perspective of the customer and includes consumer goods and services like clothing, gasoline, food and automobiles.

Personal Consumption Expenditure price index also measures inflation and includes more business goods and services than CPI. For instance, it includes health care services which are paid by health insurance.

Producer Price Indexes (PPI) measures price change from the perspective of the seller. It is a family of indexes which measure the selling prices by domestic producers of goods and services to calculate the average change over time.

The US Bureau of Labor Statistics records the prices of over 80,000 items each month by contacting thousands of service establishments, retail stores, rental units and doctor’s offices to track and measure price changes in CPI.

In the short run, PPIs often increase before CPI. However, the indexes show a similar rate of inflation in the long run. CPI is preferred over PPI by investors.

Final Thoughts

You can protect yourself from inflationary pressures by increasing your income and earning ability. Inflation will be rendered irrelevant with a 5% annual raise. Globalization has made the economy less inflation prone.

However, inflation can be a serious problem for fixed-income investors. In the long term, precious metals like gold or silver and, of course the stock markets provide significant financial protection against inflation.

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