Inflation
Inflation is defined as an increase in the overall price level. Please note that inflation does not apply to the price level of just one good, but rather to how prices are doing overall. A consumer facing inflation that occurs at the rate of 10% per year will able to buy 10% less goods at the end of the year if his or her income stays the same. Inflation can also be defined as a decline in the real purchasing power of the applicable currency.

Consumer Price Index (CPI)
The CPI represents prices paid by consumers (or households). Prices for a basket of goods are compiled for a certain base period. Price data for the same basket of goods is then collected on a monthly basis. This data is used to compare the prices for a particular month with the prices from a different time period.

Example:
The inflation rate is computed by subtracting the CPI of last year's prices from the CPI value for this year, dividing that difference by last year's CPI value and then multiplying by 100.

So if the value of the price index for the current year is equal to 165, and last year's value was 150, the rate would be calculated as:

Inflation rate = (165 - 150) X100= 10
150

CPI Sources of Bias
The CPI is not a perfect measure of inflation. Sources of bias include:

·Quality adjustments - quality of many goods (e.g., cars, computers, and televisions) goes up every year. Although the Bureau of Labor Statistics is now making adjustments for quality improvements, some price increases may reflect quality adjustments that are still counted entirely as inflation.

·New goods - new goods may be introduced that will be hard to compare to older substitutes.

·Substitution - if the price goes up for one good, consumers may substitute another good that provides similar utility. A common example is beef vs. pork. If the price goes up, and the price of pork stays the same, consumers might easily switch to pork. Although the CPI will go higher due to the price increase in beef, many consumers may not be worse off. Also, when prices go up, consumers may effectively not pay the higher prices by switching to discount stores. The CPI surveys do not check to see if consumers are substituting discount or outlet stores.
Aggregate Supply & Aggregate Demand

Related Articles
  1. Insights

    Inflation's Impact on Stock Returns

    When stocks are divided into growth and value categories, the evidence is clear that value stocks perform better in periods of high inflation, and growth stocks perform better during periods ...
  2. Retirement

    Inflation and Financial Planning: A Primer

    Inflation can erode wealth over time and must be considered carefully in a financial plan.
  3. Trading

    Coping With Inflation Risk

    Inflation is less dramatic than a crash, but it can be more devastating to your portfolio.
  4. Insights

    How Inflation Affects Your Net Worth

    When calculating your net worth, don't forget to take inflation into account.
  5. Insights

    Understanding the Substitution Effect

    The substitution effect is an economic term used to describe consumer behavior relative to price or income changes.
  6. Insights

    The Consumer Price Index: A Friend To Investors

    As a measure of inflation, this index can help you make key financial decisions.
  7. Investing

    Timeless Ways To Protect Yourself From Inflation

    Inflation is a natural part of modern life - but there are some ways to cover your assets.
  8. Insights

    Understanding Core Inflation

    Core inflation is a measure of inflation that excludes certain items that have volatile price movements.
  9. Insights

    What Does Price Level Mean?

    Price level is the average of all current prices for goods and services in an economy.
Frequently Asked Questions
  1. Short Selling, or Selling Something You Don't Own

    Money can be made without actually owning any shares, but short selling isn't for new investors.
  2. Determining a Firm's Percentage of Credit Sales

    Find out where to look for information about determining a company's percentage of credit sales.
  3. How Did Kidder Peabody's Joseph Jett Lose $350M?

    The 1980s were a rough decade for Kidder, Peabody & Co. thanks to bond trader Joseph Jett.
  4. What Is a Blank-Check Company?

    A blank-check company has a business plan based on a merger or acquisition with another company.
Trading Center