link to page 1

September 26, 2016
Introduction to U.S. Economy: Inflation
What is Inflation?
Inflation’s Impact on the Economy
Inflation is defined as a general increase in the price of
Inflation tends to interfere with pricing mechanisms in the
goods and services across the economy; in other words, a
economy, resulting in individuals and businesses making
general decrease in the value of money. Conversely,
less than optimal spending, saving, and investment
deflation is a general decrease in the price of goods and
decisions. Additionally, in the presence of inflation,
services across the economy, or a general increase in the
economic actors often engage in actions to protect
value of money.
themselves from the negative impacts of inflation, diverting
resources from other more productive activities.
As inflation occurs, individuals can purchase fewer goods
and services with the same amount of money. For this
Ultimately, these inefficient decisions reduce incomes,
reason, an individual would need about $287 in 2015 to
economic growth, and living standards. For this reason, it is
purchase the same amount of goods and services as $100
generally accepted that inflation should be kept low to
could have purchased in 1980. Measures of inflation are
minimize these distortions in the economy. Some would
used to adjust money figures to keep purchasing power
argue that an inflation rate of zero is optimal; however, a
constant over time, allowing for more accurate comparisons
target of zero inflation makes a period of accidental
across disparate time periods. Monetary figures adjusted for
deflation more likely, and deflation is thought to be even
inflation are referred to as real, and non-inflation adjusted
more costly than inflation. In an effort to balance these two
figures are referred to as nominal.
risks, policy makers, including the Federal Reserve, often
target a positive, but low, inflation rate, generally around
Causes of Inflation
2%, which reduces inefficiencies within the economy while
Inflation is largely the result of two different phenomena,
protecting against deflation.
which are often referred to as demand-pull and cost-push
inflation. Demand-pull inflation occurs when demand for
Figure 1 Annual Inflation Rate
goods and services within the economy exceeds the
1960-2016
economy’s capacity to produce goods and services. As
demand exceeds supply within the economy, “too much
money chasing too few goods,” there is upward pressure
placed on prices resulting in rising inflation.
Cost-push inflation occurs when the price of input goods
and services increases. The classic example of cost-push
inflation is the result of an oil shock, which sharply
decreases the supply of oil and other petroleum products.
The decrease in oil supplies increases the price of oil and
petroleum products. Petroleum products are an input good
for a significant portion of goods and services across the
economy, and as the price of this important input good
increases so does the price of the final goods and services
resulting in inflation. Cost-push inflation only results in a
temporary increase in inflation, unless accommodated by

Source: Bureau of Economic Analysis.
monetary policy.
Note: 12-month percentage change as measured by Personal
In addition, changes in inflation expectations can also cause
Consumption Expenditures Index.
changes in actual inflation. Individuals form expectations
The Federal Reserve and Inflation
around the future rate of inflation and incorporate those
expectations, when setting prices at the firm level or when
The Federal Reserve has been charged with promoting
bargaining for wages as a worker. For example, if a worker
stable prices by statute since the late 1970s, largely as a
expects the inflation rate to increase over the next year, he
result of the volatile and exceptionally high inflation
or she may demand higher nominal wages to offset a
experienced during the 1970s, as shown in Figure 1.
decrease in real wages. Wages are a significant production
Beginning in 2012, the Federal Reserve began explicitly
cost for many products, and the overall price of goods and
targeting a long-run inflation rate of 2%. The Federal
services will rise to reflect the increase in the cost of labor.
Reserve generally uses its ability to impact short-term
An increase in inflation expectations will cause actual
interest rates to combat demand-pull and cost-push
inflation to increase, and vice versa, all else equal.
inflation, in an effort to decrease the volatility of inflation
and keep inflation close to its target rate.
https://crsreports.congress.gov

link to page 1 link to page 1

Introduction to U.S. Economy: Inflation
As shown in Figure 1, beginning in the 1980s, the rate of
observed over time. However, in reality, this is nearly
core inflation, which excludes energy and food prices,
impossible for two reasons. First, the quality of goods and
begins to decrease, as does the volatility seen in the
services change over time. As such, some portion of
measure. Beginning in the late 1990s, the inflation rate
increasing prices over time is due to improvements in
remains relatively close to 2%, and the large swings in
quality rather than inflation. For example, a television may
inflation, such as those seen during the 1970s, mostly
cost more today than one in the 1950s, but a television
disappear. The moderation of inflation seen since the 1970s,
today is in color and offers much better resolution. It would
save for the brief period of deflation during the 2007-2009
be incorrect to say all of the increase in the television prices
global financial crisis, has largely been attributed to the
is due to inflation; only the portion that is unexplained by
actions undertaken by the Federal Reserve as part of their
quality improvements would be attributed to inflation.
mandate to promote stable prices.
Second, new products are introduced into the marketplace
over time that are fundamentally different than any
Measuring Inflation
historical products and are only slowly incorporated into
The rate of inflation is measured by observing changes in
price indices with fixed baskets. For example, television
the average price of a consistent set of goods and services,
ownership spread rapidly in the 1950s, and are now being
often referred to as a market basket. Inflation is generally
partly supplanted by personal electronic devices that did not
measured using a price index, such as the Consumer Price
exist in the 1950s. Statistical agencies try to adjust data to
Index (CPI). A price index is constructed by dividing the
account for these factors, because, if these complications
price of a market basket in a given year and by the price of
are not correctly accounted for, measured inflation would
the same basket of goods in a base year. The rate of
be inaccurate and most likely overstated.
inflation is then measured by calculating the percentage
change in the price index across different periods. For
Adjusting for Inflation
example, the CPI in January 2015 was about 235, and about
Comparing real figures is often beneficial to observe actual
238 in January 2016, which amounts to an inflation rate of
changes in purchasing power over time, rather than changes
about 1.3% over this period.
in the number of dollars.
Alternative Measures of Inflation
To adjust nominal figures for inflation, multiply the
Alternative price indices will use different goods within
nominal figure by the ratio of the price index value in the
their market basket, and they are generally used for
target year to the price index value in the base year, as
different purposes. For example, the CPI includes consumer
shown below:
goods and services typically purchased by households,
which is often used to adjust household incomes for
inflation over time. By contrast, the Gross Domestic

Product Deflator, which is generally used to adjust GDP for
For example, median household income in 1990 (the base
inflation over time, measures inflation for all of the final
year) was $29,943 in nominal terms. To determine the
goods and services produced in the United States. A
equivalent income in terms of purchasing power for 2015
number of additional measures of inflation include the
(the target year) using CPI, multiply $29,943 by the ratio of
Producer Price Index, Employment Cost Index, Personal
CPI in 2015 (237) to the CPI in 1990 (131), which comes
Consumption Expenditures Index, and Import/Export Price
out to about $54,312.
Index. Different inflation measures are calculated
differently. For example, the CPI uses a (mostly) fixed
As discussed previously, there are a number of different
basket of goods and services, whereas the GDP deflator
price indices, and within those indices more specific
allows the composition of its market basket to change with
deflators are available to make inflation adjustments. It is
spending patterns from period to period.
important to use the most relevant index for the subject
being researched. For example, when looking at corporate
In addition, within a specific price index, researchers often
revenues in the United States, it would be advisable to use
make separate calculations for so-called headline inflation
the Producer Price Index, which uses a market basket
and core inflation, as seen in Figure 1. Headline inflation
consisting of the price of goods and services sold by
incudes the full set of goods and services included within
domestic producers, as opposed to the CPI, which is
the basket of goods, whereas core inflation excludes energy
designed to reflect the goods and services purchased by the
and food prices from the basket of goods. Core inflation is
typical household.
often used by researchers in place of headline inflation due
to the volatile nature of the price of food and energy.
Resources
However, headline inflation can provide a more accurate
The Bureau of Labor Statistics creates various price indices,
sense of the price changes actually faced by individuals.
available at http://www.bls.gov/bls/inflation.htm.
Complications in Measuring Inflation
Jeffrey M. Stupak, Analyst in Macroeconomic Policy
The fundamental concept behind measuring inflation is that
the price of a consistent basket of goods and services is
IF10477

https://crsreports.congress.gov

Introduction to U.S. Economy: Inflation

Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff to
congressional committees and Members of Congress. It operates solely at the behest of and under the direction of Congress.
Information in a CRS Report should not be relied upon for purposes other than public understanding of information that has
been provided by CRS to Members of Congress in connection with CRS’s institutional role. CRS Reports, as a work of the
United States Government, are not subject to copyright protection in the United States. Any CRS Report may be
reproduced and distributed in its entirety without permission from CRS. However, as a CRS Report may include
copyrighted images or material from a third party, you may need to obtain the permission of the copyright holder if you
wish to copy or otherwise use copyrighted material.

https://crsreports.congress.gov | IF10477 · VERSION 2 · NEW