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Updated November 7, 2019
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, or 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 $330 in 2019 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
would 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 that have
deflation more likely, and deflation is thought to be even
been adjusted for inflation are referred to as real, and non-
more costly than inflation. In an effort to balance these two
inflation-adjusted 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
1960-2019
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
Source: Bureau of Economic Analysis
temporary increase in inflation, unless accommodated by
Notes: Annual percentage change as measured by Personal
monetary policy.
Consumption Expenditures Index.
Changes in inflation expectations can also cause changes in
The Federal Reserve and Inflation
actual inflation. Individuals form expectations around the
The Federal Reserve has been charged with promoting
future rate of inflation and incorporate those expectations,
stable prices by statute since the late 1970s, largely as a
when setting prices at the firm level or when bargaining for
wages as a worker. For example, if a worker expects the
result of the volatile and exceptionally high inflation
experienced during the 1970s, as shown in Figure 1.
inflation rate to increase over the next year, they may
Beginning in 2012, the Federal Reserve began explicitly
demand higher nominal wages in order to offset a decrease
in real wages. Wages are a significant production cost for
targeting a long-run inflation rate of 2%. The Federal
Reserve generally uses its ability to impact short-term
many products, and the overall price of goods and services
interest rates to combat demand-pull and cost-push
will rise to reflect the increase in the cost of labor. An
increase in inflation expectations will cause actual inflation
inflation, in an effort to decrease the volatility of inflation
to increase, and vice versa, all else equal.
and keep inflation close to its target rate.
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Introduction to U.S. Economy: Inflation
As shown in Figure 1, beginning in the 1980s, the rate of
services change over time. As such, some portion of
core inflation, which excludes energy and food prices,
increasing prices over time is due to improvements in
begins to decrease, as does the volatility seen in the
quality rather than inflation. For example, a television may
measure. Beginning in the late 1990s, the inflation rate
cost more today than one in the 1950s, but a television
remains relatively close to 2%, and the large swings in
today is also in color and offers much better resolution. It
inflation, such as those seen during the 1970s, mostly
would be incorrect to say all of the increase in the price of
disappear. The moderation of inflation seen since the 1970s,
televisions is due to inflation; only the portion that is
save for the brief period of deflation during the 2007-2009
unexplained by quality improvements would be attributed
global financial crisis, has largely been attributed to the
to inflation. Second, new products are introduced into the
actions undertaken by the Federal Reserve as part of their
marketplace over time that are fundamentally different than
mandate to promote stable prices.
any historical products and are only slowly incorporated
into price indices with fixed baskets. For example,
Measuring Inflation
television ownership spread rapidly in the 1950s, and is
The rate of inflation is measured by observing changes in
now being partly supplanted by personal electronic devices
the average price of a consistent set of goods and services,
that did not exist in the 1950s. Statistical agencies try to
often referred to as a market basket. Inflation is generally
adjust data to account for these factors, because, if these
measured using a price index, such as the Consumer Price
complications are not correctly accounted for, measured
Index (CPI). A price index is constructed by dividing the
inflation would be inaccurate and most likely overstated.
price of a market basket in a given year by the price of the
same basket of goods in a base year. The rate of inflation is
Adjusting for Inflation
then measured by calculating the percentage change in the
Comparing real figures is often beneficial to observe actual
price index across different periods. For example, the CPI
changes in purchasing power over time, rather than changes
in September 2018 was about 252, and about 256 in
in the number of dollars.
September 2019, which amounts to an inflation rate of
about 1.6% over this 12-month period.
Figure 2. How to Adjust for Inflation
Alternative Measures of Inflation
Alternative price indices will use different goods within
Source: CRS
their market basket, and are generally used for different
purposes. For example, the CPI includes consumer goods
To adjust nominal figures for inflation, multiply the
and services typically purchased by households, which is
nominal figure by the ratio of the price index value in the
often used to adjust household incomes for inflation over
target year, to the price index value in the base year, as
time. By contrast, the Gross Domestic Product Deflator,
shown in Figure 2. For example, median household income
which is generally used to adjust GDP for inflation over
in 1990 (the base year) was $29,943 in nominal terms. To
time, measures inflation for all of the final goods and
determine the equivalent income in terms of purchasing
services produced in the United States. There are a number
power for 2019 (the target year) using CPI, multiply
of additional measures of inflation, including the Producer
$29,943 by the ratio of CPI in 2019 (251) to the CPI in
Price Index, Employment Cost Index, Personal
1990 (131), which comes out to about $57,371.
Consumption Expenditures Index, and Import/Export Price
Index. Different inflation measures are calculated
As discussed previously, there are a number of different
differently. For example, the CPI uses a (mostly) fixed
price indices, and within those indices more specific
basket of goods and services, whereas the GDP deflator
deflators are available to make inflation adjustments. It is
allows the composition of its market basket to change with
important to use the most relevant index for the subject
spending patterns from period to period.
being researched. For example, when looking at corporate
revenues in the United States, it would be advisable to use
Additionally, within a specific price index, researchers
the Producer Price Index, which uses a market basket
often make separate calculations for so-called headline
consisting of the price of goods and services sold by
inflation and core inflation, as seen in Figure 1. Headline
domestic producers, as opposed to the CPI, which is
inflation incudes the full set of goods and services included
designed to reflect the goods and services purchased by the
within the basket of goods, whereas core inflation excludes
typical household.
energy and food prices from the basket of goods. Core
inflation is often used by researchers in place of headline
Resources
inflation due to the volatile nature of the price of food and
The Bureau of Labor Statistics creates various price indices,
energy. However, headline inflation can provide a more
which are available at http://www.bls.gov/bls/inflation.htm.
accurate sense of the price changes actually faced by
individuals.
Complications in Measuring Inflation
The fundamental concept behind measuring inflation is that
the price of a consistent basket of goods and services is
Jeffrey M. Stupak, Analyst in Macroeconomic Policy
observed over time. However, in reality, this is nearly
IF10477
impossible for two reasons. First, the quality of goods and
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Introduction to U.S. Economy: Inflation
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