Introduction to U.S. Economy: Inflation

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Updated December 28, 2020
Introduction to U.S. Economy: Inflation
What Is Inflation?
inflation includes the full set of goods and services within
Inflation is defined as a general increase in the price of
the basket of goods, whereas core inflation excludes energy
goods and services across the economy, or, in other words,
and food prices from the basket of goods. Core inflation is
a general decrease in the value of money. Conversely,
often used by researchers in place of headline inflation due
deflation is a general decrease in the price of goods and
to the volatile nature of the price of food and energy.
services across the economy, or a general increase in the
However, headline inflation can provide a more accurate
value of money.
sense of the price changes actually faced by individuals.
As inflation occurs, individuals can purchase fewer goods
Figure 1 Annual Inflation Rate
and services with the same amount of money. For this
January 1960-October 2020
reason, an individual would need about $304 in 2020 to
purchase the same amount of goods and services as $100
would have purchased in 1980. Measures of inflation are
used to adjust money figures to keep purchasing power
constant over time, allowing for more accurate comparisons
across disparate time periods. Monetary figures that have
been adjusted for inflation are referred to as real, and non-
inflation-adjusted figures are referred to as nominal.
Measuring Inflation
The rate of inflation can be measured by observing changes
in the average price of a consistent set of goods and
services, often referred to as a market basket. Inflation is

generally measured using a price index, such as the
Source: Bureau of Economic Analysis.
Consumer Price Index (CPI). A price index is constructed
by dividing the price of a market basket in a given year by
Notes: Annual percentage change as measured by Personal
the price of the same basket of goods in a base year. The
Consumption Expenditures Index.
rate of inflation is then measured by calculating the
Complications in Measuring Inflation
percentage change in the price index across different
periods. For example, the CPI was about 257 in November
The fundamental concept behind inflation is to measure
2019 and about 260 in November 2020, which amounts to
changes in the price of the same goods and services over
an inflation rate of about 1.2% over this 12-month period.
time. However, in reality, this is nearly impossible for two
reasons. First, the quality of goods and services change over
Alternative Measures of Inflation
time. As such, some portion of increasing prices over time
Alternative price indices will use different goods within
is due to improvements in quality rather than inflation.
their market baskets and are generally used for different
Second, new products are introduced into the marketplace
purposes. For example, the CPI includes consumer goods
over time that are fundamentally different than any
and services typically purchased by households, which is
previously available products and are only slowly
often used to adjust household incomes for inflation over
incorporated into price indices with fixed baskets.
time. By contrast, the gross domestic product (GDP)
Statistical agencies try to adjust data to account for these
deflator, which is generally used to adjust GDP for inflation
factors, because, if these complications are not correctly
over time, measures inflation for all of the final goods and
accounted for, measured inflation would be inaccurate and
services produced in the United States. There are a number
most likely overstated.
of additional measures of inflation, including the Producer
Causes of Inflation
Price Index, Employment Cost Index, Personal
Consumption Expenditures Index, and Import/Export Price
Inflation is largely the result of two different phenomena,
Index. Different inflation measures are calculated
which are often referred to as demand-pull and cost-push
differently. For example, the CPI uses a (mostly) fixed
inflation. Demand-pull inflation occurs when demand for
basket of goods and services, whereas the GDP deflator
goods and services within the economy exceeds the
economy’s capacity to produce goods and services. As
allows the composition of its market basket to change with
spending patterns from period to period.
demand exceeds supply within the economy—“too much
money chasing too few goods”—there is upward pressure
Additionally, within a specific price index, researchers
placed on prices, resulting in rising inflation.
often make separate calculations for so-called headline
inflation
and core inflation, as seen in Figure 1. Headline
Cost-push inflation occurs when the price of input goods
and services increases. The classic example of cost-push
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Introduction to U.S. Economy: Inflation
inflation is the result of an oil shock, which sharply
save for the brief period of deflation during the 2007-2009
decreases the supply of oil and other petroleum products.
global financial crisis, has largely been attributed to the
The decrease in oil supplies increases the price of oil and
actions undertaken by the Federal Reserve as part of its
petroleum products. Petroleum products are an input good
mandate to promote stable prices.
for a significant portion of goods and services across the
economy, and as the price of this important input good
In August 2020, the Federal Reserve amended its strategy
increases, so does the price of the final goods and services,
to an inflation target that averages 2% over time, meaning
resulting in inflation. Cost-push inflation results in only a
that if inflation runs below 2% for a period, the Federal
temporary increase in inflation unless accommodated by
Reserve will use monetary policy to target an inflation rate
monetary policy.
above 2% for some time. Inflation has run below 2% fairly
consistently since the financial crisis, despite several
Changes in inflation expectations can also cause changes in
notable periods of quantitative easing and an 11-year
actual inflation. Individuals form expectations around the
expansion that ended in 2020. In response to the current
future rate of inflation and incorporate those expectations
recession, the Federal Reserve has indicated that it will
when setting prices at the firm level or when bargaining for
keep the federal funds at near zero levels for the foreseeable
wages as a worker. For example, if the general consensus is
future, which, all else being equal, would stimulate
that prices will increase 2% in the next year, businesses will
economic activity and cause inflation to increase.
want to increase prices by at least 2%, and workers will
want at least a 2% raise.
Adjusting for Inflation
Comparing figures in real terms is often beneficial to
Inflation’s Impact on the Economy
observe actual changes in purchasing power over time
Inflation tends to interfere with pricing mechanisms in the
rather than changes in the number of dollars.
economy, resulting in individuals and businesses making
less than optimal spending, saving, and investment
Figure 2. How to Adjust for Inflation
decisions. Additionally, in the presence of inflation,
economic actors often engage in actions to protect

themselves from the negative impacts of inflation, diverting
Source: CRS.
resources from other more productive activities.
To adjust nominal figures for inflation, multiply the
nominal figure by the ratio of the price index value in the
Ultimately, these inefficient decisions reduce incomes,
target year to the price index value in the base year, as
economic growth, and living standards. For this reason, it is
shown in Figure 2. For example, median household income
generally accepted that inflation should be kept low to
in 1990 (the base year) was $29,943 in nominal terms. To
minimize these distortions in the economy. Some would
determine the equivalent income in terms of purchasing
argue that an inflation rate of zero is optimal. However, a
power for 2019 (the target year) using CPI, multiply
target of zero inflation makes a period of accidental
$29,943 by the ratio of CPI in 2019 (256) to the CPI in
deflation more likely, and deflation is thought to be even
1990 (131), which comes out to about $58,515.
more costly than inflation, as it can be associated with
recessionary conditions. In an effort to balance these two
As discussed previously, there are a number of different
risks, policymakers, including the Federal Reserve, often
price indices, and within those indices more specific
target a positive but low inflation rate, generally around
deflators are available to make inflation adjustments. It is
2%, which reduces inefficiencies within the economy while
important to use the most relevant index for the subject
protecting against deflation.
being researched. For example, when looking at corporate
The Federal Reserve and Inflation
revenues in the United States, it would be advisable to use
the Producer Price Index, which uses a market basket
The Federal Reserve has been charged with promoting
consisting of the price of goods and services sold by
stable prices by statute since the late 1970s, largely as a
domestic producers, as opposed to the CPI, which is
result of the volatile and exceptionally high inflation
designed to reflect the goods and services purchased by the
experienced during the 1970s, as shown in Figure 1.
typical household.
Beginning in 2012, the Federal Reserve began explicitly
targeting a long-run inflation rate of 2%. The Federal
Resources
Reserve generally uses its ability to impact short-term
The Bureau of Labor Statistics and the Bureau of Economic
interest rates to combat demand-pull and cost-push inflation
Analysis both create various price indices, which are
in an effort to decrease the volatility of inflation and keep
available at http://www.bls.gov/bls/inflation.htm and
inflation close to its target rate.
https://www.bea.gov/data/prices-inflation, respectively.
As shown in Figure 1, beginning in the 1980s , the rate of
(Note: This In Focus was originally authored by Jeffrey
core inflation, which excludes energy and food prices,
Stupak, former CRS Analyst in Macroeconomic Policy.)
begins to decrease, as does the volatility s een in the
measure. Beginning in the late 1990s, the inflation rate
Lida R. Weinstock, Analyst in Macroeconomic Policy
remains relatively close to 2%, and the large swings in
inflation, such as those seen during the 1970s, mostly
IF10477
disappear. The moderation of inflation seen since the 1970s,


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Introduction to U.S. Economy: Inflation


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