Inflation and Deflation

Have you ever talked to your parents or grandparents about what prices used to be when they were

kids?

If so, they probably told you about how milk and candy and hot dogs used to be much cheaper,

and it’s true.

Over long periods of time, most things do tend to get more and more expensive.

This is due to something called inflation.

Let’s look at an example.

Jane and Bob bought their house in 1970 for $15,000 and have lived in it ever since.

However, now that they are finally looking to retire and downsize, they find that their

home is now worth $150,000.

The reason for this isn’t just supply and demand.

It’s inflation.

Inflation is simply a general increase in prices and fall in the purchasing value of

money.

We’re not talking about the prices of specific items here.

We’re talking about prices going up for almost every commonly purchased item.

When inflation is rapid and dramatic, that is generally unsustainable and leads to an

economic crisis.

Such an event is called hyperinflation.

Essentially, hyperinflation is inflation that’s going out of control.

One negative consequence of inflation is a drop in purchasing power.

Purchasing power is the amount of stuff you can purchase with a unit of currency.

As prices go up, the purchasing power of money goes down.

If you were hoping to follow the lead of Jane and Bob, try buying a house today for $15,000.

It’s quite unlikely that you’ll be able to find anything at that price point.

So how do we know that prices are going up across the board?

Well, thankfully economists have come up with things called price indexes, which are measurements

that show how the average price of a standard group of goods changes over time.

In the United States, the best known of these is the Consumer Price Index, or CPI.

The CPI is determined by measuring the price of a standard group of goods and services

meant to represent a “market basket” of stuff typically bought by your average urban

consumer.

Here are the eight categories of goods and services that CPI currently looks at, with

examples of each listed.

Keep in mind that every 10 years these categories are updated to adjust for changes in spending

habits.

American economists use the CPI to calculate the inflation rate, which is the percentage

rate of change in price level over time.

Although they can calculate this between any two points in time, typically it is done from