What is Inflation?
What is inflation and what does it measure? Inflation measures the rate at which prices increase for consumer goods and services. Inflation also measures the rate at which a currency’s purchasing power declines. If consumer goods and services are getting more expensive, then inflation is rising. As inflation rises, the relevant currency’s purchasing power declines. As prices increase, the amount a consumer can purchase with one unit of currency decreases.
What causes inflation? Many economists point to an increase in the rate of growth of the money supply in an economy as the primary culprit. In comparison, others point to sudden changes in aggregate demand and aggregate supply, following a Keynesian approach to macroeconomic analysis.
Inflation Rate Example
For example, let’s take the price of a can of soda. Let’s say last year a can of soda cost $1.00. And let’s say the inflation rate for the past 12 months is 5%. We could then assume the cost of a can of soda today is $1.05. The price has gone up by 5%. The dollar’s purchasing power has gone down – one dollar is no longer enough money to buy a can of soda.
There are two important inflation measures in the U.S. They are the headline inflation rate and the core inflation rate. In addition, these inflation rates are published monthly by the U.S. Bureau of Labor Statistics.
The headline inflation rate, also called the consumer price index (CPI), measures the rate at which prices are rising for a wide selection of consumer goods. Headline inflation is designed to measure the rate at which cost of living expenses increase over time.
The core inflation rate is the headline inflation rate but without food and energy prices. Food and energy prices are considered more volatile than other consumer prices. Therefore, some consider it important to view the inflation rate excluding these two components.
There are a variety of other approaches to estimating the inflation rate, such as calculations based off of the US Producer Price Index (PPI) and the US Gross Domestic Product (GDP Deflator).
Inflation and Monetary Policy
Most central bank’s have a target inflation rate. For example, the U.S. central bank, the U.K. central bank, and the European Central Bank prefer to keep inflation at around 2%. A nation’s central bank can use certain monetary policy tools to influence inflation. These includes the following:
- Foreign exchange market intervention
- Open-market operations
- Adjusting the reserve requirement ratio
- Adjusting key interest rates.
Central banks often implement monetary policy tools to influence the inflation rate towards the target inflation rate.
Foreign exchange market intervention refers to a central bank buying or selling currency in the open market in order to influence the nation’s money supply. Increasing the money supply devalues the currency and increases inflation. Whereas, decreasing the money supply appreciates the currency and decreases inflation. Ergo, a nation’s central bank can purchase currency in the open market to fight inflation.
Open Market Operations Definition
Open-market operations refer to a central bank buying or selling government securities. Buying government securities increases the money supply and spurs inflation. But selling government securities decreases the money supply and curbs inflation. Therefore, a nation’s central bank can sell government securities to fight inflation.
Reserve Requirement Ratio
The reserve requirement ratio is the amount of cash a commercial bank must hold relative to the value of its customer deposits. For example, if a bank receives customer deposits totaling $100, and the reserve requirement is 10%, then that bank must always have at least $10 cash on hand. A central bank can either increase or decrease the reserve requirement ratio for the nation’s commercial banks, thereby decreasing or increasing the domestic money supply. Furthermore, increasing the reserve requirement curbs inflation, decreasing the reserve requirement spurs inflation.
Key Interest Rates
Central banks can also raise or lower key interest rates in an effort to influence inflation. In the U.S., the central bank’s key interest rate, the fed funds rate, is the rate at which banks lend to each other overnight. Raising the interest rate can reduce the money supply, damp economic activity, and curb inflation. But lowering the key interest rate can increase the money supply, stimulate the economy, and increase inflation. A central bank can raise interest rates to fight inflation.
When faced with the threat of rising inflation, which can erode the value of investment returns, investors may seek investments that are protected from inflation. One option is to invest in U.S. Treasury Inflation Protected Securities (TIPS).
TIPS are U.S. Treasury securities that are protected against inflation. The coupon payments and the principal value automatically adjust according to the headline inflation rate. This protects investors from the negative effects inflation can have on investment returns. The downside is that TIPS offer a comparatively low interest rate.
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