What is inflation

Perhaps your grandparents have told you stories about paying 20 cents for a gallon of gas. Clearly, the

price of gasoline is much higher (about $4 per gallon) today. Many other things — in fact, most things —

are like that: The prices of nearly all goods and services increase over time as a result of inflation.

Inflation is a long-term increase in the average price level in the economy and is measured by the inflation

rate or the percentage change in average prices over a fixed period of time (typically a quarter or a year).

This change is commonly measured using a price index known as the U.S. Consumer Price Index (CPI).

The CPI is calculated using a survey conducted by the Bureau of Labor Statistics that collects information

about the retail prices for a "basket" of goods that they commonly purchase. The CPI reflects the changes

in the price of this "market basket" at any one point in time to some other point in time.

Inflation is one of two key macroeconomic problems (along with unemployment) that affect a nation's

economic health. Because of this, keeping inflation in check in the U.S. economy is a goal of the Federal

Reserve Bank (the Fed). Inflation's significant negative consequences on the economy include a loss in
real purchasing power. For example, if all prices rise over time, it takes more money to buy the same

amount of goods and services.

A good example is the price of a first-class postage stamp: In 1970, the price was 8 cents; in 2013, the

price for exactly the same service was 46 cents — nearly six times the 1970 price. Because inflation

erodes real purchasing power, it can also erode our standard of living. If it now takes more dollars to buy

the same goods and services that we bought in 1970, for instance, our income must have also risen at

the same rate, or we will be worse off. Inflation such as in this example is often anticipated, as prices tend

to rise over time.

Unanticipated inflation, however, is more concerning because it creates uncertainty, and consumers and

firms prefer predictability. When inflation is unanticipated, individuals do not realize that they should

protect their real purchasing power against inflation until the inflation has already occurred and their

purchasing power has already fallen. Unanticipated inflation, therefore, creates winners and losers in

terms of purchasing power — some consumers and companies benefit while others are harmed.