Inflation = Rate at which prices for goods and services rise.
Deflation = Rate at which prices for goods and services fall.
As you can see from the above graph, inflation is much more common than deflation.
Consumer Price Index
Consumer Price Index (CPI) = “Basket” of goods and services commonly used to measure inflation. These expenses are “weighted” to reflect their proportions in a typical household.
The approximate weightings of the components of the CPI are as follows:
• food – 15%
• housing – 41%
• apparel – 3%
• transportation – 16%
• medical care – 8%
• recreation – 6%
• education & communication – 7%
• miscellaneous – 3%
Inflation and Interest Rates
In order to “fight” inflation, the Federal Reserve (Central Bank) of the United States raises interest rates (depicted by 10-Year Treasuries in the above graph). Higher interest rates make it more difficult for households to borrow money to buy the goods and services comprising the CPI. This reduced demand, in turn, forces the providers of these goods and services to lower their prices. In this way, inflation is “tamed.”
Purchasing Power = Amount of goods and services that can be purchased with a given amount of money.
Over time, inflation eats away purchasing power. For example, $100 in 1900 would have been able to purchase numerous cups of coffee. Eroded by inflation, that $100 would now have a purchasing power of approximately $3.48, perhaps enough to purchase a single cup of coffee at a café.
Practice – Questions
1. Based on the above graph, in approximately which year did inflation spike?
2. Based on the above graph, in approximately which year did deflation strike?
3. Which component has the greatest weight in the CPI?
C. medical care
4. Based on the above graph, in approximately which year did the Federal Reserve feel compelled to raise interest rates to new heights to fight runaway inflation?
5. Based on the above graph, in approximately which year did the Federal Reserve feel compelled to lower interest rates dramatically in the absence of runaway inflation?
Practice – Answers
1. D. 1980
2. C. 1931
3. D. housing
4. D. 1981
5. C. 1983