Inflation affects all areas of the economy: consumers care about it because it reduces their purchasing power, businesses carefully watch it to ensure they are paying for raw materials and wages at a reasonable rate, governments use it to adjust tax rates and spending levels and interest rates. A low and steady level of inflation is considered positive for an economy, as it means demand for goods and services is growing.
The most common measure of inflation in the US is the Consumer Price Index (CPI). This trackes prices for a basket of economic goods and services used by consumers like food, shelter and recreation. The CPI uses a weighted system to ensure changes in the cost of specific items don’t overshadow all others. For example, housing-related costs are given more weight than recreation.
One of the most important things to understand about inflation is that it’s a process and not just an event. As new money and credit enters the economy, it increases purchasing power by lowering relative prices and increasing the overall price level.
As this takes effect, more people will spend and companies will increase production, creating more jobs and higher wages. This increased spending leads to firms increasing their prices to cover the increased costs. This is known as cost-push inflation and it can accelerate the overall rate of inflation.
Core inflation is a less volatile measure that excludes the more erratic prices of food and energy. These more persistent trends are watched closely by policymakers and provide a clearer picture of long-term price trends.