Inflation and its measures
Inflation : the sustained increase in the general price level of goods and services in an economy over time. It means that, on average, things cost more than they used to. Inflation can be caused by various factors, including increased demand, supply shortages, or changes in the money supply. Moderate inflation is considered normal and even beneficial for economic growth (that's why most central banks aim for 2% inflation every year), but if it is too high it can be harmful as it disrupts economic stability and people's ability to plan for the future.
Deflation : the sustained decrease in the general price level of goods and services in an economy over time. While deflation might sound beneficial on the surface, it can lead to economic problems, such as decreased investment and increased debt burdens because of higher real rates, which can hinder economic growth. It can also lower consumption as consumers expect prices to decrease and wait before purchasing goods and services, further reducing demand and lowering prices, leading to a vicious circle.
Central banks use several measures of inflation, here are the main ones :
- Consumer Price Index (CPI): The CPI tracks the changes in the prices of a basket of goods and services typically purchased by a typical urban consumer. This basket includes items like food, housing, clothing, transportation, and healthcare. The index is adjusted for changes in the quality of goods and services over time (if the price of a good increases by 20% but its quality also increases by 20%, it will have no effect on the CPI). This index is essential for assessing how changes in prices affect the average consumer's cost of living.
- Core Inflation Rate : Similar to the CPI but it excludes prices from the food and energy sector, because they are highly volatile and can make it harder to grasp the dynamics of underlying inflation.
- Personal Consumption Expenditures Price Index (PCE Price Index) : the US Federal Reserve's prefered measure of inflation. Like the CPI, it track changes in the average prices of goods and services purchased by households, but is considered a more comprehensive measure of consumer spending than the CPI, because it takes into account changes in consumer behavior, such as substitutions between goods, as prices change.
- Producer Price Index (PPI): The PPI measures the average change over time in the selling prices received by producers for their goods and services. It helps central banks and policymakers understand price changes at the wholesale (or producer) level. Changes in PPI can indicate potential future price changes at the consumer level.