Monetary economists define inflation as too much money chasing a fixed basket of goods. What does inflation mean to you? Chances are, you think of “inflation” as describing when prices increase rapidly. What does the economists’ definition have to do with inflation you experience? How is inflation calculated? This post will discuss all these topics and explain how you can plan your finances amid inflation risk.

Inflation is the condition when the money available for goods and services grows faster than the supply.

What is Inflation?

Inflation is the condition when the money available for goods and services grows faster than the supply. Causes include changes in the money supply, changes in consumer spending, and changes in government spending. Whatever the cause, the result is an increase in prices. Indeed, most inflation measures are estimates of rates of change in price, whether they pertain to changes in the prices of consumer goods like milk and eggs, or changes in prices of producer goods such as steel and lumber.

Measures of inflation abound. Some measures fluctuate more than others, and some measures affect business producers more than consumers, and vice versa.

The US Bureau of Labor Statistics (BLS) publishes variations of the Consumer Price Index (CPI) and the Producer Price Index (PPI) each month. We refer to year-over-year changes in CPI as consumer price inflation, and year-over-year changes in the PPI as producer price inflation. The table below shows consumer price inflation was 3.2% from October 2022 to October 2023.

Table 1. 12-month percent change in Consumer Price Indexes, October 2023
Source: Bureau of Labor Statistics
Notice that different price indexes changed at different rates. While Food prices rose 3.3%, Energy prices fell 4.5%. Notice also that the price of Used cars and trucks fell 7.1%, reflecting that supply chain obstacles felt in 2021 and 2022 have resolved.
Table 2. 12-month percent change in Producer Price Indexes, October 2023
Source: Bureau of Labor Statistics
Notice again that different price indexes changed at different rates, and producer prices changed differently from how consumer prices changed. While Table 1 shows consumers’ Food prices increased by 3.3%, Table 2 shows Producers’ Food prices fell 2.3%. So, Consumers and Producers can experience inflation in the form of price changes differently.

How to Calculate the Inflation Rate

Based on the definition of too much money chasing too few goods, it is understandable if you thought we calculate the inflation rate according to changes in the money supply, but we do not. We calculate inflation rate using the year-over-year rate of change in the price of some goods or baskets of goods. In the US, the BLS maintains lists of goods in each category and their relative importance and monitors their prices each week. At the end of the month, the BLS compiles the weekly average prices for the goods in each category. To calculate year-over-year inflation, divide one price index observation by its observation 12 months earlier.
Calculate egg price inflation

For example, using the price of eggs:

Step 1. Obtain two observations in the same price index, one year apart.

In October 2022, the BLS price index for eggs was 328.423.

In October 2023, the price index for eggs was 255.489.

Step 2. Divide the latter price index by the earlier price index and subtract one. That is the year-over-year change in the price index.

255.489 / 328.423 – 1 = -22.2%.

During 2022 there was much concern about how much the price of eggs had increased. In 2021 egg prices rose about 11%, and in 2022 they rose another 60%. The calculation above shows they have fallen some 22% since October 2022.

While this calculation shows that prices of eggs fell year-over-year by 22.2%, Table 2 shows the prices of consumer foods have changed during that period by only by -2.3%, illustrating that different items’ prices do not all rise and fall at the same rate.

Calculation Controversy: Chain-Weighted Inflation

To calculate the price index of a basket of goods, BLS simply sums the price indexes of the individual components according to their weights.

While that simple explanation might not seem controversial, issues arise when deciding whether the weights change over time, and how, because of how many contracts (especially government payments) are linked to measures of consumer price inflation.

In the early 2000s, the BLS introduced chain-weighted CPI. Chain weighting was based on the idea that consumers do not keep their shopping constant, especially when prices change. Chain weighting involves averaging a set of weights one month and a separate set of weights the next month, reflecting how consumers change their consumption.

While this calculation method might seem reasonable, consider that it tends to result in lower measures of inflation, which affect cost of living adjustments (COLAs) for all kinds of contracts and measures. Based on chained inflation, the COLA for Social Security retirement benefits would not be as high. Nor would increases to federal income tax brackets, which means you might be paying more in taxes than you would if the bracket increases were based on unchained measures of inflation.

What Causes Inflation?

Prices can inflate from different causes.
Demand-pull inflation: Demand grows faster than supply
Imagine a surprise hit movie features a specific brand of sneaker and suddenly all high schoolers want to buy a pair of that sneaker brand. Demand for the sneakers surges.
Whatever the price had been no longer matters because at that price, stores are sold out. The only place to buy the sneakers is now online through auction sites such as eBay. The price is higher because shoppers are willing to pay more than the previous price.
Cost-push inflation: Producers pass their suppliers’ price increases along to customers

Imagine the price of cheese goes up a lot. The price of your favorite pizza will also go up because the pizzeria will pass along the cheese price inflation to you in the form of pizza price inflation.

Economic theories about inflation

Monetary theory: Money supply grows too fast

While demand-push and cost-pull narratives can explain short-term changes in price levels, what explains sustained changes in overall prices? University of Chicago Nobel Laureate Milton Friedman famously said that “inflation is always and everywhere a monetary phenomenon.” What he meant was inflation arises from the money supply growing too quickly. He prescribed the way for countries to control inflation was by controlling their money supply: if they simply allowed their money supply to grow at some modest rate – maybe a few percentage points per year – they could avoid problematic inflation.

Structural inflation: Too few producers can dictate prices

Consider commercial air routes with only one carrier. That one carrier can raise prices however they like.
While customers might choose not to fly, that does not change the cost of flying that one route. Structural bottlenecks might also be on the labor supply; if very few laborers have the skill or willingness to do a job, they can wield power over their own wages.

Built-in inflation: Wage contract COLAs result in cost-push and demand-pull inflation

Imagine cheese workers had COLAs built into their wages. Their employers would raise the prices of cheese, resulting in the pizza cost-push inflation mentioned above. Further, the workers’ high school children might be able to spend more, contributing to the demand-pull inflation on sneakers.

Fiscal policy: Government spending causes demand to grow faster than supply

Consider government spending to build and repair infrastructure such as bridges. Purchasing the steel and other metals they need will compete with other producers’ demand for raw materials, causing cost-push inflation on automobiles and other products that rely on similar materials. The workers needed to do the construction will result either in more workers being employed or the workers’ wages rising, either of which might result in demand-pull inflation.

Global influences on inflation

Inflation might emerge in other parts of the world, whether due to war, political decisions, or climate events, and spread. When people in another part of the world become newly affluent, they might choose to travel, invest, and buy experiences and property abroad. All these activities can push prices up in the areas where they spend.

You can tell an inflationary story from more than one perspective.

What Does Inflation Mean for Individuals?

Inflation means a dollar will buy you less of something in the future than it does now. If it is easier to think of it this way, instead of considering how much prices rise on a specific item, consider how much less of that item the same amount of money can purchase.

For example, let us say the price of milk has doubled at your grocery store from $3 per gallon to $6. One way to think of it is that the price has risen 100%.

Another way to think of it is that $6 can now buy only one gallon, whereas it used to buy two. So, your purchasing power for milk has declined by half. This presents you with decisions: Should you just keep buying the same amount of milk, and less of something else? Or should you substitute for milk?

Consider a student who knows his weekly budget for driving to school. If the price of gasoline rises too much, the student might switch to public transportation, which is less convenient, and less safe. Otherwise, he might have to take a part-time job to pay for the unforeseen expense. The job might limit his opportunities to mingle with fellow students and meet on-campus recruiters.

Changing prices change lives.

Inflation's Role in Economic Policy and Decision-Making

Inflation expectations form a key part of the Federal Reserve’s thinking behind its setting of interest rates and open market activities. In general, the interest you can earn in interest-bearing cash equivalents, such as money market mutual funds, rises and falls with inflation expectations. However, the level of interest rates might not necessarily always compensate you for expected inflation, especially when the Federal Reserve is concerned about the economy slowing into a recession.

The Federal Reserve’s dual mandate is to maintain full employment and to maintain stable prices. These mandates are at odds! Maintaining full employment can be inflationary and fighting inflation can lead to job loss and recession. When inflation emerged in late 2021 and 2022, the Federal Reserve began raising interest rates aggressively, with the objective of dampening economic speculation. The Federal Reserve mostly aims for 2% to 2.5% inflation; when inflation is above the target the Fed raises rates and when it is low the Fed tends to lower rates. As difficult as the dual mandate might be, it is even more challenging amid pandemics, global supply chain problems, and foreign wars, none of which is controllable by changing interest rates.

Managing and Mitigating the Effects of Inflation

Strategies for businesses to manage and mitigate inflation
If possible, business can pass along their cost increases to customers, diversify their supply chain, and explore whether it is possible and advisable to hedge their input costs. If businesses have borrowed debt at a fixed rate, in a time of inflation they ought to be in no hurry to pay it back.
Strategies for individuals to manage and mitigate inflation

During periods of high inflation individuals need to mind their spending to ensure they can still fund longer term goals such as retirement, college, down payments, paying off high interest debt, etc. If driving is costing too much compared to other possibilities, consider substitutions, such as public transit, carpooling, cycling, or walking.

If a dietary staple such as eggs costs too much, consider nutritionally equivalent substitutions. You might be pleasantly surprised by how much you enjoy the substitute. During periods in the 19th Century when it was difficult to obtain coffee, Louisianans stretched their coffee with roasted endive, also known as chicory. Chicory coffee has remained as a beloved coffee style ever since.

When inflation subsides to tolerable rates such as below 3%, do not expect prices to fall. When inflation declines to such tolerable levels, some prices may remain at their higher plateau, so you might still need to adjust your spending habits accordingly.

Using GuidedChoice’s and 3Nickels’ planning tools can help you plan by taking inflation into account. We present our retirement projections and base our retirement recommendations on how much you will be able to spend in retirement in current dollars, which means we take inflation into account.

Additionally, we do not just assume inflation is always going to be a constant number, such as 2.5%; instead, we simulate random fluctuations consistent with past US CPI change volatility. Thus, we consider the possibility of bad outcomes in our projections, with the intent of guiding you to well-informed choices.

goals inflation calculator


Precise causes of inflation can be elusive
Many impacts of inflation feedback to perpetuate inflation
Be prepared to adjust your lifestyle so inflation does not trap you from reaching long-term goals

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