How do you measure inflation

Inflation: what does it mean and how is it measured?

Inflation describes a general price increase in a neutral way. In contrast, price level stability is an economic policy goal in Germany. In this introductory overview article, we explain the terms on the subject of inflation and inflation measurement.

Inflation: General rise in prices.

Inflation rate: Percentage change in the price level

Price level stability: It describes the stability of the average price level. It does not mean that the inflation rate is zero, but that it is stable over time.

Colloquially and in the media, inflation is understood to mean that price stability has been violated. In fact, that is not the meaning of this term. Value-free inflation simply means that prices are rising. This process is not unusual. The negative valuation of the term becomes apparent when one takes into account the terms inflation rate and price level stability.

Even if you look at the percentage change in the price level over the course of the year, a positive value does not necessarily pose a problem. If the inflation rate is always a relatively constant value, then the price level is stable. And everything is fine. Only when the inflation rate fluctuates strongly, usually increases, is the price level stability breached. In this case one speaks colloquially of inflation. And thereby designates the historically negative specter of inflation with its negative effects on the economy.

Inflation: An increase in the overall economic price level or the cost of living that can be observed over a longer period of time.

Importance of inflation in economic policy

In Germany the economic order is the social market economy. The goals of this economic order are anchored in the first paragraph of the Law for the Promotion of the Stability of Economic Growth of 1967 (in short: Stability Law). Since four primary and at the same time hardly achievable goals are formulated here, one speaks of the magic square.

Note: Magic square: price level, employment, economic growth, foreign trade. Balance. Click on the picture to enlarge it.

One goal is price level stability. It exists in Germany if the average of the prices is constant with fluctuating individual prices over time. The aim of the ECB or monetary policy is a rate of price increase of close to but below 2%.

On the one hand, too high a rate of price increases is detrimental to the economy. On the other hand, a low rate of price increases also harbors the risk of deflation, which has a negative impact on economic activity. The level of the optimal inflation rate for the price level stability is therefore ultimately dependent on the economic conditions and differs considerably between the individual countries.

In Germany, the goal is now to have a constant inflation rate of around 2%. The background to this is also the meanwhile historical experience with the consequences of hyperinflation in 1922 and 1923. Germany experienced what is probably the strongest inflation of all time. In order to pay the national debts after the First World War, the Reichsbank printed much more money than was really necessary. As a result, prices rose so sharply that hyperinflation occurred.

This hyperinflation was finally resolved through a currency reform. As a result, millions of savers lost all of their wealth. After the Second World War there was a so-called galloping inflation again. On June 20, 1948, there was another currency reform: The introduction of the DM. The subsequent monetary policy of the Deutsche Bundesbank made the DM one of the most stable currencies in the world.

Against the background of these two experiences of inflation and the costs for the population of the currency reforms to resolve inflation, price level stability is one of the most important economic policy goals. And inflation is deeply anchored as a “bugbear” in the collective social memory.

Causes and types of inflation

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Using the example of a rise in gasoline prices, the figure illustrates how complex the causes of inflation can be.

By the time inflation finally occurs, as measured by the rise in consumer prices, prices have already risen at the producer and retail level.

In summary, a distinction is made between three causes of inflation:

  • Demand Factors - Demand Inflation: It arises when the demand for goods exceeds the available supply. The reason for this can be excessive growth in private or government demand for consumer goods. But also the demand for capital goods or exports. (Note: see usage side of GDP).
  • Supply Factors - Supply Inflation: It arises when the cost of production for companies increases. e.g. higher wage costs or increased oil prices. These costs are then ultimately passed on to consumers in the form of higher prices. Increases in the company's profits due to market power can also lead to an increase in asking prices. This process is known as market power inflation.
  • Imported inflation: It arises from the increasing dovetailing of international economic relations and foreign trade. In principle, this is triggered by changes in the economy abroad (supply and demand factors), which influence domestic price developments through exchange rates and world market prices.

In reality, supply and demand factors can overlap. It is often not immediately apparent which side is the triggering part and which is the reacting part in the inflation process. This is made more difficult by including imported inflation.

The graphic therefore shows three factors. In a first step, the respective price changes lead to an increase in producer prices. The producer reacts accordingly. There is an increase in trading prices. This is how the price increases ultimately reach the consumer.

Finally, on the causes of inflation: An important cause of inflation is not shown in the figure, as it does not lead to a price increase here. For the sake of completeness, we define it as the cause of inflation at this point:

Money supply inflation: It arises when the money supply grows too much. The cause is, for example, increased lending by banks. Or the central banks' obligation to intervene in the case of fixed exchange rates.

You can find more information in our article on the different types of inflation.

Manifestations of inflation

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Inflation costs

The cost of inflation to an economy is multiple. Depending on the form of inflation, the individual disadvantages can vary in severity. There are also differences between groups as to whether costs actually occur. When it comes to the consequences of inflation, one often speaks of “winners and losers” of inflation. Overall economic inflation costs, however, consist of these two problems:

1. Loss of monetary functions

In times of inflation, money gradually loses its function as a medium of exchange. This results in the following costs:

- Menu costs: Problems for companies to adjust prices on an ongoing basis.

- Shoe sole costs: People have to go to the bank more often to withdraw money. (This can be interpreted as a hidden tax on the holding of money).

- Distortions of incentive systems:Inflation distorts the propensity to save. Together with taxation, it affects interest rates. The higher the inflation, the higher the returns that must be achieved in order for capital to multiply (cf. the Fischer equation).

2. Redistributive effects

Economic operators always try to take expected inflation into account in their decisions. If unexpected inflation occurs, it therefore leads to a redistribution of income and wealth.

You can find detailed information in our article on inflation costs.

Inflation benefits

In addition to the high and numerous disadvantages of inflation, there are also the following reasons that speak for a moderate price increase:

  • Lubricant function for the economy / business cycle
  • Safe distance to deflation
  • Measurement problem: tendency of the measured inflation rate to overestimate the rise in price levels
  • Problem of the zero interest rate limit (see Fischer equation and liquidity trap in an expansionary monetary policy).

Measuring inflation

The inflation rate is usually measured as the change in the price index compared to the index of the same month of the previous year.

The calculation of the macroeconomic price index requires a decision about which products should be included in the calculation. An average shopping basket is therefore determined, which should best reflect the overall economic price development:

1. Consumer price index

The consumer price (CPI): In this price index, the consumption structure of a representative private household is used as the shopping basket. The CPI is the most important indicator of inflation in practice.

The following are also significant:

Core inflation rate: Same shopping basket as for the CPI, but without energy and food.

GDP deflator: The total gross value added of the economy goes into the basket. This means that in addition to the prices of consumer and investment goods, the prices of export goods and government consumption are also taken into account.

Depending on the level of consideration and the question, different shopping baskets can be relevant for calculating the inflation rate. However, the differences between these three macroeconomic indicators already show that it is difficult to measure the actual inflation rate or to depict it correctly.

The greatest difficulties in correctly mapping the macroeconomic inflation rate are the following:

  • Substitution processes:The inflation rate is calculated as the change between the reference year and the base year. Problems now arise when the interval between these two points in time increases. Because the shopping cart is becoming less and less representative. On the one hand, consumer behavior changes; on the other hand, the quality of goods changes.
  • Quality changes: Price changes resulting from changes in quality should not be taken into account when creating the cart.
  • Change in product cycles: Many goods are relatively expensive when they are launched on the market and then become significantly cheaper over time (e.g. PCs or cell phones). Now the shopping cart for calculating the inflation rate is not updated annually. So if goods with a rapid drop in price are only included when the shopping cart is updated, these price reductions are not taken into account when calculating the average price increase.

Problem: This type of inflation measurement is associated with methodological inaccuracies that can only be partially eliminated.

A solution for the substitution processes: Disclosure of core inflation rates. In order to avoid temporary price jumps, those groups of goods that are particularly prone to fluctuations are removed from the price index and shown separately. The above-mentioned core inflation rate as a price index is an attempt to represent the CPI more realistically.

2. Perceived inflation

One often has the impression that inflation is actually much higher than the measured inflation.

One speaks here of the perceived inflation.

Perceived inflation: It is based on the psychological perception of price increases. It can deviate significantly from the statistically reported inflation rate.

Since perceived inflation can influence the development of economic activity as a result of the expectations of economic operators, it should not be underestimated. A well-known example of perceived inflation is the discussion about the “teuro” after the introduction of the euro in the early 2000s. The changeover from DM to Euro gave the impression that everything had become much more expensive. This supposed price increase could not be confirmed by the official inflation indices. The Federal Statistical Office therefore also calculates the perceived inflation rate.

3. Expected inflation

In addition to the perceived inflation, there is also the expected inflation significant:

It represents the link between nominal and real quantities. The expected inflation has a major impact on the level of inflation costs. A common example to illustrate this is the relationship between inflation and unemployment, which is empirically mapped using the Philips curve. In the short term, without inflation expectations, there is a negative correlation between inflation and unemployment.

In other words, to put it simply, the higher the inflation, the lower the unemployment. The background to this is the relationship between real wages and employment. If one looks at a longer period of time and includes inflation expectations in the wage negotiations, this relationship no longer works. We'll explain this mechanism in more detail later in our article on the Phillips curve.

  • Inflation: Average rise in goods prices over time.
  • Germany: price level stability as an economic policy goal, experience with hyperinflation.
  • Inflation is officially measured using the consumer price index. This measurement is associated with methodological inaccuracies that can only be partially eliminated.
  • The causes of inflation cannot always be clearly identified. A distinction is made between supply-demand inflation and imported inflation. In addition, inflation can occur through an expansion of the money supply as part of monetary policy.
  • Finally, test your knowledge of inflation!