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What is Inflation? And Why Should You Care?

One of the topics that we have heard a lot about as the economy lurches slowly toward recovery is inflation. But what is inflation? We hear about all sorts of incarnations of inflation, from core inflation to stagflation. While getting into the nuts and bolts of inflation can be a complex exercise, some general knowledge about inflation can help you learn a little bit more about a very real force that can have a very real impact on your finances.

As you listen to monetary policymakers talk about inflation, and as you read about changes to the CPI, it helps to have a general idea about what is going on. That way, you will be prepared to make more informed decisions about what to do with your money.

The Basics: What is Inflation?

At its most basic, there isn’t really a big secret to inflation. Basically, inflation is a reduction in your spending power. As prices rise, your money buys less than it used to. Of course, the theory is that wages go up as prices rise, too, so you are still supposed to be able to preserve your earning power. Unfortunately, that theory doesn’t always hold true. Some economists point out that wage stagnation [3] over the last couple of decades has contributed to a situation in which prices keep getting higher — but household incomes aren’t able to keep up.

One of the terms that some employ to describe the disconnect between inflation and economic growth is stagflation [4]. One economic theory (and there are quite a few, many of them debatable) is that prices rise in response to economic growth. However, if prices are rising and the economy is growing at a snail’s pace, many call that stagflation. Some are convinced that we are headed right toward some serious stagflation, since the economy isn’t growing very much while energy costs rise and food inflation [5] affects more household budgets.

Measuring Inflation: CPI and Core Inflation

So, how do we measure consumer inflation? We know that inflation is a rise in prices, but how do we tell the rate at which prices are rising? The government uses various measures to determine this, but two terms you are likely to have heard are CPI and core inflation.

CPI: This stands for the Consumer Price Index. It is a basket of prices for a wide variety of goods and services. Every month, tens of thousands of prices on products and services are compiled and averaged into the index. These items are categorized with different labels, including transportation, food, energy, medical, education and more. The CPI is generally used as a gauge of how quickly prices are rising.

Core Inflation: The government, in order to get a more “accurate” view of “overall” trends, breaks out more volatile elements of CPI: food and gas prices. This means that when the government makes monetary policy based on inflation rates [6], it doesn’t include food prices and fuel prices. Some argue that this means that monetary policy is being made based on a measure that doesn’t include some of the items that have the greatest direct impact on households.

Why You Should Care

Obviously, you should care because it’s your purchasing power being eroded by inflation. Your hard-earned dollar won’t buy as much in 10 years as it bought 5 years ago. You are probably already noticing this as packages get smaller and as prices rise. Some, instead of telling you to base your financial planning on government measures of inflation, advocate looking at your personal inflation rate.

You can do this by adding up what you spend on certain items each month, and then track trends in your own household spending. You can then adjust your personal economy’s monetary policy based on what you find.

What do you think of inflation measures? And how do you plan to beat inflation so that it doesn’t erode your purchasing power?