The basic tool for measuring inflation is the consumer price index, or CPI. The CPI measures the cost of purchasing a fixed basket of goods and services in any period relative to the cost of the same basket of goods and services in a base year. The inflation rate is the annual percentage rate of change in the price level as measured by a price index such as the CPI.
The official U.S. inflation rate, based on the CPI, may overstate the true inflation rate for two reasons: First, it may not adequately reflect improvements in the quality of goods and services. Second, the method of calculating the CPI ignores the fact that consumers can substitute cheaper goods and services for more expensive ones.
A nominal quantity is a quantity that is measured in terms of its current dollar value. Dividing a nominal quantity, such as a family's income or a worker's wage in dollars, by a price index, such as the CPI, expresses that quantity in terms of real purchasing power. This procedure is called deflating the nominal quantity. If nominal quantities from two different years are deflated by a common price index, the purchasing power of the two quantities can be compared. To ensure that a nominal payment, such as a Social Security benefit, represents a constant level of real purchasing power, the nominal payment should be increased each year by a percentage equal to the inflation rate. This method of adjusting nominal payments to maintain their purchasing power is called indexing.
The public sometimes confuses increases in the relative prices for specific goods or services with inflation, which is an increase in the general price level. Since the remedies for a change in relative prices are different from the remedies for inflation, this confusion can cause problems.
Inflation imposes a number of true costs on the economy, including "shoe-leather" costs, which are the real resources that are wasted as people try to economize on cash holdings; "noise" in the price system; distortions of the tax system; unexpected redistributions of wealth; and interference with long-run planning. Because of these costs, most economists agree that sustained economic growth is more likely if inflation is low and stable. Hyperinflation, a situation in which the inflation rate is extremely high, greatly magnifies the costs of inflation and is highly disruptive to the economy.
The real interest rate is the annual percentage increase in the purchasing power of a financial asset. It is equal to the nominal, or market, interest rate minus the inflation rate. When inflation is unexpectedly high, the real interest rate is lower than anticipated, which hurts lenders but benefits borrowers. When inflation is unexpectedly low, lenders benefit and borrowers are hurt. To obtain a given real rate of return, lenders must charge a high nominal interest rate when inflation is high and a low nominal interest rate when inflation is low. The tendency for nominal interest rates to be high when inflation is high and low when inflation is low is called the Fisher effect
