Inflation is an increase in prices, or more generally, how expensive it has become to purchase certain goods and services over a period of time. If there a rise in inflation, you would be able to buy lesser from say $100 than you could a year back.
How is Inflation Measured?
Since inflation is an increase in price of good or services over time, to measure inflation, it is required to identify or fix the commodities whose price would be tracked over time. Fixing the basket of good allows us to look at the change as a result of prices only. As each household consumes different things, to understand the average consumption, government bodies conduct a survey across a sample of households to identify a ‘basket of goods’ that are commonly consumed. The cost of this basket in relation to a given year (called the ‘base year’) is called the Consumer Price Index (CPI). Percentage change in CPI over a given period of time is consumer price inflation.
Note that, this basket of goods while mostly kept constant, is also updated to ensure that commodities that are outdated or no longer widely used are not considered.
How Does Inflation Affect Me?
Inflation impacts our cost of living. If your income this year increased by 5% as compared to the previous year, but inflation rose by 7.5%, then good and services would have become costlier for you, as compared to last year, thus affecting your spending and your household budget. This is called a reduction in ‘Purchasing Power’. On the other hand, if the prices of goods were to go down, in relation to your income, you would be able to afford more.
How to Interpret Inflation Numbers?
While listening to the radio or reading the newspaper, if you hear that inflation in US in December 2021 rose to 7%, what does this mean? It implies that prices this month increased by 7% as compared to the prices in December 2020. The graph below gives a snapshot of monthly inflation rates in USA over the last year. You might want to try interpreting these numbers to check if your purchasing power increased or decreased over time.