What is inflation?
The short answer
Inflation is the rate at which prices rise on average across the economy. It is measured by repricing a fixed basket of everyday goods and services and comparing its cost with a base year, which gives a consumer price index. At 3% a year, $100 kept as cash buys only about $74 of today’s goods after ten years.
Chapters and transcript
- 0:00
Inflation is prices rising on average.
Inflation is the average rise in prices across a basket of everyday goods and services, shown here as one example household.
- 0:12
Price the same basket again, and compare the totals.
Statisticians price the same fixed basket again at each date and compare the new total with the old one.
- 0:16
Food +4%, rent +3.3%, energy +3%, transport 0%, phone −4%.
In the example, each item changes by its own rate, and the basket's total is the sum of the new prices.
- 0:23
The basket costs $1,904.20 now, up 2.9%: index 102.9.
The index is the new cost divided by the old cost, times 100: 1,904.20 ÷ 1,850.00 × 100 = 102.9. That is the consumer price index method, and it means the basket costs 2.9% more.
- 0:32
At 3% a year, prices double in about 23 years.
Compounding each year, a 3% rise doubles prices in about 23 years, since ln 2 ÷ ln 1.03 = 23.4.
- 0:37
After ten years at 3% a year, the index is 134.4.
Ten years at 3% a year multiply the price level by 1.03¹⁰ = 1.344, so the index reads 134.4.
- 0:52
Cash loses value: $100 buys $74.41 of year-0 goods after 10 years.
Cash kept in a bank earns no inflation adjustment in this example. After ten years at 3%, $100 buys $100 ÷ 1.344 = $74.41 of the goods it bought at year 0.
- 1:00
After 20 years, $55.37.
After twenty years, the same $100 buys $100 ÷ 1.03²⁰ = $55.37 of year-0 goods.
- 1:12
Two simplified causes: more money chasing the same goods.
One simplified cause is more money spent on the same goods, which pushes each price up.
- 1:19
And costs passed on: when energy or wages rise, prices rise too.
Another is costs passed on: when energy or wages rise, businesses raise their prices. Real economies mix both causes.
- 1:29
Measured this way, inflation is the change in the index from year to year.
Inflation is the percentage change in the index from one year to the next. The basket and rates in the film are illustrative, not official data.
Sources
Every figure in the film comes from these. The animation is illustrative.