Inflation is a general increase in prices. In a period of inflation, as prices rise, the same amount of money buys less. Inflation reduces people’s purchasing power, their ability to buy goods and services. To track inflation, economists use a price index, a measurement that shows how the average price of a standard group of goods changes over time. The best known is the Consumer Price Index (CPI). The CPI measures the prices of a market basket—a representative collection of goods and services used by a typical urban consumer. Economists will calculate the change in the CPI from year to year to determine the inflation rate, the percentage change in prices over time.
Economists offer three reasons for why inflation begins. The quantity theory states that too much money in the economy leads to inflation. According to the demand-pull theory, inflation occurs when demand for goods and services exceeds existing supplies. Finally, the cost-push theory states that inflation occurs when producers raise prices in order to meet increased costs for labor and raw materials. Cost-push inflation can lead to a wage-price spiral. This is the process by which increases in one type of prices can cause other prices to rise.
Typically, when unemployment falls to very low levels, inflation tends to increase. The supply of available workers shrinks and wages rise. In the early 2000s, the economy had a period of slow growth. Some economists predicted a period of deflation, or a sustained drop in the price level. The economy recovered, however, and inflation remained low.
