Introduction to inflation

When economists refer to inflation today, they are referring to a general increase in the level of prices of goods and services. So they're really talking about price inflation. The reason why I stress that is because sometimes, or especially when the term inflation first came into usage, it actually was referring to monetary inflation or an increase in the money supply. So it was referring to an increase in the money supply. These two ideas are closely related, but it's important to realize that people really are measuring inflation. When they're talking about inflation today, they're talking about price inflation. Because although these two things are related, they aren't always exactly the same thing. It is generally true that if the money supply-- and the money supply is more than just the amount of dollars that are printed. It's the amount of dollars that are printed. It's affected by the amount of lending that's occurring. It's affected by the number of transactions that are occurring in the economy. And if that money supply that's affected by all of those things grows faster than the total real productivity of the economy, then it will generally increase the level of prices. But especially in the short term, there could be other causes of price inflation. You could have things like supply shocks. And a supply shock is the supply of something becomes scarce all of the sudden. And the most typical example of a supply shock is especially in the oil crises in the 1970s. If for whatever reason oil becomes scarce in a country like the United States, then the price of oil and gas would go up. But then these are inputs into a whole set of things, even that banana that you buy at the grocery store. If the price of oil or gas-- or both of them, frankly-- or the price of oil were to shoot up, even the price of your banana would shoot up. Because to get that banana to your store, you need to use some gasoline. In fact, a significant fraction of that banana in that store was probably the cost of the gasoline for that ship to take that banana from wherever it was grown to your grocery store and then on a railroad and then on a truck or whatever. So this would affect the general prices, not just the prices of oil or gas. So these two things are related, but it's important to realize that people are referring to price inflation. And the general consensus is a little bit of it is a good thing. And I want to stress, little is good. And we're talking 1, 2. Maybe 3% per year. But anything larger than that gets a little scary because it can kind of snowball on itself. And we'll talk about that in future videos when we talk about hyperinflation. And economists are also afraid if inflation were to ever get negative. That leads to deflation, and we'll talk in future videos why in many circles that is viewed as a scary thing. Now in the United States, inflation is measured with the Consumer Price Index, CPI. And you'll always hear this reported in the news, especially if you watch some of the business programming. And there are actually multiple consumer price indices. The one that people report whenever they say the CPI went up 2%, they are actually referring to the CPI-U. And the U here stands for Urban consumers. And the reason why this is the headline CPI, or the one that people actually report, is because most of the country in the United States, they are urban consumers. So this is the CPI that affects the largest number of people's pocketbooks. And the way that it's calculated is, it's like the deflator. It's a price index. And it's measuring a general increase or a general change in the level of prices. But they actually are calculated in slightly different ways, although they should come into agreement or they should be close to each other if they really are indices from measuring the general level of prices. But the way that the CPI works is that they take a basket of goods for this type of consumer in a base year. So they'll pick up base year. And let's take a super simple example, a ridiculously simple example. Let's say in our little country, the urban consumers-- we'll focus on CPI-U-- only consumes two things. In the next video, we'll see that in reality, we consume many more than two things. But the two things-- and they spend 60% of their money on apples, and they spent 40% of their money on bananas. And in that base year, we just set that base price of apples at 100, and bananas are 100. Now we're not saying that apples and bananas cost the same thing. We're saying that we're spending 60% of our money on apples, 40% on bananas in that base year, and that this is just that base year level of prices. What will matter is how much this grew. What will this index change as we go to whatever year we want to calculate the inflation in relative to this base year. So let's say in our current year-- could be the very next year-- so let's say in our current year and we're going to assume these the same rates, that we're still spending 60% on apples and 40% on bananas. In our current year, the apple index-- let's say that it has grown 50% percent to 150. So it is plus 50%. And let's say that the banana index has grown to 180. So bananas have gotten even more expensive-- plus 80%. So how would we measure? How much would we say the CPI-U has grown? Well, we would take a weighted average of these indices, or you could say a weighted average of the growth. And you could do it either way. So let's do it either way to get you the same result. So in this year, our base index is 0.6 times 100 plus 0.4 times 100, and this will just come out to 100. This is 60 plus 40. This is equal to 100 as it should. That is our base year. That is our base for our index. Now over here in our current year, so this is what we're transitioning to, there's a couple of ways to do it. You could say, look, we're spending 60% on something that has gone up to 150 now. So we would say 0.6 times 150. And then we'll say plus 0.4 times 180. And that gets us to-- let me get my calculator out-- so this gets us 0.6 times 150 plus 0.4 times 180. So that gets us to 162. So our general-- if you look at this basket and this is an overly simplified basket-- we've increased from 100 to 162. Or you could say this is plus 62%. And you would have gotten the same result if you took the weighted average of the percentages. If you took 0.6 times 50% plus 0.4 times 80%-- in fact we could do that in our head. 0.6 times 50% is going to be 30%. And then 0.4 times 80% is going to be 32%. to 30 plus 32 gives us 62% growth for this basket of goods, which we are assuming is I guess for this urban consumer, from our base year to the current year. Now in the next video, we'll actually look at what the basket of goods actually looks like in the United States for an actual urban consumer.