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.