The inflation rate measures the increase in prices, which can erode the value of money (also known as purchasing power). Inflation is an important economic factor because it affects many aspects of the economy, including consumers’ purchasing power, business activity, and the growth of national economies. It is a critical consideration for people who save or invest their incomes, as well as those who receive fixed incomes such as pensioners or retirees.
The most common method for measuring inflation is to compare the prices of a basket of items that are typical purchases for the average person, called the Consumer Price Index (CPI). The CPI is calculated by subtracting the prices of a given selection of goods and services from the same selection of goods and services one year earlier. This comparison is expressed as an annual percentage change in the CPI, giving the monthly or annual inflation rate.
Another common measure of inflation is the Producer Price Index (PPI), which takes into account the costs associated with each stage in production, from raw materials to distribution. The PPI is commonly used by businesses to set product prices and by governments to determine tax rates. The core consumer inflation rate excludes those prices that are intentionally set by government and more volatile items such as energy and food, which are often affected by seasonality or temporary supply conditions. This focuses on the underlying trends in inflation and is the primary index that the Federal Reserve uses for making monetary policy decisions.