In the most accepted sense, inflation is a rise in the average price of products over a period of time. The rate that costs go up is known as the inflation rate. Inflation happens either when prices go up or when it takes more money to buy the same items.
CPI is not the same as inflation. Inflation is the change in CPI over a period of time. It can be calculated as [CP1 Year 1 – CPI Year 2]/CPI Year 2, where Year 1 is greater than Year 2. Using the example above the inflation rate from 1984 to 2009 would be 95%. That’s (195-100)/100.
Using CPI isn’t necessarily an indicator of the specific inflation rate for any given consumer since the goods and services you purchase might not be included in the basket. Instead, CPI and the inflation rate is an estimated value for the country as a whole.
Monetary inflation happens when the money total in circulation increases faster than the amount of goods in circulation. The government is the only entity who can do this. In the old days, they would simply produce more cash. Today, the government purchases securities from banks, thereby increasing the money supply.
Inflation can possibly lead to deflation. In theory, people would spend less money when prices are rising, but that is not always what occurs. In practice, people spend the money now because they believe the prices will be higher in the future. If they don’t have the cash for wanted purchases, then they borrow it.
Another downside to inflation is that it puts some goods and services out of reach for consumers. Rarely do wages maximize the same rate as inflation, so consumers have less money to spend. As the gap between income and expenses closes, so does spending. That situation could eventually lead to deflation.
In general, deflation is when the average price of goods goes down. When the inflation rate falls below zero, showing negative inflation, we know that there has been deflation. Remember that the inflation rate is calculated based on the change in the Consumer Price Index, or CPI.
Inflation and deflation are both parts of a normal functioning economy. They typically happen in cycles and can correct themselves without any government intervention. However, in extreme situations, like the Great Depression, the economy does need a helping hand from the Feds.
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