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Economy 101: Inflation

Inflation is one of the most familiar and easily definable economic topics to anyone who has watched the decrease in the purchasing power of their money. Put simply, inflation is a general increase in prices of goods and services over time.

What causes inflation?

Inflation can be caused by numerous factors, but the two primary types of inflation are demand-pull inflation and cost-push inflation.

Demand-pull inflation typically occurs in a time of economic expansion. During these periods of growth and increased income, consumer demand for products and services will exceed the current supply, driving prices up. This has also been a common cause of inflation during times of war, when materials and manpower are drawn upon by a military effort and therefore are in shorter supply.

Cost-push inflation, as the name suggests, happens when the costs of production rise. This can be caused by a shortage in the raw materials required to make the products people need. For instance, when draught or natural disaster causes crop failure and a subsequent lack of food products, the price of food at grocery stores and restaurants will rise. Cost-push inflation also results from wage increases that aren't matched by increases in worker productivity and the resulting rise in production costs.

How is inflation measured?

To understand how we measure inflation,we look at two factors- the Consumer Price Index and the "market basket" of goods and services.

The Consumer Price Index is a number that measures the change in the price that an average consumer pays for a predefined market basket of goods and services. This market basket represents all of the goods and services purchased by an average American family and contains roughly 80,000 items in more than 200 categories. Every couple of years the United States Bureau of Labor Statistics (BLS) conducts what's known as the Consumer Expenditure Survey, the information from which decides what goes into the market basket of goods and services. Through interviews and expenditure diaries, approximately 7,000 participants nationwide log information about their expenditures and their income. Because the Consumer Price Index charts the change in price across such a broad range of products representing the purchases of an average American family, it is the best measurement for inflation that we have.

Can I protect myself from inflation?

During the 1970's, the federal government built a cost of living adjustment (COLA) into the social security program, so that retirees living on fixed income could keep pace with inflation. Union contracts, government programs, and some corporate pensions have been known to offer a similar benefit. Perhaps the best way to protect yourself against a loss of purchasing power is through investment in assets whose value you expect to increase at a rate equal to or greater than that of inflation.

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