Definition: The steady rise over a period of several years in the prices of goods, services and wages.

Example: The cost of American college tuition from 2000 through the middle of 2011 doubled. For the price of something to double in just less than 11 years, it must increase (ie, experience inflation of) about 6.5% per year.

Investeach explains: Inflation is commonly thought of as “Public Enemy #1” because when prices go up, our money buys less and less. We’re all consumers, so inflation makes all of us poorer. It is not as though anyone is opening our wallets and taking money out. It’s just that when prices increase our money buys less and less. It’s said that our money loses its “purchasing power”.

In addition to paying more for goods and services, consumers can experience inflation when businesses reduce package sizes and content but leave the price the same, and when they produce their products using inferior materials.

For the last several decades, inflation has been about 3% per year. Just as interest from money we save builds on itself and accelerates each year (due to compounding), inflation also compounds. Let’s say that the price of an appliance is $1,000. If inflation is 5% this year, its price will rise $1,000*.05, or $50, to $1,050. If inflation is 5% again next year, the 5% applies to the $1,050 price. Therefore, the price increase next year will be $52.50. The extra $2.50 of price increase is due to inflation on the prior $50 inflation!

Not all areas of the economy experience the same rate of inflation, or inflation at all. Earlier, we mentioned that in the recent past, higher education costs have inflated at a much higher rate than average. The same is generally true for health-care and food. Starting 2006 and continuing for several years, housing prices fell as the Great Recession unfolded. When prices fall, they are said to deflate.

The US Government tracks the overall inflation rate of a “basket of goods” each year, calling it the Consumer Price Index (CPI). In this basket that is supposed to reflect the expenses a typical urban citizen experiences is food, housing, clothes, transportation, medical care, recreation, education, personal grooming, and more.

Certain government benefits, such as Social Security payments are “indexed” to inflation. This means that they will increase by the amount of the CPI each year. Notice that this preserves the purchasing power of monthly social security payments. The CPI is also made a part of certain Government and business labor contracts, calling for the wages of workers to be indexed to (ie, be increased by) the CPI. Again, this serves to make sure that wages of workers maintain their purchasing power.

Riddle me this:

1. Explain what we mean when we say inflation compounds.
2. Identify two other ways that consumers can experience inflation.
3. Over the last several decades, what has been the average rate of inflation?
4. Identify areas of the economy whose prices have risen more than the overall rate of inflation.
5. Identify an area of the economy that has deflated over the past several years.
6. What is the name of the inflation rate the Government computes and publishes?
7. Identify at least five of the types of expenditures the Government places in its “basket of goods.”
8. Explain what it means for a benefit or wage to be “indexed” to inflation.