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Inflation Part 2: How does price inflation work?

It’s not your imagination. The cost of rent, food and clothes has gone up. It's because of inflation. See how it works to learn what it means to your wallet.

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Inflation – and when most people talk about inflation, they're talking about price inflation. And that's just the general increase in the level of prices for goods and services. And you probably have a sense of that. That every year in kind of a normal economy things seem to get a little bit more expensive, although not everything does. Especially if you look at something like healthcare, or the cost of education, you definitely see things getting more expensive every year. One interesting question is how do you measure it?

How do you measure inflation? And what the Bureau of Labor Statistics does Ð this is actually the most used measurement of inflation. They create something called a Consumer Price Index. And the way they do it is they define a basket of goods - actually a basket of goods and services. So what they do is go and look at the average urban consumer and they say "what do they need in their life?" They may need some housing, they might need some fuel - natural gas for their home they need gasoline for their cars, they need energy in other ways.

They might need some type of services - they might need transportation. And they try to come up with a basket of all of the things that the average consumer in an urban environment might need. And they figure out how much that would cost them in year one. And let's say that in year one, that it costs them a hundred dollars - the actual basket CPI constructs would not cost a hundred dollars. But I am going to do this for the sake of simplicity. And they will weight these based on how much Ð what percentage they think people spend on housing vs. fuel vs. services vs. transportation. Then, they will look at the same basket each year after that. So then they will do the same things - housing, fuel, services, transportation.

And this will be in year two now. And let's say the same basket costs one hundred and two dollars. Well, then they will say the general level of price and services for this consumer went up by two dollars or went up by more important thing is by the percentage - by two percent. So, based on this measure, based on this basket of goods, prices went up by two percent. Or you'll hear the people on news say that the inflation rate went up by two percent.

Now, I want to clarify - what inflation - sometimes talks to inflation in the money supply. People talk about there's more money being printed. And often increase in money supply is one of the factors that is driving price inflation. When most people talk about inflation, they are talking about price inflation. They are talking about increase in prices. They are not directly talking about the increase in the money supply. Now this seems like a pretty simple thing to do - but it is not as simple as you might first think. Because think about something like TV sets or especially anything that is technological. Do you look at the same TV set that is getting probably cheaper every year or do you look at the average TV set that the American household is having. Do you look at the same computer that is getting significantly cheaper every year or do you look at the average computer every year? Then you would actually be looking at a different product.

So there's actually a lot of things to think about and a lot of things how can weight this. And there's been a lot of controversy in when the weightings change in different periods of time. But this is the general idea and it is really just the best attempt to figure out on average how much more expensive or how much purchasing power are we losing from one year to the next.

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