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Inflation Part 1: What is inflation?

Today's dollar buys a lot less than yesterday's did. Why? Because of inflation. Learn what inflation means and how it's calculated.

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Let's say I'm an economist and I'm curious about whether in general things are getting more expensive or not and if they are getting expensive, by how much?

So the way I'd approach that is I would think of well what are just a bunch of goods and services that the average person would buy. So I would think up some type of basket of goods – goods and services. And I would try to weight that basket based on how people actually spend their money.

So I'd say, okay, 40% of peoples' money on average is spent on housing. Maybe another 10% is spent on transportation, maybe another 10% is spent on food and I would go out into the market and I would see, I would try to take an average of what these things cost. And I would sample a bunch of products, a bunch of services so that I get a decent average of that.

So this is not a simple thing to do, but I'm an economist and I'm serious about trying to calculate that. And let's say that when I take that weighted average of all of this stuff, I just come up with a number. And I'm not giving you the details of how it's actually calculated, but to give you the idea of what they are doing.

So I get a number, so I just, you know... to rent, to buy or lease your average automobile, to lease your average apartment, to buy your average servings of food for a given family, all the rest... let's say I come up with that costs and I'm making up a number here, let's say that it costs $20,000 my basket of goods and services, just based on the way that I've weighted it. And this is all happening in year 1.

So this is in year 1. Now I'm curious whether between year 1 and let's say year 5, whether things got more expensive. So I'll take that same basket of goods and services… So basket of goods and services… and I'll try to figure out what is their weighted average cost in year 5 and this is a lot harder than it sounds right now because the basket of goods and services change.

If computers get faster, do you use the same computer? Or do you think about what the average computer is which would now be a better computer? If most people's TVs got bigger, do you use the same TV in year 1 and year 5? Or do you adjust now the average TV which has now gotten bigger? If houses have gotten bigger on average, do you use the same house? Or do you use the average house?

So there's a whole bunch of areas here that you could really tweak, and these are actually huge subjects of debate on what is the actual increase in cost. But let's say that you're able to do this in what you think is a pretty reasonable way and you find that the same basket of goods adjusted for things like technology and all of the rest, now costs $22,000.

So your takeaway from here is the same things that cost $20,000 the things that give you the same standard of living in year 1 to get that same standard of living in year 5you now need to spend 10% more it's gotten $2,000 more expensive off of $20,000 so it's gotten 10% more expensive.
So you as the economist what you would say is, as the way you've defined it your consumer price index, and this is abbreviated with CPI. Your consumer price index is up by 10%. Another way, based on the way you measured it and it changes from country to country even within countries, they change the way that they do these baskets of goods, but by the way you've measured it, you would say that the price inflation has been has been 10% between year 1 and year 5 or in general, everything got 10% more expensive or you would 10% more money to have the same standard of living, and in general, when people are just referring to inflation, so if you just see the word inflation being referred to especially in modern times, they are referring to price inflation, this general increase in the price of goods and services measured by some type of basket of goods.

There is another type of inflation, and that is monetary inflation and they are related. Monetary inflation is inflation due purely to an increase of the money supply. So this is increase in money supply. And in general, if this increase in the money supply does outstrip kind of the productive capacity of the country it could very well lead to price inflation but in general, what people measure, when they talk about inflation from one year to the next they're talking about this basket of goods they're talking about price inflation.

The other thing that you'll sometimes see maybe in year 5, someone says, "hey! I could sell you this house" this house- so this is in year 5 "I could sell you a house" and this house in year 5 is $660,000 and someone might ask, well "What would be that price if we adjusted it for inflation in year 1 dollars?"

So what they're saying is, if you adjust for how much value your money has lost. Because if things are getting more expensive that means each dollar is being worth less. You can buy less with each dollar. So when people say, "How much is that adjusted for inflation in year 1 money?"

You're essentially saying, "What amount of money would that house have had to have cost in year 1, that when you adjust it for inflation you increase it by 10%,so that's the same thing increasing by 10% is the same thing as multiplying by 110% or multiplying by 1.1.

So what amount of money would that house had to have cost in year 1 that if I multiply it by 1.1, I get $660,000? Now we can do a little quick math here to figure that out. So if we say, let's say that, I don't know that P, P is the price of the house in year 1 I'll call it P1, that times 1.1 is going to be equal to $660,000 when you factor in the 10% inflation over these years.

Now this is simple algebra right here. You could divide both sides by 1.1and we get, these cancel out, you get the price of that house in year 1 66 divided by 11 would be 6 now you can work it out with a calculator if you don't feel comfortable with what I'm about to do.
This would give you $600,000, if you work this math right out here.

And you could figure out the decimals, what we could do, well, I think you get the general idea here you can use your calculator. I kind of did this in my head. But the general idea is a house in year 1 that is $600,000 if you factor in the devaluing of the current year or how much more expensive everything got in year 5 will cost you $660,000.

So you might hear someone say when they're talking about inflation or they're talking about price increases, this house in year 5 is $660,000 which is equal to which is equal to $600,000… $600,000 in year 1 money.

And as an example of that, you know I live in neighborhood where the houses have gotten all of a sudden because I live in the heart of Silicon Valley it's not a fancy neighborhood by any stretch of the imagination but the houses now are quite expensive and we have neighbors who moved in in the 1950s, and they say, "My god, I bought my house for $10,000 and now people are selling these houses for so much more!"

And the reality is, is that it is true, the house has appreciated, but $10,000 in 1950 was actually a lot a lot of money. Doctors and engineers did not make that much more than that much per year. I don't know the exact amount.

So the reality is, that you actually have to adjust money for the year you are talking about and you have to adjust it for inflation. So if you believe this 10% inflation number, hopefully people's incomes also increased by the same amount. So the same person, maybe with the same skills and the same job, who could afford the house for $600,000 in year 1, could now pay $660,000 for it, and it won't take an unusually large chunk of their expenditures it would take the same chunk that it did in year 1.

So hopefully that clarifies things a little bit, and I'll in the future do more videos going into the details of inflation.

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