The inflation rate in the U.S. hit a 40-year high this year. Understanding it is more important than ever, since inflation can have a significant impact on people’s everyday lives. It affects everything from the wages they earn to the price of groceries. But what does inflation actually mean? And how do economists measure it?

What is inflation?

Inflation is when a nation’s currency loses purchasing power over time. It’s reflected in rising prices for a broad range of goods and services in a society. When prices rise, the same amount of money can buy less of those goods and services. Therefore, the higher the price, the lower the purchasing power of that currency, and the higher the rate of inflation. Inflation is typically expressed as the annual percentage change in the prices of those items.

One of the most common causes of inflation is an increase in the supply of a given currency, or more cash in the market. This can happen for a few reasons: Monetary authorities could print more currency, or financial institutions could loan out more money. 

A sudden change in the supply of a product or commodity resulting from a major, unexpected event—known as supply shock—can also cause inflation. This happened in 1973, when the Organization of the Petroleum Exporting Countries (OPEC) imposed an oil embargo against Western nations in retaliation for their decision to support Israel during the Arab-Israeli War. This caused a major shortage of gas in the U.S., sharply driving up prices for not just oil and gas but many other consumer goods.

Generally speaking, some inflation is inevitable. Most economies will see positive but moderate inflation. Ideally, in a growing economy, wages will rise more than enough to offset the rise in prices.

How is inflation measured?

Inflation is the rate at which a currency’s purchasing power changes between two points in time. A currency’s purchasing power is measured by price indexes, which track prices for a constant set of goods and services (often hundreds of them) produced in an economy. They reflect an average consumer’s spending habits in a given market. They are also weighted:  Changes in the price of something people buy often affects the price index more than changes in the price of something they buy less often.

Two of the most common price indexes are the consumer price index (CPI) and personal consumption expenditures price index (PCE). Inflation can be calculated by referring to either index. The U.S. Bureau of Labor Statistics (BLS) reports the CPI every month, and major institutions rely on the CPI to adjust lending rates and other financial decisions.

• The CPI

  is an index that tracks how much it costs to buy common goods and services (called “a basket of goods”) including gas, medication, and food. CPI is calculated by first noting the retail price for each product or service in the basket. These prices are compared to their prices the year before in order to determine the change in price. CPI takes the retail price change and averages them based on their weight, or by giving each a relative importance, in the basket. 

• The PCE

  is similar to the CPI, but includes a wider variety of consumer goods and services in its basket, such as insurance and health-care costs. 

Higher index prices typically indicate higher demand for goods, which usually leads to a higher inflation rate. Lower index prices typically indicate lower demand for goods, which leads to a lower inflation rate.

How are inflation rates calculated?

Inflation rates are measured by the change in value of a price index over time. They are expressed in percentage terms, and can be derived via this formula:

‍inflation rate = (final price index value - initial price index value / initial price index value) x 100

For example, let’s say someone wants to determine the inflation rate between dates one year apart. They would:

1. Locate the price index data on either the CPI or PCE for the beginning and end dates of their identified period. 
2. Plug the final (the most recent) and initial (the past) index values into the formula.
3. Subtract the initial value from the final and divide the difference by the initial index value.

4. Multiply the result by 100. This gives you the percent rate of inflation.

The same formula can be applied to prices between two points in time. Let’s say a carton of milk is worth $3 in 2021, and $3.50 in 2022. To calculate the inflation rate between 2021 and 2022:

1. Find the difference between 3.5 and 3
2. Divide that difference (0.5) by 3 
3. Multiply by 100 

In this example, the one year inflation rate for a carton of milk is 17%.

How do central banks manage inflation?

Central banks control the minting and distribution of a currency for a nation or common market (like the European Union). They can use policy to fend off unwanted inflation. In the U.S., the central bank is the Federal Reserve, which aims for a target rate of inflation of 2% a year.

One way the Fed seeks to hit this target rate is by adjusting interest rates. When inflation is high, the Fed may raise interest rates to make it more expensive for consumers to borrow money. This is done in an effort to slow consumer spending, slow economic growth, and bring inflation back down.

What are some things individuals can do to protect against inflation?

The surest way to protect an individual from the effects of inflation is to secure and grow their income at a rate that outpaces the inflation rate. If the inflation rate is 3% per year, an individual would need to earn a 3% raise on their salary each year to keep up. However, for people who can't increase their earnings, like retirees on fixed incomes, inflation can erode their living standards.

Investing is another way to potentially increase one’s income to keep pace with inflation. The average annual stock market return has been roughly 10% over the past 30 years. While past returns do not guarantee future gains, the market has historically outpaced the rate of inflation. However, investing in the stock market comes with risks. Investors should research options or consult a professional before jumping in.

‍Bonds issued by corporations or the U.S. government are another option to potentially supplement one’s income to keep pace with inflation. They are less risky bets than the stock market, but they usually offer lower returns.

The bottom line

Some inflation is a feature of a healthy economy. Economies tend to grow more often than they don’t, and with that, consumer spending, and thus prices, rise. Inflation happens when the same amount of currency buys less today than it did in the past. Inflation’s overall effect on the economy will depend on the severity and predictability of price changes. Having a basic understanding of how inflation evolves over time, and its effect on everything in the economy will also help individuals who are concerned about how inflation affects their lives. Earning more and investing may also cushion against the impact of inflation.