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Introduction to inflation

Inflation is an increase in the price level over time. In this video we explore inflation and how it is calculated using a measure called the consumer price index (CPI).  Created by Sal Khan.

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  • male robot johnny style avatar for user Godzilla007
    In this video Sal mentioned price shocks. Now some politicians(and I'm not going to name names or take a political stance)have suggested that the U.S. should place sanctions on China for its currency manipulation.If these sanctions were applied, would the U.S. suffer any price shocks due to the vast number of commodities and goods that we import from China?
    (38 votes)
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    • blobby green style avatar for user lu.runbo
      Just to illustrate Andrew's point, the Chinese are buying up USDs with Yuan, which their central bank prints in massive quantities. The result is that this vast quantity of printed Yuan is released into the market, increasing the money supply, and driving high inflation (5-15% in China depending on how you estimate it). Inflation decreases the real value of money, which is the VALUE of the money in people's pockets - so in a sense the Chinese government is stealing money from the Chinese and converting that to dollars to keep their currency relatively low. In recent years, however, the Yuan has appreciated considerably against the dollar so some analysts think the two currencies are close to a "fair" market value.
      (33 votes)
  • blobby green style avatar for user Max
    starting at , why is a little inflation considered good? doesn't this decrease the value of the currency? why is that good albeit a little at a time?
    (25 votes)
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    • old spice man green style avatar for user Jason
      The "good" value of inflation depends upon your philosophy. A little is better than a lot for sure. However, inflation steals from those who save -- as you are stealing from the purchasing power. If I save a $100 and over the next year we have 10% inflation I can only purchase $90 worth of goods. Inflation discourages saving and pushes people into making more risky investments like the stock market. It also encourages spending, which would be fine for a Keynsian (https://en.wikipedia.org/wiki/Keynesian_economics). Can inflation be good? to me is like asking is it okay to steal a little?
      (20 votes)
  • female robot amelia style avatar for user twirlgirl01
    I don't understand what the 100 means and why in the video apples and bananas were both equal to 100.
    (5 votes)
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    • aqualine ultimate style avatar for user Stefan van der Waal
      Those are known as index numbers. They make data easier to compare.
      To make it slightly more obvious, here are some made up numbers to illustrate what they do:

      A pound of apples costs $1 in year 1 and a pound of bananas $2. In year 2 they both got more expensive. This results in the following table:
                 Year 1    Year 2
      Apples $1 $1.50
      Bananas $2 $3.60

      Just by looking at this data, did apples or bananas inflate more in price measured in a percentage?
      It's required to do some math to answer that question, so economists invented index numbers. For apples they convert $1 to 100 index points and for bananas they convert $2 to 100 index points. Now the table looks like this:
               Year 1       Year 2
      Apples 100 150
      Bananas 100 180

      Now it's very easily to see bananas inflated by 80%, which is more than the 50% apples inflated in price.
      (33 votes)
  • male robot hal style avatar for user Enn
    Can inflation result in the devaluation of a currency ? That is as prices rise the price to buy a foreign currency also rises ?
    (8 votes)
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    • leaf green style avatar for user SteveSargentJr
      Yes, all things equal, you would expect a country with a higher inflation rate to see its currency depreciate relative to that of a second country with lower inflation.

      This is a result of Purchasing Power Parity--the theory that differences in inflation rates should be reflected in the changes in the exchange rate between two countries. However, I mention that this is a theory because you can't expect the relationship to hold exactly, especially over the short-run (however, over the long-run, it does tend to hold up fairly well).
      (11 votes)
  • aqualine seedling style avatar for user vaishnavi rao
    How do u consider any year as the base year?? I mean what is the criteria?
    Its not from the examination point of view..... How is it done for practical purposes...?
    (6 votes)
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    • female robot grace style avatar for user Natalie
      In the United States, the base year is set every five years -- 2000, 2005, 2010, etc. The reason the base year is generally a year that's close to the current year -- and moves as time goes on -- is because the market changes so quickly -- it would be impractical to use the year 1960 as a base year considering how there are products that exist now (which might be a significant portion of household expenditures) that didn't even exist back then, eg. consumer electronics like iPods and laptops.

      Because of this, you could consider the criteria of a base year to be a balance between closeness to the current year, to account for changing technology, and being further away from the current year, in order to more accurately compare differences in prices. The further away the base year is, the more years you have to be able to compare inflation, so you can better picture it as it moves up or down relative to other years.

      In the United States, the base year could be only every five years because technology is assumed to change so quickly, but in a country with slower technology growth, eg. Moldova, the base year might change every 10 years instead, since they don't need to factor changing technology into their analysis of inflation as much.
      (11 votes)
  • leaf red style avatar for user Ali Larizza
    Can someone please explain why having some positive inflation, real wages decrease even if nominal wages are held constant?

    Thanks in advance :)
    (6 votes)
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    • ohnoes default style avatar for user Tejas
      Nominal wages are the number of dollars given to employees. However, due to inflation, those dollars are now worth less. The formula for this is r = n / (1 + i). So, if i, which is inflation, increases and n, which is nominal wages, remains constant, then that clearly means that r, real wages, must decrease.
      (8 votes)
  • blobby green style avatar for user aidan.regan
    What about asset price inflation? Particularly housing. It seems unusual that the cost of rent, mortgages and accommodation is not mentioned in the video. Are these items excluded from the CPI? If so,mare they captured by the HCIP that the ECB In Europe uses?
    (4 votes)
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    • blobby green style avatar for user aidan.regan
      But I am almost sure that the ECB targets the HCIP which excludes asset prices inflation and hence the cost of housing. This is particularly important because it missed the housing boom in Ireland and southern Europe that has since burst leading to a financial cum sovereign debt crisis in the eurozone.
      (3 votes)
  • primosaur sapling style avatar for user Kevin Yu
    How similar is Inflation rate (CPI) compared between America and other countries that use the CPI (i.e. Australia)? Is there any difference? Are there other influences that may affect it from one country to another?

    Thanks :D
    (3 votes)
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    • leafers ultimate style avatar for user Caitlin Fischer
      CPI itself isn't the inflation rate of a nation, it's more of a measure that allows us to look at inflation.

      But anyways! Inflation rate can vary a lot from country to country. And this is because the rate of inflation depends on lots of factors that all depend on the country itself. For example, if in one country there was a sudden increase in the amount that people were paid, all these people would have more money to buy goods and services. They'd probably go out and buy a lot more, right? So aggregate demand would have risen, and the price level would have rose- i.e. we would have seen inflation. The country's inflation rate could be said to have increased. Loads of other factors can affect inflation rates: changes in the costs of production in the country, whether or not consumer confidence is high, etc. Just think about how a factor would affect prices in the economy and that should tell you how it affects the inflation rate!
      (3 votes)
  • mr pink red style avatar for user Mafalda
    given the annual inflation of 3.5% how to find the relative rate of inflation?
    (3 votes)
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  • blobby green style avatar for user Gakwandi henry
    Oes inflation breed unemployment
    (2 votes)
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    • male robot hal style avatar for user doohyeun
      that depends on how big the inflation is. generally, inflation around 2 or 3% is good, but if it is higher than that, it could become dangerous, as it would erode the value of money and make it harder for families and companies to break even. it could breed unemployment in the sense that as the value of money drops, prices for goods and services rise so much that not many consumers can by them any more. since nobody is buying thier products, companies will eventually shut down or cut its workers, resulting in unemployment. however, generally high inflation is related to low unemployment, while low inflation is related to high unemployment(see The Phillips Curve-Inflation and Unemployment)
      (3 votes)

Video transcript

When economists refer to inflation today, they are referring to a general increase in the level of prices of goods and services. So they're really talking about price inflation. The reason why I stress that is because sometimes, or especially when the term inflation first came into usage, it actually was referring to monetary inflation or an increase in the money supply. So it was referring to an increase in the money supply. These two ideas are closely related, but it's important to realize that people really are measuring inflation. When they're talking about inflation today, they're talking about price inflation. Because although these two things are related, they aren't always exactly the same thing. It is generally true that if the money supply-- and the money supply is more than just the amount of dollars that are printed. It's the amount of dollars that are printed. It's affected by the amount of lending that's occurring. It's affected by the number of transactions that are occurring in the economy. And if that money supply that's affected by all of those things grows faster than the total real productivity of the economy, then it will generally increase the level of prices. But especially in the short term, there could be other causes of price inflation. You could have things like supply shocks. And a supply shock is the supply of something becomes scarce all of the sudden. And the most typical example of a supply shock is especially in the oil crises in the 1970s. If for whatever reason oil becomes scarce in a country like the United States, then the price of oil and gas would go up. But then these are inputs into a whole set of things, even that banana that you buy at the grocery store. If the price of oil or gas-- or both of them, frankly-- or the price of oil were to shoot up, even the price of your banana would shoot up. Because to get that banana to your store, you need to use some gasoline. In fact, a significant fraction of that banana in that store was probably the cost of the gasoline for that ship to take that banana from wherever it was grown to your grocery store and then on a railroad and then on a truck or whatever. So this would affect the general prices, not just the prices of oil or gas. So these two things are related, but it's important to realize that people are referring to price inflation. And the general consensus is a little bit of it is a good thing. And I want to stress, little is good. And we're talking 1, 2. Maybe 3% per year. But anything larger than that gets a little scary because it can kind of snowball on itself. And we'll talk about that in future videos when we talk about hyperinflation. And economists are also afraid if inflation were to ever get negative. That leads to deflation, and we'll talk in future videos why in many circles that is viewed as a scary thing. Now in the United States, inflation is measured with the Consumer Price Index, CPI. And you'll always hear this reported in the news, especially if you watch some of the business programming. And there are actually multiple consumer price indices. The one that people report whenever they say the CPI went up 2%, they are actually referring to the CPI-U. And the U here stands for Urban consumers. And the reason why this is the headline CPI, or the one that people actually report, is because most of the country in the United States, they are urban consumers. So this is the CPI that affects the largest number of people's pocketbooks. And the way that it's calculated is, it's like the deflator. It's a price index. And it's measuring a general increase or a general change in the level of prices. But they actually are calculated in slightly different ways, although they should come into agreement or they should be close to each other if they really are indices from measuring the general level of prices. But the way that the CPI works is that they take a basket of goods for this type of consumer in a base year. So they'll pick up base year. And let's take a super simple example, a ridiculously simple example. Let's say in our little country, the urban consumers-- we'll focus on CPI-U-- only consumes two things. In the next video, we'll see that in reality, we consume many more than two things. But the two things-- and they spend 60% of their money on apples, and they spent 40% of their money on bananas. And in that base year, we just set that base price of apples at 100, and bananas are 100. Now we're not saying that apples and bananas cost the same thing. We're saying that we're spending 60% of our money on apples, 40% on bananas in that base year, and that this is just that base year level of prices. What will matter is how much this grew. What will this index change as we go to whatever year we want to calculate the inflation in relative to this base year. So let's say in our current year-- could be the very next year-- so let's say in our current year and we're going to assume these the same rates, that we're still spending 60% on apples and 40% on bananas. In our current year, the apple index-- let's say that it has grown 50% percent to 150. So it is plus 50%. And let's say that the banana index has grown to 180. So bananas have gotten even more expensive-- plus 80%. So how would we measure? How much would we say the CPI-U has grown? Well, we would take a weighted average of these indices, or you could say a weighted average of the growth. And you could do it either way. So let's do it either way to get you the same result. So in this year, our base index is 0.6 times 100 plus 0.4 times 100, and this will just come out to 100. This is 60 plus 40. This is equal to 100 as it should. That is our base year. That is our base for our index. Now over here in our current year, so this is what we're transitioning to, there's a couple of ways to do it. You could say, look, we're spending 60% on something that has gone up to 150 now. So we would say 0.6 times 150. And then we'll say plus 0.4 times 180. And that gets us to-- let me get my calculator out-- so this gets us 0.6 times 150 plus 0.4 times 180. So that gets us to 162. So our general-- if you look at this basket and this is an overly simplified basket-- we've increased from 100 to 162. Or you could say this is plus 62%. And you would have gotten the same result if you took the weighted average of the percentages. If you took 0.6 times 50% plus 0.4 times 80%-- in fact we could do that in our head. 0.6 times 50% is going to be 30%. And then 0.4 times 80% is going to be 32%. to 30 plus 32 gives us 62% growth for this basket of goods, which we are assuming is I guess for this urban consumer, from our base year to the current year. Now in the next video, we'll actually look at what the basket of goods actually looks like in the United States for an actual urban consumer.