Inflation: Understanding Rising Prices and Purchasing Power

Inflation is a general increase in the overall price level of goods and services over time. It is different from a price increase affecting only one product. Economists use price indexes to combine price changes for a defined group, or basket, of goods and services so that broad changes in prices can be measured.

A price index tracks prices for a defined basket of goods and services. The Consumer Price Index, or CPI, measures the average change over time in prices paid by consumers for a representative basket of consumer goods and services. An inflation rate can be expressed as the percentage change in the index between two periods: the later index minus the earlier index, divided by the earlier index, multiplied by 100.

Purchasing power describes what a given amount of money can buy. When a price index rises, the same dollar amount buys fewer goods and services on average, so the purchasing power of money generally falls. This describes an average relationship: the effect on a particular person depends on the goods and services that person buys.