Measure of Inflation: Price Index

Since inflation can cause a lot of trouble, to be able to keep it under control the government needs to be able to measure it with precision.

As we explained before, the interaction of the supply and demand of money determine its value. The supply of money is under the control of the government, but the government cannot directly establish the demand, so they need to see the way how the supply and demand interact in order to determine how much to increase or decrease in the monetary supply:

  • If there is inflation, the government knows that the supply of money is increasing more rapidly than the demand. If they want to control inflation, they need to reduce the monetary supply.
  • If there is deflation, the government knows that the demand of money is increasing more rapidly than the supply. If they want to stop deflation, they need to increase the monetary supply.

Since inflation is a general increase in the prices, the best way to detect is by observing if the cost of buying a combination of diverse goods changes in time. If you only look at one or two prices, you can end up confusing a change in the relative prices with a general change in the prices. Remember that a relative change is when one price increases a little bit while the rest remain the same.

Economists define arbitrarily a big combination of goods and services and refer to it as a big basket of goods and services. Then they measure inflation, finding out how much money is needed to buy this basket in different moments. The basket of goods and services more known as the price index to the consumer, or the CPI, that consists in what a typical family of a determined number of people would buy in a month.

Beginner Money Investing The Effects of Inflation Measure of Inflation: Price Index Determining the Standard of Life with Price Index