Explain how inflation is gauged and what the figures tell us
The idea
Inflation is measured by tracking the cost of a basket of goods and services over time, most commonly through a consumer price index. Headline inflation covers the whole basket; core inflation strips out food and energy, whose volatility can obscure the underlying trend. Indices are imperfect: substitution bias arises when consumers switch away from goods whose prices rise, and quality improvements are hard to separate from price increases. Demand-pull inflation comes from spending outrunning capacity, cost-push from rising input costs, and the two call for different policy responses.
Formulas
Inflation rate from a price index
inflation rate = CPI now ÷ CPI before − 1
- CPI now
- the index level at the end of the period
- CPI before
- the level at the start
A ratio of index levels, so the base year cancels and any base gives the same answer. What does not cancel is the basket: headline and core differ only in what is counted, not in this arithmetic.
A practice question
What does core inflation exclude?
- Housing and transportWhy not: Both are large, relatively persistent components and are exactly what a core measure is meant to capture.
- Food and energy — correct
- Imported goodsWhy not: Import prices are part of what consumers pay and stay in the measure, whatever the exchange rate does.
Food and energy prices are volatile and often driven by supply shocks, so removing them gives a clearer view of the underlying trend that policy can influence.
A harder one
Beef prices rise and shoppers buy chicken instead, but the index keeps weighting beef. What is the effect?
- The index overstates inflation, because it prices a basket nobody is buying — correct
- The index understates inflation, because chicken is cheaperWhy not: Whether buyers pay less is the point: their actual cost rose by less than the index, so the index reads high, not low.
- No effect, since the basket is updated continuouslyWhy not: The bias exists precisely because the basket is fixed between periodic revisions.
A fixed basket assumes buyers keep purchasing what has become expensive, which they do not.
The hardest tier
Why does the distinction between demand-pull and cost-push inflation matter for policy?
- Only demand-pull inflation appears in the price indexWhy not: Both show up in the index identically, which is precisely why the cause has to be diagnosed separately.
- Cost-push inflation is always temporaryWhy not: It can persist, particularly if it feeds into wage expectations, and assuming otherwise is how a supply shock becomes entrenched.
- Tightening helps one cause and worsens the other — correct
It addresses excess demand but deepens the output loss when the cause is a supply shock. Raising rates cools spending, which is the right answer to demand outrunning capacity; against a supply shock it compounds the hit to output without addressing the source, which is the central dilemma of a stagflationary episode.
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