Inflation For Dummies

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Yet another monthly consumer price index has emerged from the Bureau of Labor Statistics.  And for another month, there has been massive confusion in the media about the relationship between the year over year inflation rate and the month over month rate.  Apparently it’s time to repeat inflation for dummies.  As always, my methods are transparent.  Click here to download my Excel workbook.

First, a definition.

Inflation is the rate of change in the average price level.

Inflation is not an increase in the price of any single good or service.  It is the change in the average price level of a bundle of goods and services.  The Consumer Price Index is an index of the average price paid by urban consumers for a (large) bundle of goods and services.  If you’re interested in details, start with the BLS Factsheets.  After that, delve into the publication Relative Importance and Weight Information for the Consumer Price Indexes.

Inflation, Deflation, and Disinflation

Before getting into the simple part, let’s look at the history of inflation since 2014.  There have been periods of inflation, deflation, and disinflation.  Take a look at this graph.  Pay close attention to the green line, an inflation rate of 0.0%.

 Inflation for dummies

(click for larger image)

When the rate of change in the price level is above 0.0% there is inflation. See 2020:09 through 2023:06. When the inflation rate is negative, there is deflation.  There has been month over month deflation several times, notably 2014:09 – 2015:01 and 2020:01 to 2020:03.  When the inflation rate is positive, but falling over time there is disinflation.  That’s what the U.S. economy is experiencing right now.

  1. Inflation is an increase in the price level.
  2. Deflation is a decrease in the price level
  3. Disinflation is an increase in the price level
    smaller than the previous period.

Inflation and the Price Level

“But Dr. Lima,” you say. “The inflation rate has been falling but prices are still high.”  Burn this into your brain:

As long as the inflation rate is positive, prices will rise.  A lower price level requires deflation.

If you don’t understand that, read the previous section again.

Month Over Month and Year Over Year Inflation

This is really simple. Print the following and tape it to your monitor.

  1. If month over month inflation is above year over year inflation, year over year inflation is rising
  2. If month over month inflation is below year over year inflation, year over year inflation is falling.

I could prove that mathematically, but data is usually more convincing.

When Month Over Month is Greater Than Year Over Year

Take a close look at this graph.  Remember, the line is year over year inflation and the bars are month over month inflation.

Year over year rate is rising inflation for dummies

(click for larger image)

We’ve just lived through a period of rising inflation.  And sure enough, the month over month rate exceeded the year over year rate.

When Month Over Month is Less Than Year Over Year

That’s what’s happening right now.  This is not the first time.

Year over year is falling inflation for dummies

(click for larger image)

Conclusion

Please, please remember this.  Don’t make me write it again in a few years.

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About Tony Lima

Retired after teaching economics at California State Univ., East Bay (Hayward, CA). Ph.D., economics, Stanford. Also taught MBA finance at the California University of Management and Technology. Occasionally take on a consulting project if it's interesting. Other interests include wine and technology.