Reading time: 3 minutes

Key Points

• Inflation impacts  all facets of the economy.
• High wages lead to more disposable income, which impacts inflation.
• CPI sources data from consumers, while PCE sources from businesses.

Inflation is a term that we have been hearing a lot lately. But what is it? Inflation is the rate of increase in prices over a given period of time. Sounds plain and simple, so what is the big deal about it? Well, behind those 12 words there is a lot going. Inflation is  one of the most popular indicators to help understand how the economy is currently doing. Its fluctuations have an impact in all facets of the economy,  from individual spending power to interest on the national debt. 

But you may wonder… how? Let’s start with the basics: 

As we see, the price of bread has increased over the years. Now, consider that every product in the market has been affected by inflation. If the price of goods increases but the consumer’s income remains the same, they will not be able to keep purchasing the goods. This will cause the purchasing power of money to fall. In other words,  if 2 years ago you were able to buy eggs, milk, butter, bread, ice cream, fruits, and vegetables for $25, nowadays to stay within the same budget you may need to drop ice cream from your list. 

Some of you may argue that income has increased as well, so why is there inflation? Well, the effect goes in a circle. Michael Boyle from Investopedia explains it really well: “Increased wages would result in higher costs for businesses, which may pass those costs on to consumers. Higher wages also increase consumers’ disposable income, increasing the demand for goods that can push prices even higher.”

There are two measurements of inflation, the CPI and the PCE. According to the U.S. Bureau of Labor Statistics, the Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services; and the Personal Consumption Expenditures (PCE) includes a measure of consumer spending on goods and services among households in the U.S. Both measurements have two versions: Core and Headline. The main difference that they reflect is that the core measurement does not include gas or food. Economists (like me) prefer to see trendy graphs so they created the core measurement to make it less all over the place.

If you are interested in keep learning about inflation check out our “How does Inflation affect your savings” post on Facebook.