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Economically Speaking

Inflation: When too much money is a bad thing

graphic representation of inflationInflation refers to a broad-based rise in prices. The most widely accepted cause of inflation is an excess of money in circulation.

Having a lot of money floating around might sound like a good thing. But that overabundance erodes value. That’s what happened in the United States in the 1970s, when inflation rose into double digits, credit became extremely costly, and ultimately a deep recession occurred, which hurt many businesses and consumers.

One of the goals of the Fed in formulating monetary policy is to limit inflation—in other words, to keep prices for goods and services stable. The Federal Open Market Committee tries to act as a sort of spigot on money and credit. If inflation is a concern, as it has been lately, the Fed might increase interest rates to close the spigot somewhat and limit the amount of money flowing into the economy, thus reining in inflation.

To be sure, keeping prices stable does not mean that prices of individual items would not fluctuate. The price of a car, for example, might rise because steel used in making it is more expensive; orange juice prices could climb because cold weather has damaged the orange harvest. Consequently, when economists measure inflation, they use gauges that distinguish between these relative price movements and broader inflation, or the rate of change in the overall price level.

Several statistical series are available to track prices. The consumer price index, or CPI, is the most commonly used inflation gauge. Compiled monthly by the U.S. Bureau of Labor Statistics, the CPI is designed to track the price changes in a predetermined “basket” of goods and services—including food, medical care, housing, and clothes—that reflects items a typical family buys.

Another inflation yardstick that’s gaining popularity among economic analysts is personal consumption expenditures, or PCE, which measures prices people pay for domestic purchases and is viewed as a broader gauge of consumer prices than the CPI. Unlike the CPI, which simply measures the average price of a fixed batch of items, the PCE takes into account how people change their buying habits because of prices—for example, switching from used to new cars when financing on new cars became very attractive a few years ago.

Inflation calculators can be used to see how much the value of money has changed over time. Some popular inflation calculators are

U.S. Bureau of Labor Statistics inflation calculator

CPI inflation calculator

Columbia Journalism Review inflation calculator

FRB Minneapolis inflation calculator

By Charles Davidson, staff writer, Federal Reserve Bank of Atlanta