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Inflation and Price Indices

Macro and the Federal Reserve • Beginner Investing • 9 min

What this lesson is about

Building a CPI, calculating inflation rates, and separating real from nominal values.

Key termsprice indexinflation rateUnexpectedMenu costsShoe-leather costs

2 parts · a quick check after each · then the quiz

Part 1 of 2

A price index measures how the cost of a fixed basket changes over time, with the base year set at 100. To find the inflation rate between two years, use this formula: (new index - old index) / old index × 100. You’ll see these calculations on nearly every exam.

Another key relationship is the Fisher equation: real interest rate ≈ nominal interest rate - inflation rate. Inflation shifts wealth between borrowers and lenders. Unexpected inflation favors borrowers, since their fixed repayments lose real value. Lenders and those on fixed incomes feel the pinch. Expected inflation, however, is already included in the nominal rate and causes much less disruption. This difference is what most questions focus on.

What inflation doesThe same money, later. Move the rate and the years.

Quick check

If a price index rises from 120 to 126, the inflation rate is

Part 2 of 2

Two specific costs of inflation are important. Menu costs refer to the resources used to change prices. Shoe-leather costs are the effort spent trying to hold less cash when money loses value quickly. At low inflation, both are minor; at high inflation, they can become severe.

Insider Angle: Economists often see inflation volatility as more harmful than a steady inflation rate, and here's why. A stable 4% inflation rate gets factored into contracts, wages, and interest rates, causing little redistribution. But an erratic rate averaging 4%, swinging between 0% and 8%. Turns every long-term nominal contract into a gamble. Lenders want a risk premium, making long-term investments pricier. That’s the real cost, and it doesn’t show up in averages.
Try This: A basket costs 200 in the base year and 226 this year. Compute the index and the inflation rate. If a bank charged 7% nominal interest during that time, compute the real interest rate. Then, decide whether the borrower or the lender fared better than expected.

Quick check

The real interest rate is approximately

Quiz

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