PAGE ONE Economics

$
®

A Dollar’s Worth: Inflation Is Real

Jeannette N. Bennett, Senior Economic Education Specialist

GLOSSARY “When prices are stable, people can hold money for transactions and
Budget: An itemized summary of probable other purposes without having to worry that inflation will eat away at
income and expenses for a given period. the real value of their money balances.”
A budget is a plan for managing income, —Ben Bernanke1
spending, and saving during a given
period of time.
Bureau of Labor Statistics (BLS): A research
agency of the U.S. Department of Labor Introduction
that compiles statistics on employment,
Did you know National Tooth Fairy Day is observed twice each year on
unemployment, and other economic data.
February 28 and August 22? It’s based on the tradition that when a child
Deflation: A general, sustained downward
movement of prices for goods and
loses a tooth and puts it under their pillow, the magical Tooth Fairy visits
services in an economy. during the night and leaves money in exchange for the lost tooth. The
Income: The payment people receive for
amount of money the Tooth Fairy leaves varies and has changed over
providing resources in the marketplace. time. A few generations ago, a child might have found 10 cents under
When people work, they provide human their pillow. But over the years, the Tooth Fairy started leaving 25 cents,
resources (labor) and in exchange receive
and then 50 cents. It wasn’t long before the Tooth Fairy started leaving
income in the form of wages or salaries.
People also earn income in the forms of $1, and then $2, and even more. Today the Tooth Fairy pays an average
rent, profit, and interest. of almost $4 for one tooth!2 Even in a fantasy world, inflation is real!
Interest: The price of using someone else’s In one way or another, inflation affects everyone. News reporters anxiously
money. When people place their money
in a bank, the bank uses the money to await the monthly release of the inflation rate, which becomes headline
make loans to others. In return, the bank news. And when interviewers ask consumers what inflation means, their
pays interest to the account holder. Those answers carry the same message: Inflation means the same amount of
who borrow from banks or other orga-
nizations pay interest for the use of the
money buys fewer goods and services, or “inflation means prices go up”!
money borrowed. Inflation is a general, sustained upward movement of prices for goods and
Interest rate: The percentage of the amount services in an economy. It affects purchasing power or the amount of
of a loan that is charged for a loan. Also, goods and services that a unit of currency can buy; more specifically,
the percentage paid on a savings account.
inflation reduces purchasing power. Data show the changing value of the
Savings: The accumulation of money set
dollar and its purchasing power. Figure 1 shows the value of the dollar set
aside for future spending.
at 100 (representing full value) in 1983. The value of the dollar is 37 in 2021.
Savings account: An account with a bank
This means that since 1983, the purchasing power of a dollar has been
or credit union in which people can
deposit their money for future use and reduced by 63 percent. Put another way, if you lived in 1983 and took a
earn interest. time machine to 2021, a dollar would buy 37 cents worth of 2021 goods
and services.

October 2021 Federal Reserve Bank of St. Louis | research.stlouisfed.org

PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 2

Figure 1 Table 1
Purchasing Power of the Dollar U.S. Postage Rates in Selected Years

Date Rate Date Rate

July 6, 1932 3¢ January 7, 2001 34¢

August 1, 1958 4¢ May 12, 2008 42¢

March 2, 1974 10¢ January 21, 2018 50¢

November 1, 1981 20¢ August 29, 2021 58¢

SOURCE: http://www.akdart.com/postrate.html.

and services may remain the same or even decrease in

SOURCE: FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/ price over time. For example, the price of a computer is
series/CUUR0000SA0R#0, accessed October 6, 2021.
much less today than 20 years ago. Some of this is an
actual decrease in price, but part of the decrease is due
Inflation Types to quality adjustment.3 For example, imagine a computer
One type of inflation is cost-push inflation. This occurs model that is the same price in year 1 and year 2, but the
when the costs of production (including wages and raw year 2 version of the computer has a faster processor
materials) increase and those higher costs are passed and larger hard drive. In reality you are getting more
on to consumers. For example, if the minimum wage computer for the same amount of money; in “real”
increases from $9 an hour to $15 an hour, firms may (inflation adjusted) terms, the price of the computer has
raise prices of their products because of the higher cost decreased from year 1 to year 2, even if the price you
of wages. If firms raise prices, consumers will pay more. pay at the cash register is exactly the same.
Inflation also occurs when the overall quantity of goods Measuring Inflation
and services demanded by consumers exceeds the overall
Inflation is the increase in the average price of many goods
quantity of goods and services supplied by producers.
and services, and the most widely reported measure of
This is called demand-pull inflation, and it occurs when
inflation is the consumer price index, or CPI. The CPI
consumers have more money and want to spend it. This
measures the average change over time in the prices
is often referred to as “too much money chasing too few
paid by urban consumers for a market basket of con-
goods.” In this case, spending increases at a rate that out-
sumer goods and services. Urban consumers represent
paces production and usually occurs in an expanding
about 93 percent of the total U.S. population.4 The CPI
economy.
does not measure inflation for people living in rural areas,
What’s Not Inflation serving in the Armed Forces, or living in institutions. Since
1913, a federal agency, the Bureau of Labor Statistics
Prices tend to rise over time. But increases in the price of
(BLS), has gathered this information by contacting busi-
a single good or service, or even a few goods or services,
nesses to collect and record the prices of items. The BLS
do not indicate that the economy is experiencing inflation.
releases this information monthly, and researchers can
For example, postage rates have increased over the years
use the data to compare the prices of goods and services
(Table 1). By itself, this would not indicate inflation.
in a month, in a quarter, or over a span of years.
Technological improvements and more competition in
the marketplace for specific items can also affect prices.
In these instances, the price of some individual goods
PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 3

Table 2 Figure 2
Eight Major Groups in CPI Market Basket Annual Consumer Price Index Change

Food and beverages Medical care

Housing Recreation

Apparel Education and communication

Transportation Other goods and services

SOURCE: U.S. Bureau of Labor Statistics.

The Market Basket

Although the CPI does not literally include all items, it is
quite representative of the goods and services consumers SOURCE: FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/
series/CPILFESL#0, accessed October 6, 2021.
buy on a regular basis. It includes a market basket of about
80,000 items that are sorted into more than 200 catego-
ries and arranged into eight major groups (Table 2).5 calculates the increase in the price of goods in another
time. For example, if the value in year 1 is 100 and it rises
Some items are weighted more heavily than others. For
to 103 in year 2, the percentage increase in the price of
example, housing makes up a significant part of con-
goods and services from year 1 to year 2 is equal to a 3
sumers’ budgets, so it is weighted more heavily. CPI
percent annual inflation rate. A 3 percent annual inflation
includes some taxes, such as sales and excise taxes, that
rate means that, on average, a dollar buys 3 percent
are directly associated with the prices of specific goods
fewer goods and services than it did the year before.
and services. However, the CPI excludes other taxes, such
as income and Social Security taxes, because they are not Annual CPI Inflation Rate Formula
directly associated with the purchase of consumer goods CPI later year – CPI earlier year
× 100
and services. Financial products like stocks and bonds are CPI earlier year
not included in the market basket. Essentially, the market
basket attempts to represent the goods and services
CPI versus Core CPI
purchased by the population represented by the CPI.6
Core CPI is the CPI excluding food and energy. Core CPI
Figure 2 shows the average annual change in the prices removes food and energy from the market basket because
paid by urban consumers for a market basket of consumer these price categories are more subject to frequent and
goods and services since 1983. From the graph we can sudden changes. For example, weather events may dis-
determine that a market basket of goods or services is rupt crops, or fluctuations in oil supply can impact fuel
set at 100 in 1983 and that the CPI increased to 200 in prices. Looking at the core inflation rate can make it
2005. This means the cost of the market basket doubled easier to see the long-term, underlying trends in other
from 1983 to 2005. categories. In other words, by examining core inflation,
economists can analyze what is happening to general
The Inflation Rate prices without being distracted by sudden changes in
The inflation rate is the percentage increase in the average food and energy prices.7 Figure 3 illustrates the difference
price level of goods and services over a period of time. in the measures, as it compares the percent change from
To figure the rate, the BLS sets the price of the market year to year in the CPI and core CPI.
basket during a particular time period equal to “100” and
PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 4

Figure 3 Figure 4
Percent Change from Year to Year: CPI and Core CPI, 2000-2021 Percent Change from Year to Year in Overall CPI and CPI for
Medical Care, Apparel, and Computers, 2005-2021

SOURCE: FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/

graph/?g=Gpix, accessed October 6, 2021.

SOURCE: FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/

graph/?g=eYT#0, accessed October 6, 2021. budgets. But consumers are more sensitive to changes
in price than to changes in quantity,8 and this tendency
allows companies to benefit from shrinkflation. For exam-
Inflation and Personal Finance ple, companies might reduce the size or quantity of their
Inflation affects consumers in different ways. As long as products without reducing the price. Shoppers can easily
personal incomes increase at the same rate as the infla- find downsized product packing in grocery store aisles.
tion rate, purchasing power remains constant and infla- For example, what used to be a 1 pound package of
tion is hardly noticeable. However, if consumers’ personal bacon may look the same and cost the same, but it may
income does not increase, or it increases at a slower rate have been downsized to only 12 ounces. Or a box of cereal
than the inflation rate, consumers aren’t able to buy the that used to be 18 ounces may have been downsized to
same amount of goods and services as they could previ- 16 ounces. Shrinkflation is inflation that can go unnoticed,
ously. This reduces purchasing power and is an important but it’s real.
factor in making a budget. Inflation also reduces the
value of people’s savings if the interest rate at which The Fed and Inflation
their savings grows is less than the rate of inflation. For Inflation is a concern to the Federal Reserve (Fed), the
example, if a savings account is paying 1 percent annual central bank of the United States. Congress has given
interest and the inflation rate is 2 percent, the purchasing the Fed a dual mandate—the responsibility to promote
power of the money in that savings account is reduced maximum employment and price stability. Price stability
by 1 percent. means maintaining a low and stable rate of inflation. To
Inflation is the average increase in prices for the typical meet its price stability goal, the Fed seeks to achieve
urban consumer, but few people are exactly “typical.” inflation that averages 2 percent over time.9 Sometimes
Individual consumers experience inflation differently inflation may be a bit above 2 percent, while at other
because they buy different items. The price of some times it may be a bit below 2 percent; but, on average, it
items may increase more rapidly than the price of others. should be 2 percent. Economists generally agree that a
Figure 4 illustrates the difference in the overall inflation low and stable inflation rate creates economic conditions
rate and the rate for individual categories. that encourage economic growth and employment.10

As “prices go up,” consumers experience the obvious When the inflation rate is less than 2 percent, the danger
effects of inflation and learn to make adjustments in their of deflation exists. Falling prices and deflation can signal
PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 5

a weak economic condition. An inflation rate greater Notes

than zero maintains an “inflation buffer”—that is, some 1 Bernanke, Ben S. “The Benefits of Price Stability.” Speech presented at The Center

“wiggle room”—which reduces the chances of deflation for Economic Policy Studies at Princeton University, Princeton, New Jersey,
February 24, 2006;
should the economy start to weaken. Fed policymakers https://www.federalreserve.gov/newsevents/speech/bernanke20060224a.htm.
see a 2 percent inflation target as a compromise—high 2 Tyko, Kelly. “How Much Does the Tooth Fairy Pay for a Lost Tooth? It May
enough to provide a buffer against deflation while low Depend On What’s In Your Wallet.” USA Today, August 22, 2019; https://www.
usatoday.com/story/money/2019/08/22/national-tooth-fairy-day-2019-heres-go-
enough to minimize the distortions that arise from high
ing-rate-lost-tooth/2075890001/.
inflation.11 3U.S. Bureau of Labor Statistics. “Measuring Price Change in the CPI: Computers,
Peripherals, and Smart Home Assistant Devices.” September 3, 2021;
Conclusion https://www.bls.gov/cpi/factsheets/personal-computers.htm.

Inflation affects the overall economy and individual 4U.S. Bureau of Labor Statistics. “Consumer Price Index Frequently Asked
Questions: Whose Buying Habits Does the CPI Reflect?” July 15, 2021;
consumers alike. The Fed is charged with addressing https://www.bls.gov/cpi/questions-and-answers.htm#Question_6.
inflation for maintaining a healthy economy. A desirable 5U.S. Bureau of Labor Statistics. “Consumer Price Index Frequently Asked
goal for inflation and the economy may be described as Questions: What Goods and Services Does the CPI Cover?” July 15, 2021;
the “Goldilocks Effect.” This is another way of saying “not https://www.bls.gov/cpi/questions-and-answers.htm#Question_10.

too hot and not too cold, but just right” as in the fairy tale 6 U.S. Bureau of Labor Statistics (2021). See footnote 5.
The Three Bears. 7 See “What Is ‘Core Inflation,’ and Why Do Economists Use It Instead of Overall
or General Inflation To Track Changes in the Overall Price Level?” Federal Reserve
Inflation is also embedded in personal finance and has Bank of San Francisco, October 2004; https://www.frbsf.org/education/publica-
tions/doctor-econ/2004/october/core-inflation-headline/.
effects in everyday decisions. It affects consumers based
on different situations. When inflation increases, savers
8Rosalsky, Greg. “Beware Of ‘Shrinkflation,’ Inflation’s Devious Cousin.” NPR Planet
Money, July 6, 2021;
may lose purchasing power and spenders need more https://www.npr.org/sections/money/2021/07/06/1012409112/
dollars for purchasing goods and services. Yes, every- beware-of-shrinkflation-inflations-devious-cousin.

one knows that inflation means “prices go up,” but there’s 9 The Federal Reserve uses the personal consumption expenditures price index
(PCEPI) to assess whether it is achieving its dual mandate.
a lot to learn about inflation and the real effects on
10 Bernanke, Ben S. (2006). See footnote 1.
consumers.
11Ihrig, Jane; Peneva, Ekaterina and Wolla, Scott. “Inflation Expectations, the
So, what’s a dollar worth? To answer this, the Tooth Fairy Phillips Curve, and the Fed’s Dual Mandate.” Federal Reserve Bank of St. Louis
gives us a clue: Inflation is real and the value of a dollar Page One Economics, Summer 2021;
https://research.stlouisfed.org/publications/page1-econ/2021/07/15/inflation-
changes with time. n expectations-the-phillips-curve-and-the-feds-dual-mandate.

Please visit our website and archives at http://research.stlouisfed.org/publications/page1-econ/ for more information and resources.
© 2021, Federal Reserve Bank of St. Louis. Views expressed do not necessarily reflect official positions of the Federal Reserve System.
PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 6

Name___________________________________ Period_______

Federal Reserve Bank of St. Louis Page One Economics ®:

“A Dollar’s Worth: Inflation Is Real”

After reading the article, select the best answer to each question.

1. Which statement is an example of inflation?

a. The price of gasoline increases by $1 a gallon after a weather disaster.
b. The average price level of many things you buy decreases over time.
c. The price of a gallon of milk increases by 50 cents in one week.
d. The average price level of many things you buy increases over time.

2. Louisa has a savings account that pays interest at an annual rate of 2 percent. The current annual inflation rate is 4 percent.
Based on this information, and assuming these rates stay constant in the future, which statement is true?
a. The purchasing power of Louisa’s savings account income increases by 2 percent each year.
b. The purchasing power of Louisa’s savings account income decreases by 2 percent each year.
c. The purchasing power of Louisa’s savings account income remains the same each year.
d. The purchasing power of Louisa’s savings account income decreases by 6 percent each year.

3. Which statement is true based on Figure 4 in the article?

a. Apparel prices increased more than medical care prices.
b. Medical care prices increased while computer prices decreased.
c. The overall CPI is the same as the CPI for computers.
d. Medical care prices increased at the same rate as computer prices.

4. Which statement is true based on Figure 1 in the article?

a. The purchasing power of the dollar remained the same in the past 10 years.
b. The purchasing power of the dollar was more in 1995 than in 2020.
c. The purchasing power of the dollar increased in the past 5 years.
d. The purchasing power of the dollar increased from 1983 to 1993.

5. Inflation
a. is a concern for the nation’s economy but not for individuals.
b. affects individual consumers in different ways.
c. is a concern for individuals but not for the overall economy.
d. causes the value of a dollar to increase over time.

6. Which statement is true based on Figure 2 in the article?

a. The average annual change in the prices paid by urban consumers for a market basket of consumer goods and services
remained the same from 1983 to 2010.
b. The figure shows the annual change in the prices paid by rural consumers for a market basket of consumer goods and
services from 1983 to 2020.
c. Consumers needed more dollars to buy the same goods and services in 2020 than they needed in 1983.
d. Consumers needed fewer dollars to buy the same goods and services in 2020 than they needed in 1983.
PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 7

7. Kara’s annual income is $32,000. She feels financially secure knowing she will receive a 2 percent raise each year. The current
inflation rate is 3 percent. Which statement best describes Kara’s purchasing power going forward?
a. Kara’s purchasing power depends on the inflation rate each year.
b. Kara’s purchasing power will decrease 3 percent each year.
c. Kara’s purchasing power will increase 2 percent each year.
d. Kara’s purchasing power will remain the same each year.

8. The CPI market basket

a. intends to be representative of the goods and services an average urban consumer buys on a regular basis.
b. is made up of eight major groups of goods and services that 93 percent of the people in rural areas and in the Armed
Forces buy most often.
c. includes fewer major groups of goods and services than the number of groups measured by the core CPI.
d. is made up of six major groups of goods and services that 93 percent of the people in urban areas buy most often.

9. Cost-push inflation
a. is often referred to as “too much money chasing too few goods.”
b. is the same type of inflation as demand-pull inflation.
c. does not affect the individual consumer.
d. is caused by an increase in production costs.

10. The Federal Reserve

a. seeks to achieve inflation that is as close to 0 percent as possible.
b. seeks to achieve an inflation rate above 5 percent to promote economic growth.
c. seeks to achieve inflation that averages 2 percent over time.
d. does not monitor the inflation rate in any way.

11. All consumers experience the same inflation rate because everyone buys the same market basket.
a. True
b. False

12. Tanika loaned her friend $5,000. Her friend paid back $5,020 at the end of the year. This paid the loan in full and included
$20 for interest. If the inflation rate for the year was 2 percent, Tanika actually lost purchasing power by making this loan.
a. True
b. False

13. The BLS collects data on the price of a market basket of goods. The information is released on a monthly basis.
a. True
b. False

14. Consumers do not need to be concerned with inflation or inflation rates. These are important only to overall economic
conditions.
a. True
b. False
PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 8

Extension Activities
1. Open the online CPI inflation calculator found at the following link: http://data.bls.gov/cgi-bin/cpicalc.pl.
2. Increases in the price of a single good or service, or even a few goods or services, do not indicate that the economy
is experiencing inflation, and individual price increases may not follow the same increase as the inflation rate. But it’s
interesting to use the CPI calculator to determine what the inflation-adjusted prices of individual items might be based
on the inflation rate. Use the CPI inflation calculator to find what the price of each item in the chart might be in the
current year based on their prices in 1981.

Item Price in 1981 Inflation-adjusted price (20___)

First-class stamp $0.20 $

Gallon of gas $1.38 $

Dozen eggs $0.90 $

Gallon of milk $2.22 $

TOTAL

SOURCE: www.1980sflashback.com/1981/economy.asp.

3. What was the total price of the four items in 1981?

4. If the prices of these items increased at the rate of inflation, what would the total price of the items be in the
current year?

5. Is the price of any of the four items actually more now than the inflation-adjusted price? If so, what items?
Are any prices actually less now than the inflation-adjusted price? If so, what items?

6. Why is it important for personal income to increase at least at the same rate as inflation?