Inflation

An inflation rate is a growth rate applied to a level series. A statistical agency prices a fixed basket of consumption goods and services in each period, aggregates those prices using expenditure weights into an index number, and the inflation rate is the percentage change in that index: the current index value divided by the index value one year earlier, minus one, expressed as a percentage. Because the calculation is a ratio of two levels, the base year is irrelevant to the rate itself.

Sequential and year-over-year measures answer different questions. A month-over-month change annualized captures current momentum but is noisy and sensitive to seasonal adjustment; a year-over-year change smooths seasonality but embeds base effects, so a single large price move continues to influence the reported rate for twelve months before dropping out of the comparison window.

The standard consumer price index is a Laspeyres index: it holds quantities fixed at base-period levels and lets prices vary. This construction creates an upward bias in measured inflation. Consumers substitute away from goods whose relative prices rise, so a fixed basket overweights the items that became expensive; new goods and quality improvements also enter the basket with a lag. A Paasche index, which uses current-period quantities, embeds the opposite substitution bias and tends to understate inflation. The Fisher index, the geometric mean of the two, is a compromise measure.

Agencies mitigate bias through chained indices that update weights frequently and through hedonic adjustment, which strips out the portion of a price change attributable to improved product characteristics rather than pure inflation.

Demand-pull inflation arises when aggregate demand exceeds the economy's sustainable productive capacity, typically after monetary or fiscal stimulus, with the output gap positive and labour markets tight. Cost-push inflation arises from adverse supply conditions: higher commodity or energy prices, wage growth in excess of productivity, or supply chain disruption. The distinction matters for policy, because cost-push pressure raises prices while reducing output, confronting a central bank with a genuine trade-off rather than a straightforward tightening decision.

Expectations transmit both channels into persistence. If households and firms expect elevated inflation, they bargain for higher wages and reset prices pre-emptively, and a temporary shock becomes embedded. Anchored expectations are therefore the operational objective behind most inflation-targeting mandates.

Inflation converts nominal quantities into real ones throughout finance. The Fisher relation states that a nominal interest rate approximately equals the real rate plus expected inflation, so a rise in expected inflation raises required nominal yields; the spread between conventional government bond yields and inflation-linked bond yields of equal maturity is read as a market-implied breakeven inflation rate. Unexpected inflation redistributes wealth from creditors and holders of fixed nominal claims to borrowers, and it distorts reported financial results through inventory accounting and historical-cost depreciation.

At Level I a candidate should compute an inflation rate from index levels, distinguish inflation, disinflation and deflation, identify which index bias a construction implies, classify a shock as demand-pull or cost-push, and translate between nominal and real returns.