Measuring prices and inflation

Inflation is a sustained rise in the general level of prices. When inflation is 3 %, a basket of goods and services that cost 100 dollars last year costs about 103 dollars this year, and each dollar buys about 3 % less. For most of the period from the early 1990s to 2020, inflation in Canada and the United States stayed close to 2 % and attracted little public attention. Then, in 2021 and 2022, it surged to the highest rates in four decades, and cost of living became a dominant political issue. In 2026 an oil price shock pushed headline inflation up again. This lesson explains how inflation is measured, why the measures differ, what inflation costs, and what the 2021–2023 episode taught economists.

Price indexes

A price index measures the cost of a fixed basket of goods and services relative to its cost in a base period. The most widely watched is the consumer price index (CPI), which tracks the prices that households pay. To build it, a statistical agency first surveys household spending to decide what goes into the basket and how much weight each item gets. Shelter might be weighted at about a quarter or more of the basket, food at about a sixth, transportation at about a sixth, and so on. Each month, price collectors record the prices of thousands of specific items across the country. The agency then calculates the cost of the basket at current prices, divides by its cost in the base period, and multiplies by 100.

The inflation rate is the percentage change in the price index, usually measured over twelve months to avoid seasonal patterns. If the CPI rises from 160.0 to 164.8 over a year, the inflation rate is \( (164.8 - 160.0) \div 160.0 \times 100 = 3.0 \) %. Monthly changes are often reported too, sometimes after seasonal adjustment, and can be annualized in the same way as quarterly GDP growth.

# CPI from a weighted basket and item contributions to inflation
basket = {  # item: (quantity, base price, current price)
    'Food (kg)':        (10, 6.00, 6.30),
    'Rent (months)':    (1, 1500.00, 1560.00),
    'Gasoline (L)':       (60, 1.50, 1.80),
}
base = sum(q * p0 for q, p0, p1 in basket.values())
now = sum(q * p1 for q, p0, p1 in basket.values())
cpi = now / base * 100
print(f"Base cost {base:,.2f}  current cost {now:,.2f}  CPI {cpi:.1f}  inflation {cpi - 100:.1f} %")
for item, (q, p0, p1) in basket.items():
    weight = q * p0 / base
    change = p1 / p0 - 1
    print(f"  {item:18s} weight {weight * 100:5.1f} %  price change {change * 100:5.1f} %  "
          f"contribution {weight * change * 100:4.2f} pts")

Base cost 1,650.00  current cost 1,731.00  CPI 104.9  inflation 4.9 %
  Food (kg)          weight   3.6 %  price change   5.0 %  contribution 0.18 pts
  Rent (months)      weight  90.9 %  price change   4.0 %  contribution 3.64 pts
  Gasoline (L)       weight   5.5 %  price change  20.0 %  contribution 1.09 pts

The contributions add up to the overall inflation rate. Agencies publish similar breakdowns, which is how analysts can say, for example, that gasoline accounted for most of the rise in inflation in a given month.

The Bureau of Labor Statistics publishes the CPI monthly. The most common version, CPI-U, covers all urban consumers, about 90 % of the population. Basket weights are updated every year based on the Consumer Expenditure Surveys. Shelter is the largest component; for homeowners, the BLS uses owners' equivalent rent, an estimate of what owners would pay to rent their own homes, rather than mortgage payments or house prices.

Core inflation and other measures

Headline CPI inflation can swing sharply because of volatile items such as gasoline and fresh food, whose prices respond to weather, wars and global commodity markets. Central banks therefore watch measures of core inflation that strip out or down-weight volatile components and give a better signal of underlying inflation pressure.

In the United States, core CPI excludes food and energy. The Federal Reserve's official inflation goal, however, is defined in terms of the personal consumption expenditures (PCE) price index published by the BEA, which covers a broader range of spending (including spending on behalf of households, such as employer-paid health insurance) and updates its weights continuously. PCE inflation usually runs a few tenths of a percentage point below CPI inflation. In September 2026, headline CPI inflation was 3.7 %, well above core inflation, because of the jump in gasoline prices.

The CPI and the GDP deflator differ in two main ways. The deflator covers all domestically produced goods and services, including capital goods and government services, while the CPI covers consumer purchases, including imports. So a rise in the price of imported cars raises the CPI but not the deflator, and a rise in the price of exported oil raises the deflator more than the CPI. And the CPI uses a fixed basket, while the deflator's weights reflect current production.

Is the CPI biased?

For decades economists have argued that a fixed-basket CPI tends to overstate increases in the cost of living. Substitution bias arises because consumers switch toward goods that have become relatively cheaper, but a fixed basket assumes they keep buying the same quantities. Quality bias arises when products improve: if a new phone costs the same as last year's but is faster and has a better camera, part of what looks like an unchanged price is really a price cut. New goods bias arises because new products enter the basket only after a delay, missing the early price declines and the gains to consumers from their availability. Outlet bias arises when consumers shift to discount stores and online sellers. A US commission led by Michael Boskin estimated in 1996 that these biases overstated inflation by about 1.1 percentage points a year; since then, agencies have adopted quality adjustments, more frequent basket updates and chained indexes, and the remaining bias is generally thought to be smaller, perhaps around half a point.

On the other hand, many households feel that official inflation understates their own experience. This is partly because frequently purchased items such as groceries and gasoline loom large in perception, partly because individual baskets differ from the average (renters, homeowners with new mortgages, and older people all face different price changes), and partly because people often compare current prices with those of several years ago rather than last year. The cumulative rise in the price level since 2020, around a fifth in both countries, has not been reversed even though inflation has come down. Lower inflation means prices are rising more slowly, not that they are falling.

Using price indexes: real values

Price indexes let us compare money amounts across time. To convert a dollar amount from year A into year B dollars, multiply by the ratio of the price index in year B to that in year A. A real wage is a nominal wage adjusted for inflation. If your hourly wage rose from 25 dollars to 26.50 dollars (a 6 % increase) while prices rose 4 %, your real wage rose by about 2 %; precisely, 1.06 ÷ 1.04 − 1 = 1.9 %.

Indexing ties payments to a price index so that their real value is preserved.

In the United States, Social Security benefits receive an annual cost-of-living adjustment based on a version of the CPI for wage earners, and federal income tax brackets are indexed using the chained CPI, which grows a little more slowly. Treasury Inflation-Protected Securities (TIPS) pay interest and principal that rise with the CPI.

Why inflation is costly

Moderate, predictable inflation is less harmful than many people believe, but high or unpredictable inflation imposes real costs. Shoe-leather costs are the resources spent minimizing cash holdings when money loses value quickly. Menu costs are the costs of changing prices frequently. Relative-price distortions arise because firms change prices at different times, so prices give misleading signals about relative scarcity. Tax distortions arise because tax systems are often based on nominal values: a capital gain that merely reflects inflation is still taxed, raising the effective tax on saving. Unexpected inflation redistributes wealth from lenders to borrowers, because loans are repaid in dollars that buy less than expected, and it hurts people on fixed nominal incomes. And high inflation creates uncertainty that makes long-term planning and contracting harder, discouraging investment.

Deflation, a sustained fall in the price level, is also costly. It raises the real burden of debts, can lead consumers to postpone purchases in expectation of lower prices, and limits central banks' ability to cut real interest rates when nominal rates are already near zero. Japan's experience with mild deflation from the late 1990s to the early 2010s is the standard cautionary example. This is one reason central banks aim for low positive inflation, typically 2 %, rather than zero.

Very high inflation, called hyperinflation (conventionally, more than 50 % a month), is almost always caused by governments printing money to finance large deficits. Germany in 1923, Zimbabwe in 2008 and Venezuela in the late 2010s are well-known cases. In these episodes, money loses its usefulness as a store of value and unit of account, and economic life is badly disrupted. Lesson 7 explains the link between money growth and inflation.

The inflation surge of 2021–2023

After the pandemic recession of 2020, inflation rose rapidly. In June 2022 twelve-month CPI inflation peaked at 8.1 % in Canada and 9.1 % in the United States, the highest since the early 1980s. Economists identify several causes, and still debate their relative importance. On the supply side, pandemic disruptions snarled global supply chains, shipping costs soared, semiconductor shortages limited car production, and Russia's invasion of Ukraine in February 2022 pushed up energy and food prices. On the demand side, large government support programs and very low interest rates boosted spending, and consumers shifted spending from services toward goods just when goods were hardest to supply. Labor markets became very tight, with job vacancies at record highs. Many economists now conclude that the combination of strong demand and constrained supply was what produced such high inflation; neither alone would have done it.

Inflation then fell. Supply chains recovered, energy prices eased, and central banks raised interest rates rapidly: the Bank of Canada from 0.25 % to 5 % between March 2022 and July 2023, and the Federal Reserve from near zero to a range of 5.25–5.50 % over a similar period. By 2024 inflation was back near target in both countries. Unusually, disinflation occurred without a recession and with only a modest rise in unemployment, an outcome sometimes described as a soft landing. Lessons 8, 9 and 12 examine the policy decisions in more detail.

In 2026 a new shock hit. After war broke out between the United States and Iran in late February 2026, oil prices rose sharply, with Brent crude spending long periods above 100 US dollars a barrel. Gasoline prices jumped by more than a quarter over the year, and headline inflation rose above 3 % in both countries. Central banks faced a classic dilemma, discussed in lesson 9: an oil shock raises prices while also weakening growth.