Inflation Rate
The inflation rate measures the change in price level over time, and it's the reason a car would cost about 5 bucks in the 1900s, but now you need a small fortune for a popcorn and soda at the movie theater.
Inflation has to be measured relative to a base year, and often by measuring changes in prices of a standard basket of goods. On the other hand, measuring inflation today relative to 1900 might not make the most sense, because cars, phones, TVs, and a whole host of other common place modern inventions won't be included in the standard basket of goods from a century ago.
There are two forms of inflation: demand-pull and cost-push. As the aggregate demand increases, both economic output and price level increase, pushing up the inflation rate. This relationship is the basis of the Phillips curve. On the other hand, when input costs increase for companies, they drive up prices to maintain their profit margins, which also increases inflation. Cost-push inflation lowers economic output, and creates the particularly-difficult-to-deal-with stagflation.
Example:
You're ready to start your Primo Pizza Parlor, but you need money for a pizza oven, ingredients, workers, a store, and a whole host of other things. So you go to a bank, apply for a loan for $100,000, and promise to pay it back in 5 years. The bank says, "Sure, we'll give you the dough, but you'll have to pay interest on it."
The interest you pay helps account for the expected rate of inflation, because when you give back the $100,000 in 5 years, it won't be worth as much.
Related or Semi-related Video
Finance: What are T-Notes, T-Bonds and T...19 Views
Finance allah shmoop what are t notes t bills and
tips All right we'll see that tea in there Well
it stands for treasury and all of these air one
flavor or another of government debt that is the u
s government raises cash for itself teo fix roads build
bridges and erect statues of lebron james dunking on the
statue of liberty or you know whatever else he thinks
the public wants or needs it does that by auctioning
off these debt securities with the promise of its full
faith and credit to pay back the money is the
paper specifies well t notes are quote mid range unquote
paper in that they generally have maturity ease of two
three five seven and ten years that's a teen note
t notes carry a stated interest rate and look a
lot like a normal corporate bond paying interest twice a
year T bills on the other hand are generally very
short term paper usually coming due within a few days
all the way up to a year they're sold or
auctioned at a discount meaning that the t bill might
promise to pay a thousand bucks if it comes due
In six weeks you might pay nine hundred ninety six
dollars for it and you get a whopping fee Four
bucks an interest for your six weeks hard work of
owning that t bill and just you know sitting there
kind of looks like a zero coupon bond Okay so
now we have tips that's tips treasury inflation protected securities
tips as in show us your tips getting Why do
we have such a thing Well the problem with super
duper safe bonds like those of the u s government
is that investors holding them a long time often do
worse after taxes than inflation meaning that if inflation is
growing at three percent a year in their bonds are
only returning one percent a year after tax while then
the investors actually losing two percent a year in buying
power and that's a problem in nineteen nineties when investors
started to realize this issue well they began Tio you
know stop buying u s government bonds and that's a
huge problem for a country that desperately needs to borrow
cash all the time So rather than risk a liquid
marketplace where there's just no buyers buying government paper uncle
Sam created tips which basically adjust the end value of
the principle that investors get based on the c p
i or consumer price index which is a measure of
the average selling prices of a carton of milk a
gallon of fuel a dozen eggs and a grand slam
breakfast at denny's Basically what happens is that the price
of the principal the investor gets back goes up with
inflation over time So they're not losing buying power and
that's a big deal That's it go Enjoy your grand 00:02:33.995 --> [endTime] slam It'll be fourteen thousand dollars in fifty years
Up Next
What is inflation and how does it work? Inflation is the gradual increase in prices over time. You might today pay 100x for the commodity coffee wh...