In general, inflation is the extent to which your money today will buy less in the future. You have probably come face-to-face with inflation at some point in your life. For example, you may have noticed that the price of a movie ticket has gone up, or that the cost of your favorite food items has increased. There are many reasons why prices go up:

  1. Inflation can be caused because more people want a particular product. For example, on Valentine's Day, roses are more expensive because husbands and boyfriends want to buy them for their loved ones.

  2. Inflation can be caused by companies raising prices in response to the increase in the amount of money it takes to make the products they are selling to the public. For example, car prices went up slightly when automobile companies were required by law to include air bags in cars.

  3. Inflation can be caused by planned shortages. For example, if the companies that produce the oil used to make gasoline decide to cut back on the amount of oil they ship to customers (as they did in the early 1970s and 1980s, way before you were born), this could increase the price of oil. I

  4. Inflation can be caused by fear of shortages. For example, during a war or during rumors of war , certain items such as oil may go up in price because people are scared their supplies will be cut off. For example, there are those who said that the reason the price of gasoline exceeded $3.50 per gallon in many parts of the United States in 2007 was because people were scared of the result of the conflicts between U.S. and oil producing countries in the Middle East such as Iraq and Iran. 

CPI - How Inflation Is Measured

The Consumer Price Index or CPI is one measure of inflation used by the government. The U.S. Labor Department produces the monthly CPI, which measures the increase in the price of a given "basket" of goods and services purchased by typical consumers. It covers a large number of items, including food, housing, apparel, transportation, medical care, and entertainment.

A very simplified example of how the CPI calculation works is that prices are added together for the typical items people buy and this sum is compared to the same "basket" of goods a year later. For example, a basket of goods could include things like milk, gas, meat, rent, clothes, and other things essential for everyday life. Adding up the prices of these items one year and adding up the prices a year later can tell you whether prices are moving up or down. The percentage increase in price for these goods will be the inflation number. Of course, prices can also go down, too, in which case you've got deflation.

Inflation is given in percentage terms. In 2006, the inflation rate reflected in the change in the CPI, was about 3.2%. You can interpret this number to mean that, in general, basic items cost 3.2% more in 2006 than in 2005. The highest inflation rate based on the CPI was 18% in 1918 and the lowest was negative 10.5% in 1921 (i.e. a deflation of prices between 1920 and 1921). Statistics on inflation rate (as computed using the CPI index) can be found at the website of the U.S. Department of Labor,www.bls.gov.The inflation rate from 1913 is shown on the bottom of this file. The table from which the data was pulled is here: cpi.data. The last column in this table shows the yearly inflation rate as determined by computing the year-to-year changes in the CPI.

To understand how inflation affects the stock market, you first have to understand what determines stock prices of the companies traded on the various exchanges we discussed earlier. The stock price of a company depends on how much that company is expected to make in the future. To make it perfectly clear, net earnings (also known as net income and net profit) drive a company's stock price. In other words, the more you expect a company to earn in the future, the higher the value of the company's stock.

If inflation is high, a company's earnings in the future are worth less and less. That's because what the company earns in the future can't buy the same things it can buy today. If a company's future earnings are worth less in the future, then its stock price will go down. Therefore, in general, the higher the inflation, the worse things are for the stock market. The relationship between stock prices and inflation is further explained in another section of this website.

To show you a real example of how inflation rate (as reflected in the consumer price index) affects the stock market, here is an excerpt from the May 12, 2006 edition ofThe Wall Street Journal:

"After falling short of a record close by 80 points Wednesday, the blue-chip average (Dow Jones Industrial Average) stumbled 262 points in two days as investors bit their nails over the prospects for inflation and interest rates. The trigger for the tumble: worriies that Washington's central bankers will have to keep boosting short-term rates above their current 5% level to stamp out inflation.....Concerns about inflation were coming from a variety of sources, economists said, including higher oil and gold prices."

The passage above was referring to a big drop of the Dow Jones Industrial Average over a two-day period from May 11 to May 12, 2006. This drop was caused primarily by the U.S. Labor Department's report that petroleum prices jumped by 11.5% in April 2006 and that other prices that are included in the CPI also went up dramatically in that period.

Inflation also affects the interest rate on borrowing money. (Interest rates are the fees you pay for borrowing money). The higher the inflation rate, the higher the interest rate you will pay in order to borrow money. This is because lenders want to make up for the fact that the higher inflation will make the interest paid them by borrowers worth less and less. So, to make up for these losses, they have to increase the amount of interest they are paid.