Inflation: what it is, what causes it and how it is measured
Inflation is the rate at which the general price level rises, and almost every money figure in finance has to be read against it. This lesson explains how a consumer price index is built, why a falling rate is not falling prices, and the three classic causes of inflation. A calculator uses the real weights of the US consumer price index to show how one shock, such as energy, reaches the headline rate, and why a household with a different budget feels a different rate. It closes with how Unilever and Procter & Gamble split their sales growth into price and volume.
- Level
- Beginner
- Reading time
- About 26 minutes
- Know this first
- Supply, demand and prices
By the end you will be able to:
- tell inflation, deflation and disinflation apart, and a rate from a level
- calculate an inflation rate and a change in purchasing power from price index values
- explain how a basket and its weights produce headline and core inflation
- describe demand-pull, cost-push and expectations as causes of inflation
- read a company's sales growth as price plus volume
A rate is not a level
Inflation is a rise in the general level of prices. It is a rate: how fast prices, taken together, are climbing. When inflation is 3% a year, a basket of goods that cost $100 last year costs $103 this year, and money buys about 3% less than it did. The opposite, a fall in the general price level, is deflation. A slowing of inflation, from 7% to 3% say, is disinflation, and it is not a fall in prices. Prices are still rising, only more slowly. Keeping the rate and the level apart is the most useful habit in this whole subject.
Inflation matters to finance because every other number is measured in money, and money changes in value. A salary, a loan balance, a company's sales and an investment return all look different once they are adjusted for what the money can buy. The lesson on compound interest showed how growth builds up over time. Inflation compounds in the same way, working against the saver and in favour of someone who owes a fixed sum. The previous lesson, supply, demand and prices, explained how the price of one good is set. This one asks what happens when prices as a whole move.
How inflation is measured
No one can follow every price in an economy, so statisticians price a fixed basket of goods and services and track what it costs. The US Bureau of Labor Statistics describes its Consumer Price Index (CPI) as measuring the average change over time in the prices paid for a representative basket of consumer goods and services, covering more than 200 categories grouped into eight major groups. The categories are given weights, based on what families actually report buying in the Consumer Expenditure Surveys. A group on which households spend more counts for more. BLS notes that there is a time lag between the survey and its use in the CPI.
The result is an index number. BLS sets the average level over 1982, 1983 and 1984 equal to 100, so an index of 110 means prices have risen 10% since that base period. The base period is arbitrary. What matters is the change from one date to another.
BLS publishes the all-items index, which is the headline rate, and also an index that leaves out food and energy, called core inflation. BLS says some users rely on the core measure because food and energy prices are relatively volatile, which lets them focus on the underlying rate. Neither is the right one for every purpose. And neither is any one person's inflation: BLS bases the index on the average household, so it says that if you spend more of your budget on, say, medical care, your personal rate may be higher than the CPI, and the index seldom mirrors a particular consumer's experience.
The rate fell, the level did not
The table shows the US CPI at the end of each year from 2019 to 2025, with the inflation in each year and the cumulative change since the end of 2019. BLS did not publish a figure for October 2025 because of a lapse in US government funding, so the table uses December values only.
| Year-end (December) | CPI-U index, 1982-84 = 100 | Inflation in the year | Prices compared with end of 2019 |
|---|---|---|---|
| 2019 | 256.974 | n/a | base |
| 2020 | 260.474 | +1.4% | +1.4% |
| 2021 | 278.802 | +7.0% | +8.5% |
| 2022 | 296.797 | +6.5% | +15.5% |
| 2023 | 306.746 | +3.4% | +19.4% |
| 2024 | 315.605 | +2.9% | +22.8% |
| 2025 | 324.054 | +2.7% | +26.1% |
Inflation was 1.4% in 2020, rose to 7.0% in 2021 and 6.5% in 2022, and then fell to 3.4%, 2.9% and 2.7%. A reader who sees only the rate would think the episode is over. The level tells the rest of the story: at the end of 2025 prices were 26.1% higher than at the end of 2019, so a basket that cost $100 then cost $126.10. Put the other way, $100 of purchasing power at the end of 2019 bought only $79.30 worth at the end of 2025. Disinflation slowed the climb, and it did not bring prices back down.
What causes inflation
The Reserve Bank of Australia's explainer sorts the causes into three groups.
Demand-pull. When total demand for goods and services rises above what the economy can sustainably produce, the excess demand pushes prices up across many sectors. Firms hire and pay more, household incomes rise, and spending rises further. It is like the shift of a demand curve in the previous lesson, but applied to the whole economy at once.
Cost-push. When total supply falls, often because production costs rise, prices follow. The RBA gives higher prices for oil and other imported inputs as an example, and notes that these costs spread to other goods such as transport and groceries. A currency that loses value makes imports dearer, which adds to inflation directly. Here the supply curve shifts left, as in the egg example. A large or lasting supply shock can produce stagflation, which combines weak output and rising unemployment with high inflation.
Expectations. What households and firms expect prices to do affects how they set prices and wages today, which can make expectations come true. If expectations stay anchored to the central bank's target, a temporary shock tends to fade. If they become unanchored, higher inflation can persist. The RBA says it is much easier for a central bank to manage inflation if expectations are anchored. Expectations cannot be observed directly, so they are estimated from surveys and from the prices of financial assets such as government bonds.
The September 2026 US release, used below, reports energy prices up 20.4% over twelve months. The table gives the size of the rise but not its cause, so this lesson uses it only to show how a cost shock in one group reaches the headline rate.
One shock, two budgets
The calculator uses the weights BLS published for the US CPI in its September 2026 release: food 13.5%, energy 7.4%, shelter 35.3% and everything else 43.8% of the basket. Set how much each group's prices change over a year, and it computes the headline rate, the core rate and what energy adds. It then does the same sum for an invented household that spends 20% of its budget on food, 12% on energy, 38% on shelter and 30% on everything else, shares chosen only to show that a household with a different budget gets a different inflation rate. At the starting settings energy rises 20%, food 3%, shelter 3% and everything else 2%.
If energy prices change by 20%, food by 3%, shelter by 3% and everything else by 2% over a year, headline inflation is 3.82%. Energy supplies 1.48 percentage points of that. Core inflation, which leaves out food and energy, is 2.45%. The household that spends more of its budget on food and energy sees 4.74%, 0.92 percentage points above the headline rate.
Four experiments. First, at the starting settings the headline rate is 3.82% and the core rate is 2.45%. Energy is only 7.4% of the basket, yet it supplies 1.48 points of the headline, because it moved so much. Second, set energy to 0%. The headline falls to 2.34%, now below the core rate of 2.45%. Food is still rising a little faster than core, but energy is flat, and its pull downward is the larger of the two. Third, set energy to −20% and food to 0%. The headline drops to 0.45% against a core of 2.45%. Cheaper energy and food can pull the headline well below the core rate. Fourth, return to the starting settings and raise shelter to 8%. Shelter has the largest weight, 35.3%, so a rise of 5 points in shelter adds 1.77 points to the headline. The same 5-point rise in energy, a much smaller group, would add only 0.37. The household with the different budget is the other lesson. At the starting settings it sees 4.74%, which is 0.92 points above the headline, because energy and food take a bigger share of its spending. Move energy to −20% and it sees a lower rate than the headline. The index is an average, and nobody lives on the average budget.
Where the 3.7% came from
The September 2026 release reports US consumer prices up 3.7% over twelve months. It also reports food up 2.5%, energy up 20.4% and everything except food and energy up 2.6%. A reader might try to add these up with the shares in the basket today and find a different answer: weighting the three changes by their August 2026 shares gives 3.9%, not 3.7%. The weights are the problem. Energy rose 20.4% during the year, so its share of the basket is larger now than it was a year ago. The right weights for a twelve-month change are the shares at the start of the year. Dividing each current share by one plus its price change recovers them, approximately:
| Group | Share of basket, August 2026 | Change over 12 months | Share a year earlier (derived) | Points of the headline rate |
|---|---|---|---|---|
| Food | 13.5% | +2.5% | 13.7% | 0.34 |
| Energy | 7.4% | +20.4% | 6.4% | 1.30 |
| Everything except food and energy | 79.1% | +2.6% | 79.9% | 2.08 |
| All items | 100.0% | +3.7% published | 100.0% | 3.72 |
With the year-ago weights the three contributions add up to 3.72 points, which matches the published 3.7% within rounding. Energy was about 6.4% of the basket a year earlier, yet it supplied 1.30 of the 3.72 points, or 35% of the total. This is an approximation, because the shares are for August and the changes run to September, and the published changes are rounded to one decimal place. It shows the main point: a small group with a large move can account for a large part of the headline rate.
How companies show inflation: price and volume
Inflation reaches a company through the prices it pays and the prices it charges. In its results a company shows the second part by splitting sales growth into price and volume. Unilever calls them underlying price growth, defined as the increase in turnover attributable to changes in prices, and underlying volume growth, which excludes any effect of price changes. Procter & Gamble reports organic sales, which exclude currency and acquisitions, and splits their change into price, volume and mix. The two companies report for different years and sell different mixes of products in different places, so the table is not a like-for-like comparison. It shows how to read the split.
| Measure | Unilever | Procter & Gamble |
|---|---|---|
| Year reported | Calendar year 2025 | Year to 30 June 2026 |
| Growth measure | Underlying sales growth | Organic sales growth |
| Growth | 3.5% | 1% |
| From price | 2.0 points | 1 point |
| From volume | 1.5 points | 0 points (volume and mix unchanged) |
| Share of the growth that was price | 57% | 100% |
Unilever's underlying sales growth of 3.5% came from 2.0 points of price and 1.5 points of volume, so about 57% of the growth was price. Procter & Gamble's organic sales growth of 1% came entirely from higher pricing, while volume and mix were unchanged, so all of it was price. A company that grows only by raising prices is selling the same quantity of goods. Whether that is good depends on its costs: if its own costs rise faster than its prices, its margin shrinks, and if it raises prices too far, customers may buy less, as the previous lesson showed with elasticity.
What this lesson leaves out
- One country's index. The data are US CPI figures. Other countries build their indexes with different baskets, weights and methods, so rates are not exactly comparable across borders.
- Four groups, not 200. The calculator folds the basket into four groups. The real CPI prices more than 200 categories, and each moves differently.
- Weights are for one month. The calculator applies the August 2026 weights to a coming year, which is a first approximation: the weights drift as relative prices change.
- The household is invented. Its shares show a principle. They are not a statistic about any real group.
- Causes interact. Real inflation usually has demand, cost and expectation elements together, and economists argue about their relative size in any one episode.
- The CPI has known limits. It measures a fixed basket of consumer goods and does not include income tax or the price of investments such as shares.
Common mistakes
Reading falling inflation as falling prices
Disinflation means prices rise more slowly. The table shows prices 26% above their 2019 level even after the rate fell to under 3%.
Averaging component changes without weights
Food up 2.5% and energy up 20.4% do not simply average to about 11%. Each counts in proportion to its share of spending.
Using the weights from the wrong date
For a change over a period, the starting weights are the right ones. Current weights overstate the effect of whatever rose most.
Treating the CPI as your own inflation
It is an average household's basket. Your rate depends on what you buy.
Comparing index numbers from different base periods
An index of 336.9 on a 1982–84 base and an index of 111.9 on a 2020 base cannot be compared directly. Compare changes, not levels.
Try it yourself
1. The US CPI was 256.974 at the end of 2019 and 260.474 at the end of 2020. What was inflation in 2020?
Show the working
260.474 ÷ 256.974 − 1 = 1.4%.
2. A basket cost $100 at the end of 2019. Using the index values of 256.974 and 324.054, what did it cost at the end of 2025, and what did $100 buy in 2025 terms?
Show the working
The price level rose by 324.054 ÷ 256.974 = 1.261 times, so the basket cost $126.10. The purchasing power of $100 fell to 100 × 256.974 ÷ 324.054 = $79.30.
3. Food is 20% of a household's budget and its prices rise 10%. Everything else is 80% of the budget and its prices do not change. What is the household's inflation rate?
Show the working
0.20 × 10% + 0.80 × 0% = 2.0%. The weights turn a 10% rise in one group into a 2% rise for the budget.
4. A worker's pay rises 3% in a year when inflation is 3.7%. What is the change in real pay?
Show the working
1.03 ÷ 1.037 − 1 = −0.68%. Pay rose in money terms and fell in purchasing power.
5. Inflation fell from 7.0% in 2021 to 2.7% in 2025. Why are prices still higher?
Show the working
Inflation is the rate of change of the price level. A positive rate, even a low one, still raises the level. Between the end of 2019 and the end of 2025 the level rose 26.1%, and no year in the table had a negative rate.
Where this is used
- A central bank sets its policy by comparing measured inflation with its target, and watches expectations as well as the current rate.
- A business writes a price rise into its budget and judges how much of its sales growth is price and how much is volume.
- An employee or a union compares a pay offer with inflation to see whether real pay is rising.
- An investor or saver adjusts returns for inflation to see the real growth of their money.
- Contracts such as rents and some pensions are tied to a price index, so they rise with measured inflation.
Key terms
- Inflation
- A rise in the general level of prices, expressed as a rate.
- Deflation
- A fall in the general level of prices.
- Disinflation
- A slowing of inflation. Prices still rise, but more slowly.
- Consumer price index (CPI)
- An index of the cost of a basket of goods and services bought by households.
- Base period
- The period on which the index is set to 100. For the US CPI it is 1982–84.
- Weight
- The share of the basket a group of goods represents.
- Headline and core
- The all-items rate, and the rate that leaves out food and energy.
- Demand-pull and cost-push
- Inflation caused by demand above supply, and by a fall in supply or a rise in costs.
- Inflation expectations
- What households and firms expect future inflation to be.
- Purchasing power
- What a unit of money can buy.
- Real and nominal
- Adjusted for inflation, and not adjusted.
Questions people ask
Is 3% inflation a fall in my money's value?
Yes, in purchasing-power terms. Money buys about 3% fewer goods than a year earlier, as measured by an average basket.
Why do other countries report different inflation numbers?
Each country's statistics agency builds its own basket, weights and methods, so rates are not exactly comparable across borders. The ideas are the same.
Why does the headline rate differ from core?
Because core leaves out food and energy, which are volatile and sometimes move a lot, as the energy example shows.
Does the calculator forecast inflation?
No. It adds up price changes you choose, using real weights. It does not predict what those changes will be.
Sources and review
- US Bureau of Labor Statistics, Consumer Price Index frequently asked questions (last modified 25 September 2025), for what the CPI measures, how the weights come from the Consumer Expenditure Surveys, the 1982-84 base period, the core measure and why a personal rate can differ.
- US Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers (CPI-U), Table 1, September 2026 (released 14 October 2026), for the relative importance of food, energy and all items less food and energy in August 2026 and the 12-month changes to September 2026.
- US Bureau of Labor Statistics, Consumer Price Index historical tables for the US city average, for the December CPI-U values from 2019 to 2025 and the note that October 2025 data are unavailable because of the 2025 lapse in appropriations.
- Reserve Bank of Australia, Causes of inflation (explainer, modified 7 October 2026), for the definition of inflation, demand-pull and cost-push causes, stagflation and inflation expectations.
- Unilever PLC, 2025 full year results announcement (12 February 2026), for underlying sales growth of 3.5%, underlying volume growth of 1.5%, underlying price growth of 2.0% and the definitions of price and volume growth.
- The Procter & Gamble Company, Fourth quarter and fiscal year 2026 results (Form 8-K, Exhibit 99.1, 29 July 2026), for organic sales growth of 1% from higher pricing and the note that volume and mix were unchanged.
How the numbers were checked: the index values, the inflation rates, the cumulative change and the purchasing-power figures were recomputed in plain code from the BLS figures cited above. The calculator, which runs separately, was compared with that code for every combination of settings it allows. The year-ago weights in the basket table were derived in code and checked by adding up the contributions. The percentage figures for the companies are those in their own announcements. The weights in the calculator are BLS's relative importance figures for August 2026, and the second household is invented for teaching.