Everything old is new again: Inflation plagues the US economy. The Consumer Price Index is up 7.9% from a year ago. The Personal Consumptions Expenditures index is up 6.1%from a year ago. We haven’t seen price pressures like these in 40 years.

If we want to understand inflation, we need a framework to organise our thoughts. Economies are fiendishly complex; without a model that helps us focus on the relevant details, we’re lost in the woods.

Inflation means a general increase in prices. Equivalently, it means the dollar is losing purchasing power. Economists distinguish general price changes from relative price changes. The latter come from the forces of supply and demand operating in specific markets. The former are common to all markets. 

We frequently use the concepts of aggregate demand and aggregate supply to analyse inflation. But despite the similarity in names, these concepts aren’t the same as microeconomic supply and demand. Aggregate demand refers to total nominal spending in the economy. Aggregate supply means general productive conditions.

We measure inflation by tracking changes in a price index. There are many of these, each focusing on a subset of the economy, such as consumers’ goods or producers’ goods. Also, some price indexes that cover the same area are calculated differently. For example, the above-mentioned CPI and PCEPI are both snapshots of prices for consumers’ goods. But what’s under the hood is somewhat different.