Many people are familiar with inflation. The idea that, every year, prices for the things you buy get a little bit higher. In the United States, the rate of inflation has varied across the years, but it tends to average around two percent. In other words, if one year a particular product costs $1.00, the next year, it will cost $1.02, and so on.

Is this necessarily a bad thing? Imagine a world where everyone has $100 to spend and there is only one product: Christmas trees. If there are exactly as many Christmas trees as there are people, what will the price of Christmas trees be? It’s likely they’ll ring in at $100 as well. There’s only one thing to buy, there’s one for everyone, and that’s how much money people have.

Now, let’s snap our fingers and give everyone $1,000 instead of $100. There’s still just as many trees as people, and it’s still the only thing to buy. What will the price be now? Well, it will likely jump to $1,000—a 1000% inflation rate! Although it sounds bad, it’s not truly, because people still have just as many trees as they had before.

When discussing inflation, it’s useful to also consider its effect on paychecks. If your paycheck has increased more than the average cost of inflation, you’re still doing better than you were before.

Finding out your annual raise typically isn’t difficult. Your manager will likely tell you, or you can do some arithmetic using your paycheck. But the rate of inflation for the economy is much harder to calculate. Without that number, you can’t do the comparison described. So, what can you do?

Economists in national governments around the world spend a lot of time working to produce this number by creating what’s known as a “basket of goods,” or a wide assortment of products and services they consider the average member of their country to purchase in a given year. They then compare the price of that basket to the price of last year’s and use that to determine the inflation rate. For the US, this is called the US Consumer Price Index.

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This general concept of a “basket of goods” is a bit abstract. Here’s something more concrete: Many of you might be familiar with the carol, “The Twelve Days of Christmas.” It’s a memory carol in which, each day, the singer recites the various presents they’ve received on each of the 12 days of Christmas, from three French hens and two turtle doves to a partridge in a pear tree. Each verse, another day is added, and the entire list is repeated.

If “The Twelve Days of Christmas” were a basket of goods: How much would it cost to purchase all the items on the list? What has the rate of inflation been on these items?

PNC Bank answers this every year through their Christmas Price Index. It turns out, in 2018, it would cost $39,094.93 to purchase every item on the list—a 1.2 percent increase from last year. If this were the basket of goods being used to determine inflation rates, inflation in 2018 was 1.2 percent.

Of course, that rate is not consistent across all the goods. For example, the price of “six geese-a-laying” has increased 8.3 percent from 2017, while the price of the “five gold rings” has decreased by 9.1 percent. This is why it’s so important to consider an entire basket of goods. Prices are constantly changing in the economy, and the inflation rate only represents an average across the year. While prices may be slowly increasing over time, that doesn’t necessarily mean that purchasing a computer this year will be more expensive than purchasing a computer last year. There are a lot of other factors.

In fact, there are even further complications that the Christmas Price Index doesn’t consider. For example, if the price of “five gold rings” gets high enough, maybe the buyer decides that their true love would be just as happy with five silver rings. Maybe they don’t need a full “11 pipers piping,” but would be just as happy with a string quartet. In the real world, as prices change, people often look to substitutes. Economists need to adjust the basket of goods to reflect this, before trying to calculate inflation rates.

Worse, there are several items in an economist’s basket of goods that are extremely volatile. You may have noticed that food and gasoline prices vary wildly from year to year. From a calculating-inflation point of view, they’re also large items in an annual budget. They can then have a profound effect on the inflation rate, leading to wild swings that aren’t really representative of what’s going on in the economy. Because of that, economists developed a statistic called “core inflation,” which is basically the inflation rate without considering those goods. The Christmas Price Index does the same thing—providing a value without “swans-a-swimming,” their most volatile gift.

Fortunately, the hard work of producing the US Consumer Index, and the Christmas Index, is performed by unsung heroes of the modern economy. For everyone else, you can spend your time trying to figure out whether this year’s paychecks will allow you to purchase everything you want for Christmas, or whether you should consider one or two fewer “lords-a-leaping.”

Are you wondering what the right price for your turtle doves should be this holiday season? Explore our eight-week course Economics for Managers and learn more about how to develop effective pricing strategies.

Brian Misamore

About the Author

Brian is a member of the HBX Course Delivery Team and was the lead content developer for Leading with Finance and Becoming a Better Manager. He is a veteran of the United States submarine force and has a background in the insurance industry. He holds an MBA from McGill University in Montreal.