The Federal Reserve has announced that it will raise its target interest rate to 1.25 percent to stave off inflation. The following provides a basic guide to inflation-what it is, how it works, and how the Fed tries to manage it.

Q: What is inflation?

A: A basic definition of inflation is that inflation is a rise in the general price level throughout the economy. This general price level is commonly measured by the Consumer Price Index.

Q: What causes inflation?

A: There's no easy answer here. Think of a business that has more customers than it can handle and, therefore, is doing quite well. The owners of this business are likely to raise the prices they charge their customers. In this way, economic activity can, in general, lead to a temporary rise in the level of prices. Such a rise is temporary because high prices attract other firms to compete with the business owner. Also, every business owner's interest in high profits puts an emphasis on increasing productivity, and that can put downward pressure on prices.

Often, when economists talk about inflation, they are referring to a sustained rise in prices that is "too high" or "too fast." Although economists may not agree on precise definitions for these terms, they describe the basic problem: too many dollars chasing too few goods.

Q: What does "too many dollars chasing too few goods" mean?

A: Imagine if all the banks in the United States simultaneously placed an extra $500,000 in every bank account. Most people would probably rush out to spend a good bit of this money. Let's say most of them decided to buy a new car. Unfortunately, carmakers would not have enough cars to satisfy everyone. The likely response by carmakers would be to raise their prices. In other words, too many dollars (people with "extra" money) chasing too few goods (cars).

Q: How would we end up with too many dollars in the economy?

A: Essentially, the Federal Reserve serves as the monetary authority in the United States and controls the amount (or supply) of money in the economy. If the Fed miscues, for instance, we could easily end up with too much money in the economy.

Q: How does the Federal Reserve control the amount of money in the economy?

A: The term "control" has to be qualified. For example, if the Fed wants to increase the supply of money, it can simply have more money printed (at the U.S. Mint). But that's unlikely because it would be the best way to make sure too many dollars are chasing too few goods.

Instead, the Fed tries to influence the amount of money through interest rates. Currently, the Fed "targets" the short-term interest rate called the federal funds rate. The idea is this: if the Fed can keep interest rates low, there will be more money in the economy, and if the Fed can send interest rates higher, there will be less money in the economy. This policy is supposed to work through bank lending. Banks will lend more money when interest rates are low (because the price of credit is lower) and less money when they are high (because the price of credit is higher).

Q: How does the Federal Reserve influence the federal funds rate?

A: The Fed employs a group of bond traders to buy and sell bonds on its behalf. If the Fed wants to increase the amount of money in the economy, it directs its traders to buy bonds. This money will end up in banks that, in order to profit, will lend the new money. If the banks want to lend the new money, then they will have to lower the price of credit-interest rates. The process is supposed to work in reverse, too; when the Fed wants to decrease the amount of money in the economy, it sells bonds, thus taking money out of the economy.

Q: Ideally, what should be the goal of the Federal Reserve's monetary policy?

A: The Federal Reserve's monetary policy should support a growing economy but should not adversely affect the general level of prices. Put another way, the Federal Reserve should constantly strive to maintain an amount of money and credit that meet the economy's need for cash and credit, but at levels that do not cause inflation.

Q: What influence do foreign oil producers have on U.S. inflation?

A: The inflation rate can respond quickly to changes in the price of materials that are widely used in the economy. Because American consumers use a great volume of petroleum-derived goods, oil qualifies as such a material.

The production policies of the Organization of Petroleum Exporting Countries (OPEC) and non-OPEC producers that follow OPEC's lead can significantly affect overall prices in the short-term. Many people remember how much inflation rose during the oil boycott of the early 1970s, when the CPI hit double-digit levels several times. OPEC production policies, however, have short-term effects because high oil prices stimulate domestic production of oil and oil substitutes. Thus, the economic "shock" from high oil prices that Americans feel through higher prices for transportation, food, manufactured household products, and other goods dependent on energy from oil ultimately fades away as new sources of energy come onto to the U.S. energy market.

Q: Does the strength of the dollar in foreign money markets affect the inflation rate?

A: There is a two-way relationship between exchange rates and inflation. When U.S. consumers buy foreign products they pay prices that reflect the exchange rate of the dollar against the currency of the country that produced the product. For example, if the importer of German beer to the United States must pay more dollars for the same amount of beer he usually buys, then U.S. consumers will in turn pay more dollars to the importer when they buy the beer at their grocery store. Thus, the exchange rate between Germany and the United States can impact inflation in the United States. Of course, inflation in either country could also impact the exchange rate between the two countries.

Q: How can we measure inflation?

A: There are several ways to measure inflation, but the most commonly recognized is the Consumer Price Index (CPI).

Q: What exactly is the CPI?

A: The CPI is a measure of what it costs to buy a bundle of goods today compared to what that bundle of goods cost in the past. The Bureau of Labor Statistics (BLS) conducts a survey (called the Consumer Expenditure Survey) that collects data on how much people pay for various goods and services. The BLS then uses this information to develop the cost of a "typical" bundle of goods. The actual index is calculated by dividing the price of the bundle in a given year by the price of the bundle in the base year (the starting point) and then multiplying by 100. The resulting number is the CPI.

Although we frequently hear about "the CPI," the BLS actually computes more than one CPI, but the most used is the CPI-U, which measures prices for urban consumers.

Q: How do I use the CPI?

A: It's quite easy to use the CPI. Let's measure the rate of inflation (how fast prices rose) from 2001 to 2002. The annual CPI for 2001 is 177.1, and the annual CPI for 2002 is 179.9. Just calculate the percentage change between the two index values ((179.9 - 177.1) / 177.1 )*100), and you'll see that prices rose 1.6 percent from 2001 to 2002.

Another way of thinking about the inflation rate is to ask how much will a dollar buy now versus what a dollar would have bought before? In our example, $1.00 in 2001 had the same value as $1.06 in 2002. In terms of what you can buy with one dollar, you are worse off in 2002: to buy what cost $1.00 in 2001, you needed $1.06 in 2002.

This relationship is easier to see if we use a longer time period. One dollar of goods in 1980 would cost $2.29 in 2004. You can calculate this measure for any two years with the BLS inflation calculator.

Norbert Michel, Ph.D., is Policy Analyst in, and William W. Beach is Director of, the Center for Data Analysis at The Heritage Foundation.