Inflation refers to a general increase in the prices of goods and services in the economy over time that corresponds with a decrease in the value of money.
Learn how inflation works and affects consumers, savers, and investors, how it's measured, and how to distinguish it from deflation.
- Inflation is a general increase in the price level of goods and services in the economy over time.
- It's caused by demand-pull or cost-push inflation.
- It can hurt everyday consumers, savers, and fixed-income investors, but it can help borrowers and lenders in certain circumstances.
- Inflation is the opposite of deflation, which is marked by a general decrease in the prices of goods and services.
What Is Inflation?
The simple definition of inflation is the sustained upward movement in the overall price level of goods and services in an economy. Holding all else constant, this corresponds with a loss of purchasing power for a currency utilized within the economy.
You see, as a result of inflation, it takes more currency units to buy the same amount of goods and services than it did in the past. In other words, your money buys you less stuff, be it bread, toothpaste, rent, or medical services.
How Inflation Works
Many consumers erroneously associate inflation with the rise in the price of a few key goods or services, such as oil, or even a particular industry, such as real estate. But inflation is by definition only present when the overall price of goods and services is rising. Two main forces are thought to be responsible for this increase in the economy-wide prices of goods and services: demand-pull inflation and cost-push inflation.
With demand-pull inflation, the demand for goods and services in the economy exceeds the economy's ability to produce them, and their short supply places upward pressure on prices and gives rise to inflation.
Cost-push inflation is a phenomenon wherein the rising price of input goods and services increases the price of final goods and services and causes inflation. For example, an oil crisis often causes a decrease in the oil supply and an increase in the price of petroleum, an important input good. The rising price of petroleum puts upward pressure on the price of final goods and services, leading to a temporary increase in inflation.
Inflation affects individuals and the economy. When inflation rises faster than wages increase, it causes a decrease in purchasing power that forces individuals to fork over more dollars, euros, or other forms of currency to buy necessities ranging from food and clothing to medical services, which can put the average consumer in a financial pinch and reduce discretionary spending. For example, as a result of inflation, you would have to pay $101 in 2020 to buy what could have been bought for $100 in 2019. It can also hurt savers, as inflation diminishes the value of the interest you earn on your deposits.
Some investors may also lose as a result of inflation. The central bank of a government will often adjust short-term interest rates to maintain the desired rate of inflation. For example, amid rising inflation, the Federal Reserve often raises a short-term interest rate known as the federal funds rate, which typically results in a decrease in the price of fixed-rate securities like fixed-rate bonds. This inverse relationship between interest rates and bond prices can depress the market value of investment portfolios laden with bonds.
Not Always a Bad Thing
However, inflation isn't always a bad thing. Oftentimes, borrowers stand to gain from inflation, especially if it corresponds with increasing wages. In this scenario, they get to repay debts with money that is worth less than it was before.
In inflationary environments that do not correspond with wage increases, lenders may benefit at the expense of borrowers. In this scenario, consumers often face strong pressure to borrow money to afford the things they need, which boosts lenders' income potential. In the face of heightened demand for loanable funds, lenders often further benefit from upward pressure on interest rates.
A rise in the price of a single good or service isn't considered inflation. Inflation only occurs with a general increase in the price level of goods and services throughout the economy.
How to Measure Inflation
The inflation rate is typically measured by changes in something called a price index. The most popular price index in the United States is the Consumer Price Index (CPI), which is a measure of the average change over time in the price of a standard set of consumer goods and services known as a market basket.
CPI is calculated by dividing the price of a market basket in a particular year by the price of the basket in the base year. Find the rate of inflation by calculating the percentage change in the CPI from one point in time to another. For example, the Consumer Price Index for All Urban Consumers (CPI-U) was 256.57 in July 2019 and 259.10 in July 2020, resulting in an inflation rate of about 1% over the year.
Inflation vs. Deflation
|Marked by a general increase in the prices of goods and services||Marked by a general decrease in the prices of goods and services|
|Caused by demand-pull or cost-push inflation||Caused by contractions in the economy or the supply of money or credit|
|Decreases purchasing power||Increases purchasing power|
Whereas inflation is associated with a general increase in the price of goods and services and a decrease in the value of money, deflation refers to a general decrease in the price of goods and services and an increase in the value of money. If the percent change between CPI from one period to another is negative, you have deflation; the reverse is true for inflation.
A negative rate of inflation indicates deflation.
Unlike inflation, which is typically caused by demand-pull or cost-push inflation, deflation is typically caused by contractions in the economy or the supply of money or credit. As a consequence, consumers may buy more with a unit of currency, whereas inflation generally forces people to buy less if their wages have not kept up with inflation.
But deflation can have a similarly negative impact on consumers and the economy as inflation. For example, it's often associated with less demand for goods and services, which can force firms to take cost-cutting measures that can increase the unemployment rate.