- Inflation is the increase in the prices of goods and services in an economy over time.
- It could also be considered a decrease in the value of your money and purchasing power.
- Low inflation indicates a healthy economy, but high or rapidly changing inflation can be dangerous.
If you notice that it costs more to fill up your car with gas or buy your regular grocery purchases, this is likely due to inflation. Inflation often coincides with a changing economy. But that doesn't mean it's always a bad thing — in fact, moderate inflation can be a good sign.
What is inflation?
Inflation is an increase in the prices of goods and services in an economy over time. That means your cash loses purchasing power. In other words, your money doesn't go as far as it used to due to inflation.
For example, if apples cost $0.25 each, one dollar buys four. But say apples become scarcer or more expensive to grow. The next year, the grocer prices them at $0.50 each. Now, one dollar buys only two apples. In purchasing power terms, the dollar has effectively lost half its value (at least as far as apples are concerned).
Here's everything you need to know about this everyday economic term.
How inflation works
Increased demand, excess spending, and supply chain issues can cause inflation to rise vigorously.
Supply and demand
There's a lot of literature on the causes of inflation, and it can be fairly complex. But in short, inflation happens because of supply and demand. Keynesian economists emphasize that demand pressures are most responsible for inflation in the short term.
- Demand-pull inflation: When prices rise from increased demand throughout an economy, but supply remains the same. Moderate demand-pull inflation can spark market competition and indicate a healthy economy.
- Cost-push inflation: Occurs when supplies are limited (such as from a natural disaster, a struggling economy, or increased production costs). Prices rise, but supply remains the same.
- Built-in inflation: When prices of goods and services start rising, businesses raise prices to prepare for continuous inflation at the same rate. Workers demand higher wages, raising the costs of consumer goods and other services.
Measuring inflation
Inflation is measured by the inflation rate, which is the percent change in prices from one year to another. The inflation rate can be measured in a few different ways:
- Consumer Price Index (CPI): The US Bureau of Labor Statistics measures the inflation rate using the CPI. Based on household surveys, the CPI measures consumers' total cost of goods and services using a representative basket of goods. Increases in the cost of that basket indicate inflation, and using a basket accounts for how prices for different goods change at different rates by illustrating more general price changes.
- Producer Price Index (PPI): The PPI measures inflation from the producer's perspective, finding the average prices producers receive for domestically produced goods and services. It's calculated by dividing the current prices sellers receive for a representative basket of goods by their prices in a specific base year, then multiplying the result by 100.
- Personal Consumption Expenditures Price Index (PCE): The Bureau of Economic Analysis uses the PCE to measure household goods and services price changes based on producer GDP data. Its data is based on the GDP report. The PCE is generally less volatile than the CPI because its formula accounts for potential price swings in less stable industries.
Causes of inflation
Causes of inflation are increased demand, increased production costs, and excessive money printing.
Increased demand
Low inflation rates can encourage increased consumer spending, boosting the economy and increasing demand. Instead of putting away money for a rainy day, people are more motivated to spend and put the money back into the economy.
When consumer spending increases, businesses profit more and are more likely to invest in development, production, and new technologies. Businesses are also more likely to invest more in their own workers and increase wages to balance the effects of inflation.
Increased production costs
Rising wages, energy costs, and supply chain disruptions can contribute to inflation. Higher labor costs increase production expenses, which may raise prices for goods and services. Similarly, rising energy prices can impact the cost of production and transportation.
Also, supply chain bottlenecks caused by production delays or transportation disruptions can lead to shortages and higher prices for certain goods.
Other factors
Other analysts cite another cause of inflation: an increase in the money supply — how much cash, or readily available money, there is in circulation. Whenever there's a plentiful amount of something, that thing tends to be less valuable (cheaper).
Indeed, many economists of the monetary school believe this is one of the most important factors in long-term inflation: Too much money sloshing around the supply devalues the currency, and it costs more to buy things.
Effects of inflation
Economists generally like inflation to occur at a low, steady rate. This indicates a healthy economy: Goods and services are being produced and grown, and consumers are buying them in increasing amounts, too. The Federal Reserve targets an average 2% inflation rate in the US over time.
The following are effects of inflation:
- Reduced purchasing power: The dollar's purchasing power decreases due to inflation, meaning your money buys less as prices rise.
- Erosion of savings: Savings kept in cash or with an interest rate lower than the inflation rate will gradually lose value over time due to inflation. One way to prevent the erosion of your savings is by investing.
- Uncertainty: Rapid and aggressive inflation can result in market and economic uncertainty, making it difficult for businesses and consumers to plan for the future. The best strategy for preserving wealth during financial uncertainty is portfolio diversification in various asset classes.
- Social unrest: In extreme cases of high inflation, uncertainty and the increased price of living can lead to social unrest and political instability.
How to protect yourself from inflation
Inflation means costs and prices are rising. When they do, paper money buys less. Low, steady inflation is good for the economy but bad for your savings. Zach Ashburn, President of Reach Strategic Wealth, says, "While having cash available is important for financial security, cash will see its value slowly eaten away by inflation over time."
- Invest wisely: To beat inflation, don't leave your cash under your mattress — or in any place where it's stagnant. Aim to structure your investment portfolio in the best online brokerages to provide a rate of return that is better than, or at least keeps pace with, inflation.
- Increase your income: Increasing your income can help reduce the impact of inflation on your household, so seek opportunities to earn more money. Asking for a raise at your current place of business or getting a second job can increase your earnings.
- Reduce expenses: Review your budget and cut unnecessary expenses to reduce your spending and save money. Regularly adjusting your budget should be part of your financial plan.
- Maintain an emergency fund: An emergency fund is another important element of your financial plan. Emergency savings can help lessen the impact of higher-priced goods and services when experiencing unexpected financial challenges.
Types of extreme inflation
Steady, low inflation rates indicate a strong economy, but aggressive and prolonged high inflationary periods can harm the economy. Let's explore types of extreme inflation.
Hyperinflation
Hyperinflation refers to a period of extremely high, uncontrolled inflation rates, sometimes raising prices over 50% a month for several months. A "normal" or low inflation rate is typically around 2%.
A triggering event like war, civil unrest, or natural disasters can cause hyperinflation. Government deficits and overprinting money are the most common situations that lead to hyperinflation. As people recognize the possible threat of future inflation, they spend more, fearing that their money will soon be worth less. Demand then increases, and prices get ramped up.
Stagflation
Stagflation is a rare event in which rising costs and prices are happening simultaneously as a stagnant economy — one suffering from high unemployment and weak production. It can occur when a supply shock or poor fiscal and monetary policies are enacted.
A supply shock is defined as a period when the economy's capacity to produce goods and services is reduced. During the height of the COVID-19 pandemic, supply shocks in labor, goods, and services greatly affected the economy.
An example of fiscal and monetary policies sparking stagflation was in the 1970s "Great Inflation" period, which not only proved that stagnation was possible (as many economists at the time deemed it impossible) but also how devastating it was. In 1973 and 1974, the result of a rapid increase in oil prices amid low GDP caused uncontrollable inflation rates.
Fed Chairman Arthur Burns issued an ineffective monetary policy that kept inflation rates skyrocketing.
Deflation
Deflation happens when the prices of assets and goods decrease over time.
Falling prices lead to more purchasing power for the consumer. You'll be able to buy more goods or assets with the same amount of money. On the surface, deflation might be a welcome relief to consumers. But sinking prices often point to challenging economic times ahead.
Three different situations can cause deflation:
- An increase in the money supply
- A drop in demand for goods and services
- A drop in production costs for suppliers
Reflation
Reflation is a period of economic expansion that usually results from fiscal and monetary policies. In the US, this came in the form of Congress's massive direct federal stimulus packages, historically low interest rates, and other measures the Federal Reserve took to spur growth amid the coronavirus pandemic.
The government and central banks can step in to begin reflation by taking actions that put more money into the economy by implementing fiscal and monetary policies. Fiscal policy refers to government decisions that impact taxation and spending. This can include sending money directly to consumers and lowering taxes to stimulate the economy and jumpstart reflation.
If businesses and consumers have more money, they will spend it, and the impact will multiply throughout the economy. Every dollar the government spends or gives as a tax cut will have a greater effect on the economy than the original dollar alone.
Downside of inflation
When inflation starts mounting higher and higher, it can become a real problem. It interferes with how the economy works as currency quickly loses value and the cost of goods skyrockets. Uninvested money loses a lot of its value, especially cash or bonds. Wages can't keep up, so people stop buying. Production then stops or slows, and an economy can tumble into recession.
The problem of where, how, and when new money enters the economy can also significantly harm it. Usually, new money is distributed to certain individuals and businesses in the hope that it eventually circulates back through the economy and is fairly distributed. But this can take time.
Inflation FAQs
The current inflation rate is 2.6% over the last 12 months from October 2024. The US Labor Department publishes the next annual inflation rate on December 11, 2024.
Inflation can benefit people looking to secure a higher fixed rate on a newly issued bond, CD, or high-yield savings account. A healthy amount of inflation also helps workers get higher wages and increases consumer spending, which indicates a strengthening economy.
How does inflation affect my investments?
Inflation affects investments by sparking fluctuating market volatility and increasing labor and material costs, negatively affecting stock prices. Inflation generally leads to lower returns on fixed-income assets like bonds and CDs. You can mitigate the impact of inflation on your portfolio by diversifying across various assets.
