What Is Inflation?

Definition and Example of Inflation

Inflation is a sustained upward movement in the overall price level of goods and services in an economy. It corresponds with a loss of purchasing power for a currency that's utilized within the economy. It takes more currency units to buy the same amount of goods and services as a result. Your money buys you less, be it bread, toothpaste, rent, or medical services.

Inflation causes a decrease in purchasing power when prices rise more quickly than wages increase. It forces individuals to spend more dollars, euros, or other forms of currency to buy necessities, which can put the average consumer in a financial pinch. It can reduce discretionary spending, too. You would have had to pay $106.80 in November 2021 to buy what could have been bought for $100 in November of 2020, for example.

How Inflation Works

Many consumers associate inflation with a 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 only present when the overall prices of goods and services are rising. Two main forces are thought to be responsible for the increases: 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. This short supply places upward pressure on prices, giving rise to inflation.

Cost-push inflation occurs when the rising price of input goods and services increases the price of final goods and services and causes inflation. 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 inflation.

Some investors may also lose as a result of inflation. A country's central bank will often adjust short-term interest rates to maintain the desired inflation rate. The Federal Reserve often raises a short-term interest rate known as the "federal funds rate" when it's facing rising inflation. This action typically results in a decrease in the price of fixed-rate securities like fixed-rate bonds.

The Benefits of Inflation

Inflation isn't always a bad thing. Borrowers stand to gain from it when it corresponds with increasing wages. They get to repay debts with money that's worth less than it was before in this case.

Lenders may benefit at the expense of borrowers in inflationary environments that don't correspond with wage increases. Consumers often face strong pressure to borrow money to afford the things they need in this case. This boosts lenders' income potential. They often further benefit from upward pressure on interest rates in the face of a heightened demand for loanable funds.

How To Measure Inflation

The inflation rate is typically measured by changes in a price index. The Consumer Price Index (CPI) is the most popular price index in the U.S. It's 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 same 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. The Consumer Price Index for All Urban Consumers (CPI-U) rose 6.8% for the 12 months over November 2020 to November 2021, the largest 12-month increase since the period ending June 1982.

Inflation vs. Deflation

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. You have deflation when the percentage change between CPI from one period to another is negative. The reverse is true for inflation.

Inflation is typically caused by demand-pull or cost-push inflation. Deflation is caused by contractions in the economy or the supply of money or credit. Consumers may be able to buy more with a unit of currency as a result, whereas inflation generally does not allow people to buy as much if their wages have not kept up.

Deflation can have a similarly negative impact on consumers and the economy as inflation. 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.