Inflation measures how much prices rise over time. When prices rise, the value of a dollar falls and your purchasing power goes down.
The price of goods and services—stuff you buy—isn’t constant; prices change over time. When prices go up, that’s inflation. During moments of inflation, it takes more money to buy products or services. This means that purchasing power goes down.
To measure inflation and purchasing power, economists look at a price index, often the Consumer Price Index (CPI), which measures the average price of goods at specific moments in time. Economists then compare changes in cost averages to figure out the rate in which they’ve gone up. That rate is the rate of inflation and is measured as a percentage.
The Good and the Bad
If inflation is mild and consistent, it encourages consumers to buy now instead of later when they’ll have to pay more. Demand rises, companies increase production and hire more workers—the result is a boost in economic growth.
Another good side effect of inflation is that it decreases the chance of deflation, inflation’s much more disastrous cousin. Deflation is when prices for goods and services go down. Lower prices sound pretty good… But over time, it can lower demand for goods, cause companies to lay off workers, decrease the amount of money circulating in the economy, and create a cycle of economic decline.
One tough side effect of inflation is obvious: stuff costs more. If wages don’t match the rise of prices, consumers are forced to spend less and some may not be able to afford basic necessities like housing, childcare, or groceries. With less money to go around, inflation could spike further, causing the economy to slow down and unemployment to go up.
Stagflation is bad news and happens when there’s high inflation, high unemployment, and slow or stagnant economic growth. Such a troublesome combination of events generates a decrease in spending—that means less money circulating in the economy. Plus, the money that is available is worth less and less as time goes on. It can get a little complicated, but stagflation is likely caused by fiscal policies. Because of changes in policy and economic conditions, it’s pretty unlikely to happen today.
What Causes Inflation?
There are two ways that prices typically rise—both have to do with supply and demand: demand-pull and cost-push.
Demand-pull inflation happens when goods or services are in higher demand than usual, but the supply remains the same—so companies can raise prices, knowing that people are willing to spend the money. During the COVID-19 pandemic, many people needed cleaning supplies, disinfectant, and hand sanitizer, resulting in a shortage and driving some of those prices up.
Cost-push inflation is when the supply of goods and services is limited but the demand stays the same. And so, again, companies can raise prices. One common example of cost-push inflation has to do with oil and gas prices. If conflicts or natural disasters in the Middle East make it difficult to distribute oil, the price of oil goes up–even though demand stays the same.
Inflation is just one part of normal economic conditions. But, like most things, too much can be damaging. Even in moments of healthy inflation, the loss of purchasing power feels significant when your budget is tight. Try tracking your spending and adjusting your budget to match actual prices now instead of what prices were.
Check out a handy inflation calculator here.
Photo credit: Eric Fellegy
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