What is Inflation?

What is Inflation?

Prices are always rising. In the 1950s, you could buy a gallon of gas for just over a quarter, but that’s not the case today. Inflation estimates the rate at which prices increase. This rate may refer to the price of a particular product, such as a loaf of bread or a gallon of gas, or the overall increase in the price of goods and services across the entire economy. Inflation is generally bad for the economy and your pocketbook. Learn more about inflation, why it happens, and how it affects the economy at large.

What exactly is inflation?

Most of us associate inflation with rising prices, but it also signifies a loss in purchasing power for a particular currency, such as the dollar or euro. As prices increase, individuals that use this currency can’t buy as much as they could before. Inflation may apply to a particular product or industry and is expressed as a percentage. As consumers, we purchase a wide variety of goods. When prices rise across the economy, the cost of living increases. This escalation makes it harder for everyone to pay rent, buy a home or car, or put food on the table.

Economists note that inflation occurs when a nation’s money supply grows faster than the economy. Governments control how much money is in the economy through various fiscal policies. Regulators set interest rates and instruct banks and other lenders on how to hold reserves and extend credit based on economic conditions. This leads to more investments and puts more money in the hands of consumers.

Investor Tutorial: What Really Causes Inflation?

However, lowering interest rates and infusing too much money into the economy can also overheat it. As demand for various goods and services increases, so do prices. Companies may not have the resources to scale up demand, leading to delays and higher prices for consumers. Thus, inflation typically also leads to higher wages as the cost of living increases.

Sustained inflation can also lead to what’s known as built-in inflation, which is when companies and consumers start to expect higher wages and prices. This becomes a self-fulfilling prophecy as businesses raise prices and wages.

What is the inflation rate?

The inflation rate is a percentage that represents the weighted average of how much prices have increased. Various organizations and analysts keep track of when and how much prices increase over time, usually on a quarterly or annual basis. They then aggregate the numbers to find the average inflation rate.

The most famous is the Consumer Price Index (CPI), which tracks the price of primary goods for consumers in the United States, including basic necessities such as food, transportation, housing, and healthcare. The CPI calculates the average price change for each item and then averages them based on their weight relative to the other items. Since the CPI covers everything we need to live, it represents the cost of living.

What Is the Difference Between Inflation and Deflation?

Inflation is the opposite of deflation, which marks the increase in purchasing power for a particular currency. Prices decline during periods of deflation. This decrease occurs when economic growth exceeds the nation’s money supply. As demand for goods and services increases, prices drop, and consumers can purchase more with the same amount of money.

Deflation isn’t necessarily a good thing. It can harm borrowers if their investment is now worth less than it was before. For example, someone may be “upside-down” on their mortgage if their home depreciates in value over time. They still owe the lender money even though their house is worth less than when they first bought it.

Read More: What is Deflation in Economics?

What Is the Average Inflation Rate?

The average inflation rate marks the average rate at which prices change over the course of a year relative to a particular currency. Analysts will often compare the average prices of various goods and services from one year to another to see how much the price has changed. The rate will vary from one country to another based on economic conditions.

What Is Transitory Inflation?

Transitory inflation refers to inflation over the short term. Prices will rise temporarily without leaving a permanent mark on the economy. If inflation subsides within a certain period of time, usually a few months, it won’t lead to built-in inflation. Prices will return to normal before consumers and businesses start to expect higher prices and wages.

What Is a “Good” Inflation Rate?

Inflation isn’t always a bad thing. Some inflation is required for economic growth, which is why prices have been steadily increasing since they were first recorded. Experts say a good inflation rate is around 2%. This shows prices are rising at an acceptable level without overburdening consumers or businesses.

What Is Inflation Targeting?

Inflation targeting is when a government sets a goal for inflation, such as 2%. It then organizes its monetary policies around that goal. Governments can control the amount of money in the economy by adjusting interest rates and regulating banks and lenders.

If inflation is low, the economy won’t grow, which makes it harder for people to find work. If inflation is too high, consumers will lose buying power and may not be able to pay their bills. That’s why governments have to strike the right balance when setting monetary policy. In the U.S., these policies are set by the Federal Reserve. Inflation targeting is often about balancing economic growth with the nation’s money supply.

The Bottom Line

Inflation will always be a part of our lives. Understanding this concept can help you prepare for price increases in the future, so you don’t get caught off guard.

RELATED CATEGORIES: Monetary Policy