What is inflation?

Definition and Example of Inflation

Inflation refers to a general increase in the prices of goods and services in the economy over time, corresponding with a decrease in the value of money.

Key Takeaways:

– Inflation is a general increase in the level of prices of goods and services over time.

– It is caused by demand-pull inflation or cost-push inflation.

– Inflation can negatively impact everyday consumers, savers, and investors with fixed incomes, but it can benefit borrowers and lenders in certain situations.

– Inflation is the complete opposite of deflation, which is characterized by a general decrease in prices of goods and services.

How Inflation Works

Many consumers associate inflation with rising prices of specific essential goods or services, like oil, or even a specific industry such as real estate. However, inflation occurs only when the prices of general goods and services rise. It is believed that two main forces are responsible for these increases: demand-pull inflation and cost-push inflation.

– In the case of demand-pull inflation, the demand for goods and services in the economy exceeds the economy’s ability to produce them. This short supply puts upward pressure on prices, leading to inflation.

– Cost-push inflation occurs when the prices of raw goods and services rise, which increases the costs of final goods and services, causing inflation. Often, an oil crisis reduces oil supplies and raises the price of petroleum, a key commodity. The rise in petroleum prices puts upward pressure on final goods and services prices, leading to inflation.

– Some investors may incur losses due to inflation. Often, the central bank adjusts short-term interest rates to maintain the desired inflation rate. The Federal Reserve often raises the short-term interest rate known as the “federal funds rate” when faced with rising inflation. This action typically leads to a decrease in the prices of fixed-income securities like bonds.

Benefits of Inflation

Inflation is not always a bad thing. Borrowers benefit when it aligns with wage increases. They can pay off debts with money that loses value compared to what it was before in this case.

Lenders may benefit at the expense of borrowers in inflationary environments that do not coincide with wage increases. Consumers often face strong pressure to borrow money to afford necessary expenses in this situation. This increases the income potential for lenders. They often also benefit from upward pressure on interest rates in the face of increased demand for borrowed funds.

Note: A rise in the price of a single good or service is not considered inflation. Inflation occurs only with a general increase in price levels for goods and services throughout the economy.

How to Measure Inflation

Inflation rates are usually measured by changes in price indices. The Consumer Price Index (CPI) is the most common price index in the United States. It is a measure of the average change over time in the price of a standard basket of goods and services known as the “market basket.”

The Consumer Price Index is calculated by dividing the price of the market basket in a given year by the price of the same basket in the base year. You can find the inflation rate by calculating the change in CPI from one point in time to another. The Consumer Price Index for All Urban Consumers (CPI-U) rose by 6.8% over the 12 months from November 2020 to November 2021, the largest increase over a 12-month period since the period ending in June 1982.

Inflation vs. Deflation

Inflation Deflation

A general increase in prices of goods and services A general decrease in prices of goods and services

Caused by

Demand-pull inflation or cost-push inflation is caused by contraction in the economy, or the supply of money or credit.

Reduces purchasing power increases purchasing power.

While inflation is associated with a general rise in the prices of goods and services and a decrease in the value of money, deflation refers to a general decline in the prices of goods and services and an increase in the value of money. Deflation occurs when the change in the CPI ratio between periods is negative. The reverse is true for inflation.

Demand-pull inflation or cost-push inflation often causes inflation. Consumers can purchase more with a unit of currency as a result, while inflation generally does not allow people to buy much if their wages do not keep pace with it.

Deflation can have a similar negative impact on consumers and the economy as inflation. It is often associated with lower demand for goods and services, forcing companies to take cost-cutting measures that can increase the unemployment rate.

Source: https://www.thebalancemoney.com/what-is-inflation-357610