What Is Inflation?
This chart displays the Consumer Price Index, which tracks the price changes of an average basket of goods. You can clearly see the sharp price increase since 2020. The inflation rate reflects the annual change in the Consumer Price Index.
Want to view the current rate in this chart? Set the time period to one year and select the percentage view.
Inflation Explained Simply
It often makes headlines as a daunting concept. It’s something consumers feel strongly about in everyday life. But what exactly is it? What causes it, what are its effects, and how is it measured? This guide answers all these questions.
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What You Need to Know
Inflation, also known as purchasing power loss, means that the same amount of money buys fewer goods than before, as money loses value.
The causes of inflation are diverse and often overlap. Common triggers include a sudden surge in demand, sharply rising costs for labor or goods, political decisions, currency devaluation, or wage pressures.
A moderate level of inflation is normal and generally harmless. However, if inflation rises sharply and stays high, it can create problems for the economy and consumers. On the flip side, inflation reduces the real value of debt, which benefits borrowers.
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How to Respond
You can’t fully shield yourself from inflation, but by analyzing and adjusting your spending habits based on different inflation rates, you can lower your personal inflation rate.
Financial products marketed as “inflation-protected” often reduce returns due to high costs and are generally not recommended. Long-term investing in stock ETFs remains worthwhile, even during inflationary periods.
What Is Inflation?
Inflation occurs when the price level of goods and services rises, meaning money is worth less than before. As a result, the same amount of money buys less.
For example, if an ice cream scoop cost $0.50 in the past and now costs $1, the currency has lost half its purchasing power. This effect is called inflation, also known as purchasing power loss or currency devaluation.
Extreme cases of purchasing power loss are historically known as hyperinflation, where money rapidly loses value, sometimes requiring currency denominations in the billions.
Causes of Inflation
The reasons for inflation are varied and often debated in economics. Key factors that frequently play a role and may overlap include:
- Costs: Sudden cost increases (e.g., due to external events like war) can create significant price pressure, leading to a spiral of rising costs (e.g., for materials and wages) and prices.
- Demand: A sharp increase in demand for scarce goods can drive price pressure and inflation.
- Currency Exchange Rates: Currency devaluation can make imports more expensive, increasing domestic demand and triggering a price spiral that fuels inflation.
- Money Supply: While debated, an excessive money supply relative to production can lead to purchasing power loss, as more money chases the same amount of goods.
- Wage Pressure: Since wages are part of production costs, sharp wage increases can create a price spiral, contributing to cost-driven inflation.
- Policy: Political decisions, including central bank actions, significantly influence inflation. Policies ranging from minimum wages to foreign affairs can trigger or mitigate inflationary dynamics.
What Are the Effects of Inflation?
Moderate inflation is normal and part of monetary policy. Many central banks aim to keep inflation around 2% annually, as deflation (currency appreciation) is considered more harmful to economies. But what are the effects of inflation, and are they always negative?
Positive Effects: Inflation reduces the real value of debt, benefiting borrowers. Highly indebted entities may intentionally fuel inflation to reduce debt burdens, transferring value from investors to borrowers.
Negative Effects: Inflation reduces the real returns for investors, making investments less attractive and potentially causing economic challenges. Combined with low interest rates, inflation can lead to negative real interest rates, making savings accounts or similar financial instruments less appealing. This can, however, boost consumer spending in certain conditions, as savings lose value quickly.
Wage-Price Spiral: A feared negative effect is the wage-price spiral, where rising costs lead to higher prices, which fuel demands for higher wages, further driving inflation. Government intervention often ends this cycle.
Inflation also disproportionately affects lower-income individuals due to purchasing power loss, slow wage adjustments, and potential recessions. High inflation adds economic uncertainty, which harms both consumer and business confidence, potentially amplifying recessionary trends.
What Is the Inflation Rate?
The inflation rate is a statistical measure of average inflation. It’s calculated using a basket of goods representing typical household consumption. This basket includes:
- Everyday products (e.g., food, toiletries).
- Durable goods (e.g., cars, computers, appliances, clothing).
- Services (e.g., insurance premiums, haircuts).
Prices of this basket are compared monthly to track price changes, reflected in the Consumer Price Index. For example, if the basket costs $100 in 2017 and $103 in 2018, its rate is 3%.
Protecting Against Inflation
Since the inflation rate is an average, your personal inflation rate may vary depending on price increases in specific areas. You can lower your personal inflation rate by reducing spending in high-inflation categories where possible.
Negative real interest rates (nominal interest minus inflation) make money market products like savings accounts less attractive. Instead, long-term, diversified investments in stock ETFs are recommended, even during low-inflation periods, to achieve returns that outpace it. Avoid financial products marketed as “inflation-protected,” as they often reduce returns without fully mitigating its risks. A long investment horizon (at least 15 years) naturally minimizes its risks without sacrificing returns.
