What is inflation?

If you’ve ever noticed the overall cost of goods and services—like gas, groceries, clothing and rent—increase, you may have wondered about inflation or heard people talking about it. So what is economic inflation, and what causes it? 

Understanding what inflation means for your finances can help you make the appropriate adjustments and budget more effectively. Keep reading to learn more.

Key takeaways 

  • Inflation is when the cost of goods and services rises over a period of time and decreases your overall purchasing power.
  • Inflation is measured by multiple price indexes—including the consumer price index, the personal consumption expenditures price index and the producer price index.
  • Common causes of inflation can include cost-push inflation and demand-pull inflation.
  • Inflation can affect both consumers and businesses because of the rising prices of goods and services and the increase in production costs.

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What is a simple definition of inflation?

Inflation is when the prices of goods and services rise over a period of time and decrease your overall purchasing power. You can think of inflation like this: The more the prices of goods and services increase, the less you might be able to buy to stay within your budget. 

It’s important to understand that inflation isn’t based on the price change of a single item. It has to do with items that consumers commonly use on a daily basis.

For instance, an increase in the cost of milk doesn’t necessarily mean that inflation is occurring. However, if the prices of things like food, transportation, education, apparel, gas and housing have gone up, those can be signs of inflation. These are some of the items that make up the market basket of goods and services measured for inflation. 

How is inflation measured?

Inflation is measured by price indexes. A price index evaluates the difference in the costs of a variety of goods and services over time. There are multiple indexes that contribute to measuring inflation in an economy.

Consumer price index (CPI)

The CPI is the most popular tool. It’s used by the U.S. Bureau of Labor Statistics to measure the change in the inflation rate in the U.S. economy. The CPI focuses on the average change in price of a diverse group of goods and services commonly purchased by consumers, known as the market basket of goods and services. Some of these goods and services include food, gasoline, electricity, apparel, transportation, medical care, rent and airline fare. When there are changes in the CPI, the statistics bureau is able to see that there’s a change in the cost of living.

Personal consumption expenditures price index (PCE)

The Federal Reserve, also known as the Fed, largely follows the PCE. It’s similar to the CPI because they both track the change in price of U.S. consumer expenses. However, the PCE has a narrower focus and looks at consumer behavior. For example, if consumers switched from buying salmon to trout because the cost of salmon increased, that’s a change in consumer buying behavior. 

While the PCE and CPI track changes in expenses, they are used to measure inflation for various reasons and may reveal different inflation rates.

Producer price index (PPI)

The PPI measures the change in prices experienced by the seller rather than the buyer or consumer. The PPI evaluates the difference in the selling price of goods and services accepted by domestic producers over time. For instance, a local farmer who produces the food you purchase in grocery stores may be affected by the increase in supply costs to grow the food. And then the farmer may sell the food at a higher price, which will result in you purchasing more expensive food in grocery stores.

What causes inflation?

You’re probably wondering: What causes inflation? Economists believe that there are a few common causes of inflation, including:

  • Cost-push inflation: This type of inflation occurs when the demand for goods and services stays the same, but there’s a shorter supply of those goods and services. This causes prices to increase. For example, consider gas prices. There’s a consistent need for gas to drive to work, run errands and more, but if the supply of gas is restricted, it can cause the price of gas to increase.
  • Demand-pull inflation: This type of inflation occurs when the demand for goods and services increases, ultimately causing the prices to increase. For example, when the economy grows from a high employment rate, more people are making money, which allows them to spend more money. In this case, the demand for those goods and services increases because people are able to spend more. Economists often refer to this inflation as having a lot of money to spend but fewer goods to buy.

How is inflation controlled?

Central banks—like the Fed—can control inflation through monetary policy. Monetary policy focuses on the availability and control of the money supply. It can affect the money you withdraw from your local bank and use to purchase goods—and the money that businesses have readily available.

The Fed focuses on three factors when setting monetary policy: maintaining stable prices, keeping a good employment rate and implementing moderate long-term interest rates in the economy. According to the Fed, policymakers support an inflation rate of 2% or below year over year.

Who is affected by inflation?

At the end of the day, everyone’s a consumer contributing to the economy by spending money on things like food, clothes, education and transportation. When inflation rises quickly, it can affect consumers’ spending ability and the overall economy. 

Retirees on a fixed income, business owners and prospective loan borrowers may be especially affected by inflation.

How to protect your finances during inflation

Your financial goals don’t have to take a backseat due to inflation. Here are some things you can do to stay on track and protect yourself financially when prices soar:

  • Create a budget. Making a budget can help you determine the overall health of your finances and keep your spending under control. This can be especially helpful during times of inflation. It may help you pinpoint where you’re spending more or where you can cut back. In general, creating a budget can give you a snapshot of where your money is going, which could help you find ways to save. 
  • Establish an emergency fund. It’s a good idea to have an emergency fund to fall back on. And that extra cushion can provide an even greater sense of comfort during times of inflation. You can find tips for establishing an emergency fund to help offset your expenses when inflation hits. 

Inflation in a nutshell

Inflation can be challenging and stressful to navigate. However, understanding what causes it and how it’s corrected can be an empowering first step for anyone aiming to take control of their finances. To learn more, check out tips for how to budget and save, even when money is tight.

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