What is inflation?

You might’ve heard the term “inflation” pop up in the news, economic forecasts and even conversations about personal finance. Inflation impacts many things, from the price of a cup of coffee to your car or mortgage payment and possibly even the emergency fund in your savings account. But what is inflation, exactly?

How to define inflation

Put simply, inflation is the rise in the prices of goods and services over time. Let’s examine what inflation means in broader economic terms.

Defining and measuring inflation may be as simple as tracking the cost of routine goods and services — such as groceries, clothing and transportation — to estimate how much consumers are typically paying for everyday needs. A common measure of inflation is the Consumer Price Index (CPI), which groups such items together and can be used to monitor changes in price levels over time.

Types of inflation

Inflation may occur for a variety of reasons. Let’s look at each of the different types of inflation and their underlying causes.

Cost-push inflation

Cost-push inflation occurs when the cost of production for goods and services increases. For example, if the price of raw materials increases, it becomes more expensive for companies to produce the same goods and services. These increased costs may then be passed on to the consumer which may lead to a rise in overall prices resulting in inflation.

Demand-pull inflation

Demand-pull inflation happens when the demand for goods and services is greater than their supply. When demand outpaces supply, it creates a “seller’s market” in which sellers have more negotiating power and more leeway to raise their prices. When this price increase becomes widespread, it can create demand-pull inflation.

Built-in inflation

Built-in inflation may occur when future inflation is expected. If businesses predict that prices will rise in the future, they might choose to raise prices ahead of time. Consumers expecting prices to rise may choose to buy items in bulk ahead of time, inflating demand quickly and raising prices. This expectation-driven cycle can lead to a steady rise in prices creating built-in inflation.

Stagflation

When a country experiences high inflation, high unemployment and stagnant demand in the economy simultaneously, it’s known as “stagflation.” This type of inflation is considered especially puzzling as many traditional economic policies, designed to respond to each of these components individually, may struggle to address them all at once.

Hyperinflation

Hyperinflation is a form of inflation that occurs at a much higher rate than standard inflation. Hyperinflation quickly erodes the real value of the local currency, as the prices of all goods and services increase. This creates a situation where the amount of currency needed to purchase routine items may become extremely high.

How does inflation affect me?

Inflation generally makes most things more expensive. From the price of your favorite cereal to the interest you pay on your loan, inflation may affect several aspects of your budget.

Rising prices of goods and services

Inflation, at its most basic level, affects you by raising the price of goods and services. If you’ve ever noticed that your grocery bill has been slowly but steadily creeping up over the years, you’ve witnessed inflation in action. This rise in prices may extend beyond your groceries.

Employment and wages

More than just the price tags on the shelves, inflation could potentially impact the job market as well. As companies face rising production costs, they may start looking for ways to cut expenses. In some cases, this could possibly mean hiring freezes, layoffs or other cost-cutting measures. Conversely, during periods of mild inflation, some employers may actually raise wages to keep up with the cost of living for employees.

Loans and savings

Inflation may even affect how you borrow and save. Say you have a variable-rate loan; as periods of higher inflation come to be, your interest rate may increase causing your payment to go up. On the other hand, if you have a fixed-rate loan, your interest rate is fixed so your payments will remain the same. Also, if you have savings, inflation might outpace your interest earned and begin to affect the purchasing power of your money over time.

Controlling inflation

As we’ve learned, the many components of inflation can have wide-ranging effects on both the consumer and the economy at large. As such, controlling inflation is an important task that falls to governments and policymakers. Let’s take a look at some of the monetary and fiscal policies used to try to curb inflation.

Monetary policy

One of the main channels for controlling inflation is through monetary policy, typically managed by a country’s central bank. One common method is adjusting the interest rates. Raising interest rates promotes more saving and less borrowing, slowing spending and helping to cool off inflationary pressure. On the other hand, lowering interest rates often encourages people to spend and borrow more, stimulating economic activity in an effort to counteract deflationary trends.

Fiscal policy

Another primary lever for controlling inflation is a country’s fiscal policy — essentially, governmental decision-making about spending and taxation. For example, if a government wants to reduce inflation, it may decide to reduce spending or raise taxes. This would hypothetically have a similar effect on the economy as raising interest rates by reducing the amount of money in circulation.

Supply-side policies

Certain supply-side policies may also be deployed in times of high inflation. These strategies aim to increase the overall production capacity of an economy by encouraging competition and improved productivity. A government could, for example, take steps to reduce barriers to entry within specific industries, or promote research and development to foster innovation or competitiveness.

In summary

At its simplest, the answer to the question, “What is inflation?” is that inflation is the rise in prices of goods and services over time. As you’ve seen, inflation can affect more than just the cost of your coffee and cereal; it can have wide-reaching effects on the wider economy and job market. Governments and policymakers strive to control inflation through monetary and fiscal strategies, aiming to strike a balance that fosters economic stability.