What is inflation?

Inflation is defined as the rate of change in prices over time. And price increases are correlated with a reduction in purchasing power, which means your money buys you less. It also means the money you save today will be less valuable in the future. The most immediate way people feel the negative affects of inflation is when prices rise too much – especially when prices rise, and paychecks do not. 

Key takeaways


Causes of inflation

Economic inflation, which refers to the overall increase in the cost of living as a result of price increases over time, can be caused by increased demand for goods and services, increased production costs, or increased wages.


Measuring inflation

Inflation is a broad measure, and every healthy economy experiences some level of inflation. Inflation is monitored by the central banks of developed economies, including the Federal Reserve in the U.S.


Inflation pros and cons

While high inflation has a negative impact on society and can hurt low-income families the most, inflation is not always a bad thing. Homeowners and certain asset owners may actually benefit from inflation.


What causes economic inflation?

We’ve all heard stories from our parents and grandparents about what things used to cost. In the 1950s, you could see a movie in the movie theatre for around 50 cents. These days, a ticket is more like $11.1 Sixty years ago, you could get a gallon of milk for 49 cents. Today it’s more like $4.2 Milk didn’t suddenly become more expensive to make; the price today reflects the decrease in the value of a dollar over time. That’s inflation. 

Typically, low inflation is a sign of a healthy economy as it can encourage investing and growth, and keep interest rates low. Economists generally agree that a stable economy requires a stable level of inflation. 

But what actually causes inflation? The answer usually falls into one of three categories.

Demand-pull inflation

Demand-pull inflation is a result of the increase in aggregate demand for goods and services. In other words, Nike can charge more for a pair of sneakers because people really want them. Supply and demand are very influential in pricing. 

Demand-pull inflation can also stem from a growing economy, increased government spending, or even economic growth overseas.

Cost-push inflation

Just the opposite, cost-push inflation results from a decrease in the aggregate supply of goods and services, related to an increase in the cost of production, raw materials, or labor. If the cost of materials needed for the production of goods rises, a business may pass these costs onto consumers in the form of higher prices. 

Think back to when the Covid-19 pandemic first appeared, and the production of automobile parts was curtailed at times. What did that do to the price of a car? People were selling used cars for more than they originally paid for them. 

Wages also affect the cost of production and are typically a business’s single biggest expense. When the rate of unemployment is low and businesses are experiencing labor shortages, they may increase wages to attract the right candidates. Increased wages lead to rising production costs – another form of cost-push inflation.

Built-in inflation

As costs rise and workers begin to anticipate spending more, they may start asking their employers for a raise. And employers typically comply so they don’t end up with a labor shortage. If a company increases wages and salaries, and also raises prices to maintain their profit margins, that’s called built-in inflation.



The formula for measuring inflation

Inflation is a broad measure, and every healthy economy experiences some level of inflation. Inflation is monitored by the central banks of developed economies, including the Federal Reserve in the U.S. The Fed has an inflation target of around 2% – and will tighten their monetary policy and hike rates if prices rise too much or too quickly. 

There are two primary ways the Fed measures inflation: the Consumer Price Index (CPI) and the Personal Consumption Expenditure (PCE).

Types of price indexes

Consumer Price Index (CPI)

Used by the U.S. Bureau of Labor Statistics, CPI is one of the most popular tools for measuring the inflation rate. It tracks price changes for roughly 80,000 different consumer goods and services including gas, food, healthcare, education, and recreation. Changes in this basket of goods and services are considered an approximate measure of the changes in prices across the whole economy. 

Personal Consumption Expenditures (PCE)

PCE also tracks the changes in prices for consumer goods and services, but unlike the CPI, the PCE tracks all items consumed by Americans. While the CPI tracks what households are buying, the PCE follows what businesses are selling. The Fed considers the PCE to be a very reliable economic indicator.

Producer Price Index (PPI)

Another tool to measure inflation is the PPI. It reports price changes for things like fuel, farm products, chemicals, and metals, which all have an impact on domestic producers. If the prices increases that cause the PPI to spike are passed onto consumers, that will be reflected in the CPI.

Gross Domestic Product (GDP) Deflator

indicator of inflation levels in the U.S. It measures the aggregate prices of goods and services across the nation and encompasses statistics from both the CPI and PPI.


Is inflation good or bad?

While high inflation has negative impacts on society, inflation isn’t always a bad thing. Inflation that is too low can lead to permanently low interest rates, which may sound great to some, but that actually limits the Fed’s ability to strengthen the economy when it’s needed and can cause a deep recession.

Who benefits from inflation?

Inflation benefits borrowers with low fixed interest rates. Homeowners with fixed rate mortgages benefit from repaying their loan with inflated money, lowering their debt service costs, and see their home equity increase as housing prices increase due to inflation. Investors can also enjoy a boost if they own assets that rise alongside inflation.
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Who is hurt by inflation?

Price increases have serious consequences for low-income families. When wages can’t keep up with inflated prices, the purchasing power of those wages decreases. Working families who spend a higher proportion of their overall income on necessities may not be able to afford all the things they need, like food, medicine, and rent.
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Top questions about inflation

  • Inflation is the rate of change in prices over time. When prices increase, purchasing power decreases, meaning your money buys you less.

  • Inflation can happen when prices increase due to rising production costs, whether that’s wages or raw materials. A surge in demand for goods or services can also cause inflation as consumers are willing to pay inflated costs. Additionally, as workers anticipate rising costs and demand wage or salary increases, companies may raises prices to maintain their profit margins.

  • There are three main types of inflation: demand-push, cost-pull, and built-in inflation. Demand-pull describes how demand pushes up the cost of certain goods or services. Cost-pull is when the price of raw materials increases, and companies pass those expenses onto the consumers in the form of higher prices. Built-in inflation is when businesses have to raise wages and salaries and raise prices in order to maintain their profit margins.

  • The historically high inflation in 2022 occurred as a direct result of the Covid-19 pandemic, exasperated by the Russian invasion on Ukraine. The pandemic changed what consumers were spending on – more on goods, less on services. The economy wasn’t set up to meet that new composition of demand. And before we could recover from that, the whole world felt the commodity shock when the Russian invasion resulted in soaring energy prices.

  • Inflation benefits borrowers with lower fixed interest rates as well as some investors who own assets that rise alongside inflation.

  • Inflation tends to hurt lenders, savers, and low-income families the most.