Inflation: Definition and how it affects you

Inflation is the increase in prices of commonly used goods and services over time. It can reference the higher prices of individual items, like milk or a movie ticket; of many components within an industry, such as computers and software development in the tech sector; or as part of the economy as a whole.

But there’s a little more to inflation than just an increasingly expensive grocery bill or tank of gas. As prices rise, the value of money decreases; a $20 bill buys less than it did before. This is also referred to as a decline in purchasing power of a dollar.

The opposite of inflation, or deflation, occurs when the general price of goods and services falls over time and currency becomes more valuable.

Governments and central banks like the Federal Reserve track the level of inflation using indices that measure changing prices using a representative group of products, also known as a basket of goods. No single index perfectly measures price changes across an economy, so in the United States, economists often use multiple measures of inflation to get an accurate reading:

• The Consumer Price Index (CPI) is collected by the Bureau of Labor and Statistics (BLS) and is the most commonly used index. It surveys the prices of 80,000 products each month, focusing on food, education, transportation, recreation, and other things most consumers buy.

• The Producer Price Index (PPI), which is also overseen by the BLS, measures price changes of goods and services most used by domestic producers, including fuel, metal, and agricultural products. When the costs of these items increase, the change is often passed onto consumers.

• The Personal Consumption Expenditures Price Index (PCE), gathered by the Bureau of Economic Analysis, also follows the prices of commonly used consumer goods, but the PCE basket is updated regularly to reflect changes in what consumers are actually spending money on.

To calculate the inflation rate, use the following formula:

(CPI A – CPI B) / CPI B

If you want to find the rate of inflation since 1996, for example, CPI A would be the current CPI value, and CPI B would be the index value in 1996.

While many, complicated factors can trigger an increase in prices, there are three main types of inflation which are defined and differentiated by their root causes.

1. Demand-pull inflation

When the demand for a product increases but the supply doesn’t change, the price of that product is “pulled up” to meet the rising demand. There are a few reasons that demand might spike like this, but usually, it’s because of an increase in the money supply, either following fiscal policy changes or as the result of a growing economy. 

However, demand can also surge because of changes in consumer habits and expectations. During the recent coronavirus pandemic, grocery prices rose 2.6 % because dine-in restaurants closed and everyone had to cook at home. Sometimes demand increases simply because consumers are willing to pay more for popular goods, as they tend to every time a new Apple product launches.

2. Cost-push inflation

The less common cost-push inflation is caused by a rise in the costs of production. When production inputs like fuel, metal, and even labor (which are required to make many other commodities, become more expensive) that increase is “pushed” onto the consumer in the form of higher prices. 

Demand for higher wages during a time of low unemployment might lead to an increase in production costs, as would a shortage of raw materials. Production input scarcity can be attributed to many things, including changing international treaties, like the OPEC oil embargo in the 1970s which caused a gasoline shortage in the U.S., and even natural disasters like Hurricane Katrina, which damaged gas lines.

3. Built-in inflation

Built-in inflation reflects the changing expectations of consumers. When people become used to a regularly rising inflation rate or have reason to believe that inflation will get worse, they demand higher wages to preserve their current standard of living. However, this can be a self-fulfilling prophecy: If producers are forced to pay higher wages, they’ll pass that onto the consumer in the form of higher prices, which can result in more inflation. If the cycle continues, it becomes a wage-price spiral.

We mostly think of inflation in terms of its immediate effect on our wallets, but the government and the Federal Reserve use fiscal policy to control inflation and its effects on a larger scale. Tax cuts, for example, can inject more money into the economy since companies and consumers can use that money on goods and services instead. The Federal Reserve can also lower interest rates, encouraging banks to lend money, again increasing the money supply.

Pros of inflation

The Federal Reserve tries to maintain a roughly 2% rate of inflation leads to a healthy economy by encouraging consumers to spend money rather than saving it. Here are other ways in which inflation can be a good thing.

• Non-cash assets, including investments and real estate, become more valuable.

• It’s easier to pay off debts because you’re using money that is worth less than the money you originally borrowed.

• Inflation also neutralizes the threat of deflation, which can intensify an economic recession.

Cons of inflation

Still, inflation often feels like a bad thing for a few reasons.

• The value of a dollar is reduced, and money doesn’t go as far.

• Any cash savings become less valuable over time.

• If wages and salaries don’t rise alongside inflation, the cost of living increases.

The best way to protect yourself from the risks of inflation is to come up with a good, long-term financial plan that includes a range of investments—because while savings lose value during a period of inflation, investments can help you gain more than you’d lose due to inflation.

Spending responsibly on rent can help keep your personal finances on track. Shared housing is one of the best ways to lower your rent cost. Bungalow’s homes are designed for roommates, located in the best neighborhoods, and set up for seamless living. Whether you already have roommates or are looking for new ones, there’s a Bungalow with your name on it. Find your Bungalow.