What Is Inflation?

Inflation is an economic factor that causes all our regular expenses to cost more money over time. Price increases caused by inflation may feel subtle and slow, yet they can also be sudden and intense. Either way, too much inflation means each dollar you have is worth less with each passing year.

If you're worried about inflation or wondering about inflation causes and inflation effects, read on to learn more about this economic phenomenon and what you can do about it.

Key Takeaways

• Some inflation is normal and part of the economic cycle, yet high rates of sudden inflation can be bad for the economy.
• Where U.S. inflation hit a 40-year high of 9.1% over the 12-month period that ended in June 2022, inflation figures from May of 2023 show a lower inflation rate of 4.9%.
• Some of the causes of inflation include rising wages to meet hiring demand, government spending, and a surge in demand for products and services.

What Is Inflation?

According to the U.S. Department of Labor, inflation is "the overall general upward price movement of goods and services in an economy." A certain amount of inflation is normal and expected over time, yet too much inflation can wreak economic havoc.

• Inflation is a broad term. Inflation cannot be measured by considering the cost of just one product or service alone; instead, inflation is a measure of price increases across all goods and services in an economy.
• Inflation is measured on a monthly and annual basis. From there, government bodies and third parties use average inflation numbers over time to create monetary policy
• Inflation impacts everyone. Having everything cost more means your money is worth less and less over time, and that can make paying bills and covering living expenses significantly harder.

How Does Inflation Work?

A range of moving parts contribute to inflation, and multiple causes can add fuel to the fire at once. That said, inflation effects slowly lead to price increases for the products and services we all have to buy. 

• Inflation can impact all your expenses. Inflation can cause housing prices to surge, including rent, as well as utility bills, household services, groceries, gas, car prices, and more.
• Inflation can cause a domino effect. For example, rising fuel costs can lead to higher prices for nearly every type of consumer good.
• Inflation leaves you with less purchasing power. If prices for your bills increase but your wages stay the same, this means you have less money to spend each month after you pay for necessities.

Why is Inflation Important?

Inflation may not seem like a big deal, but it is when you realize you have less spending money than you did before. After all, inflation leads to higher prices, yet your employer is unlikely to increase your wages enough to keep up.

• Inflation can mean you earn less money each year. If you are getting a raise each year of around 3% but inflation is at 5% to 9%, this means your real income becomes lower from one year to the next.
• Too much inflation can impact your short-term financial goals. Rising prices can make it difficult to save money for a home remodeling project, upgrade your car, or save up the capital to start your own business.
• Inflation makes it more difficult to save enough for retirement. Inflation eats away at investment returns, which means the money you save in a 401(k) or other retirement account is worth less when you need it.

Is Inflation Good or Bad?

According to the International Monetary Fund, a low amount of inflation can be good for the economy, especially if inflation levels remain level and predictable.

• A certain amount of inflation is natural. Some level of inflation is normal, expected, and beneficial to society.
• Low, predictable inflation can help businesses plan ahead. For example, the IMF says level inflation helps companies make better predictions as they set their future contracts and interest rates.
• Level inflation pushes consumers to make purchases. The IMF also notes that level inflation can incentivize consumers to make large purchases, and that provides a boost to the economy.

On the flipside, too much inflation can hurt consumers from all walks of life. Inflation effects can be especially impactful to low-income families and consumers on a fixed income since their bills are going up much faster than their earnings.

How Is Inflation Controlled?

Controlling inflation can be nearly impossible, especially in the short-term. However, the Federal Reserve attempts to control inflation through a range of monetary policy initiatives. 

Generally speaking, the Fed uses interest rates to control inflation — or at least try. 

• The Fed controls the federal funds rate. This rate is what banks pay when they lend money to one another, and it ultimately impacts the interest rates offered for financial products across the board.
• Increasing rates can help rein inflation in. When inflation is high, increasing interest rates can slow the economy and inflation as a result.
• Lowering rates helps boost economic activity. The Fed cuts interest rates in order to increase economic growth during times when inflation is too low.

Inflation vs Recession: What’s The Difference?

It's possible a range of pending economic conditions have you worried about your finances, including not only inflation but also a coming recession. While these terms are both associated with times of economic upheaval, inflation meaning is much different from a recession.

• Inflation is a rise in prices. As we mentioned, inflation definition includes a rise in prices for goods and services across the board.
• Recession is a period of declining economic activity. A recession is a period of time marked by a slippage in economic activity.
• Inflation can take place during a recession, before or after. Inflation can take place during a recession, but not always.

Types of Inflation

There are many types of inflation out there, with some types caused by unique economic factors and influences. Consider the following types of inflation and related price changes that could impact your finances.

• Demand-Pull Inflation: This type of inflation is caused by consumer demand that leads to a lower stock or availability of products and services. When consumer demand goes up and items or services become more valuable, prices tend to surge.
• Cost-Push Inflation: This type of inflation occurs when the cost of producing an item increases. This leads directly to prices for goods going up, which contributes to overall inflation.
• Built-In Inflation: This type of inflation takes place when prices rise and you need to earn more to keep up. Your employer may increase your wages to account for inflation, but the wage increase doesn't help you get "ahead."
• Stagflation: This term describes time periods when there is low economic activity and high inflation. During stagflation, high levels of unemployment are also common.
• Hyperinflation: Hyperinflation takes place when inflation is spiraling out of control, typically when prices rise by 50% or more per month.
• Deflation: Deflation definition is the opposite of inflation meaning since it happens when prices for goods and services go lower than they were before.
• Pricing Power Inflation: This type of inflation occurs when businesses have the power to increase prices for their goods or services without losing any business to another company. 
• Disinflation: The term disinflation is used to describe periods of time when the inflation rate is dropping. 
• Reflation: Reflation refers to types of monetary policy that aim to stimulate the economy and fight against deflation.
• Creeping Inflation: This type of inflation occurs when price increases take place at a slow and stable rate, usually less than 3% per year.
• Walking/Trotting Inflation: This type of inflation happens faster than creeping inflation but slower than running inflation and especially hyperinflation. 
• Running/Galloping Inflation: This type of inflation occurs when prices begin to rise by 10% or more.

Causes and Effects of Inflation

Consider this inflation example that shows both the causes and effects of rising prices:

You recently opened a restaurant, and you set your menu prices based on costs for ingredients, labor, and overhead accordingly. Yet, over the 12 months you have been in business, overall inflation was measured at 9%. In this case, you may have to:

• Pay workers more to account for inflation, which drives your prices even higher
• Increase menu prices to keep up with food inflation costs
• Come up with excess funds to cover higher fuel costs, higher utility bills, increasing rent charges and more
• Accept lower wages as the business owner to keep up with rising costs

How Inflation Is Measured

• The Consumer Price Index (CPI): According to the Bureau of Labor Statistics, the Consumer Price Index (CPI) is "a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services."
• The Wholesale Price Index (WPI): This metric measures the cost of wholesale prices for products over time.
• The Producer Price Index (PPI): This family of indexes looks at the average costs producers charge to sell their products over time.
• The Personal Consumption Expenditures Price Index (PCE): This index measures price changes for goods and services consumers select in the United States.

Ways to Protect Yourself Against Inflation

Regardless of what is causing inflation, it's hard to deny the impact on all of us. That said, there are some ways to combat inflation in your personal and professional life, whether you're a consumer who wants to "get ahead" in a financial sense or you're a business owner who wants to avoid laying off workers.

• Look for ways to lower your expenses. For example, cut discretionary spending on food and entertainment.
• Delay big purchases. Avoid major expenses when you can. For example, put off financing new business equipment if you are able to continue using what you have.
• Continue investing. Save for retirement in a 401(k) or another retirement plan since you'll need the money eventually.

Final Word

Some level of inflation may be good for the economy, yet it's important to understand how rising prices impact your bottom line. If you're earning more but prices always seem to outpace your wages, for example, you'll need to look for ways to sidestep inflation and still get ahead.

In many cases, the best way to deal with inflation is spending less so you can increase savings and investments. You can't bring record inflation to an end on your own, but you can be more mindful when it comes to where your money goes.