Inflation, simply put, is the rate at which prices rise, and it’s an important concept that every investor and consumer should understand. In this article, you’ll learn how inflation works, what causes it and how it affects investments, economic growth, and more. You’ll also learn tips on protecting yourself from the effects.
What Is Inflation?
Inflation describes an increase in general price levels. It means that prices of goods and services are increasing, leading to higher rates. Inflation can occur naturally due to supply-and-demand market forces, but governments can also trigger it in certain situations.
When people talk about inflation, they usually mean consumer price; however, there are other types. For example, asset price inflation occurs when assets such as stocks or real estate increase in value faster than consumer prices. There can even be wage inflation when wages rise faster than consumer prices.
Causes (Main Types)
The three main types of inflation are cost-push, demand-pull, and monetary. Cost-push inflation happens when manufacturers pass along increased raw materials or labor costs to consumers. Demand-pull inflation occurs when an increase in consumer spending exceeds what producers can supply at existing prices, so they raise prices to meet demand profitably. Lastly, monetary inflation occurs when central banks print money to inject liquidity into a declining economy.
How Inflation Is Measured
Inflation measures a rise in the prices of goods and services. It’s often referred to as inflating prices. Economists track inflation with measures like CPI (consumer price index) or PCE (personal consumption expenditure). We could get technical here, but let’s not. Instead, let’s talk about what it means for consumers.
The U.S. Federal Reserve Bank says that when inflation rises, your money buys less over time—in other words, its purchasing power declines. When it falls, your money buys more over time—in other words, its purchasing power increases. How much more or less depends on how quickly prices rise or fall.
Who Does Inflation Hurt/Help?
Inflation hurts savers and helps borrowers. If a saver puts his money in a bank account that earns interest, he will lose purchasing power. His $10 saved today has less buying power than what $10 bought when he deposited his money a year ago. That’s why there are rules about the adjustment for people on Social Security—the cost of living rises faster than their checks can keep up. On the other hand, if someone borrows money at an adjustable mortgage or car loan, her payments go down. So, she benefits from rising prices (at least until they get too high).
How Fast Does This Happen
A common misconception about inflation is that prices will rise steadily continuously. In reality, this happens in periods of deflation (when prices drop), stability, or mild to moderate changes. High inflation only occurs when there’s a severe imbalance between the money supply and goods.
That happened in the Weimar Republic, where people used wheelbarrows of money to buy bread. It also happened in Zimbabwe, where inflation reached 231 million per year. As for how fast this happens on average, according to Investopedia: The U.S. Federal Reserve estimates that from 2005-2014, overall U.S. inflation has averaged 2% annually based on their preferred measure of core PCE price index excluding food and energy items.
Final Thoughts
The idea of inflation has existed for hundreds of years, but that doesn’t mean it’s an easy concept to grasp. There are many misconceptions about what it means. If you struggle with understanding what it means and how it works, we hope our simplified guide will help clear things up for you! Happy planning!
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