What Is Inflation? How Inflation Works

What is inflation? Why the cost of goods rises over time and what it means for the value of your money

Inflation, an increase in the costs of goods and services, means that your money has effectively gone down in value. PeopleImages/Getty Images

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• Inflation is the increase in the prices of goods and services in an economy over time.
• It could also be thought of as a decrease in the value of your money and purchasing power.
• While a low, steady inflation rate of 2% indicates a healthy economy, high or rapidly changing inflation can become dangerous.

Does it feel like a dollar buys less than it used to? You're not imagining things. "It's inflation," people sigh.

You probably have a rough idea of what inflation means. The cost of things is going up. 

But what is inflation really, what causes it, and how does it affect your finances? Here's everything you need to know about this everyday economic term.

In the news: As of April, inflation rates have slowed for 10 months in a row — less than economists had estimated.

What is inflation?

Inflation is an increase in the prices of goods and services in an economy over a period of time.

That means you lose buying power — the same dollar (or whatever currency you use) buys less, and is thus worth less. In other words: With inflation, your money doesn't go as far as it used to.

Example: If apples cost 25 cents apiece, one dollar buys four of them. But say apples become scarcer or more expensive to grow, and the next year, the grocer prices them at 50 cents apiece. Now one dollar buys only two of them. In purchasing-power terms, the dollar has effectively lost half its value (at least as far as apples are concerned).  

Remember that modern money really has no intrinsic value — it's just paper and ink, or, increasingly, digits on a computer screen. Its value is measured in what or how much it can buy. 

While it's easier to understand inflation by calculating goods and services, it's typically a broad measure that can be applied across sectors or industries, impacting the entire economy. In fact, one of the primary jobs of the Federal Reserve is to control inflation to an optimum level to encourage spending and investing instead of saving, thereby encouraging economic growth.

How is inflation measured?

Inflation is measured by the inflation rate, which is the percent change in prices from one year to another. The inflation rate can be measured a few different ways: 

• The US Bureau of Labor Statistics measures the inflation rate using the Consumer Price Index (CPI). The CPI measures the total cost of goods and services consumers have purchased over a certain period using a representative basket of goods, based on household surveys. Increases in the cost of that basket indicate inflation, and using a basket accounts for how prices for different goods change at different rates by illustrating more general price changes.
• In contrast with the CPI, the Producer Price Index (PPI) measures inflation from the producer's perspective. The PPI is a measure of the average prices producer's receive for goods and services produced domestically. It's calculated by dividing the current prices sellers receive for a representative basket of goods by their prices in a specific base year, then multiplying the result by 100.
• The Bureau of Economic Analysis measures the inflation rate using a third common index, the Personal Consumption Expenditures (PCE). The PCE measures price changes for household goods and services based on GDP data from producers. It's less specific than the CPI because it bases price estimates on those used in the CPI, but includes estimates from other sources, too. As with both other indices, an increase in the index from one year to another indicates inflation.

The PPI is useful in its ability to forecast consumer spending and demand, but the CPI is the most common measure  and tends to have a significant influence on inflation-sensitive price forecasts. 

The PCE is less well-known than the CPI, using different calculations to measure consumer spending. It's based on data from the GDP report and businesses and is generally less volatile than the CPI, because its formula accounts for potential price swings in less stable industries.

Real versus nominal prices

To make meaningful historical cost comparisons — to compare apples to apples, so to speak — economists adjust prices for inflation. 

When you hear a price from the past talked about in "real" dollars, that means the price has been adjusted for inflation. When you hear prices from the past talked about in "nominal" dollars, that means it hasn't been adjusted. 

Is inflation good or bad?

Inflation is both good and bad. Inflation is certainly a problem when it comes to ready cash that isn't invested or earning anything. Over time, it'll erode the value of your cash and bank account. It's also the enemy of anything that pays a fixed rate of interest or return.

But individuals with assets that can appreciate in price, like a home or stocks, may benefit from inflation and sell those assets at a higher price. 

In general, economists like inflation to occur at a low, steady rate. It indicates a healthy economy: that goods and services are being produced at a growing rate, and that consumers are buying them in increasing amounts, too.  In the US, the Federal Reserve targets an average 2% inflation rate over time.

When inflation starts mounting higher than that or changes quickly, it can become a real problem. It's a problem because it interferes with how the economy works as currency loses its value quickly and the cost of goods skyrockets. Wages can't keep up, so people stop buying. Production then stops or slows, and an economy can tumble into recession.

Why does inflation happen?

There's a massive economic literature on the causes of inflation and it's fairly complex. Basically, though, inflation happens because of supply and demand. Keynesian economists emphasize that it's demand pressures that are most responsible for inflation in the short term.

• Demand-pull inflation happens when prices rise from an increase in demand throughout an economy.
• Cost-push inflation happens when prices rise because of higher production costs or a drop in supply (such as from a natural disaster).

Other analysts cite another cause of inflation: An increase in the money supply — how much cash, or readily available money, there is in circulation. Whenever there's a plentiful amount of something, that thing tends to be less valuable — cheaper. Indeed, many economists of the monetary school believe this is one of the most important factors in long-term inflation: Too much money sloshing around the supply devalues the currency, and it costs more to buy things.

Types of extreme inflation

Hyperinflation refers to a period of extremely high inflation rates, sometimes as much as price rises over 50% per month for several months.  Hyperinflation is usually caused by government deficits and the over-printing of money. For example, hyperinflation occurred during the US Civil War when both the Union and the Confederate states printed money to finance their war efforts.

In a modern case, Venezuela experienced hyperinflation in October 2020, reaching an inflation rate over 800,000%. 

Stagflation is a rare event in which rising costs and prices are happening at the same time as a stagnant economy — one suffering from high unemployment and weak production. The US experienced stagflation in 1973-4, the result of a rapid increase in oil prices in the midst of low GDP. 

How inflation is controlled

Inflation can be controlled by governments through their monetary policy with have three primary levers: interest rates, bank reserve requirements, and money supply.

• Interest rates: Increasing interest rates makes it more expensive to borrow money. So people spend less, reducing demand. As demand drops, so do prices. 
• Bank reserve requirements: Increasing reserve requirements means banks must hold more money in reserve. That gives them less to lend, reducing spending and leading (hopefully) to deflation, a drop in prices.
• Supply of money: Reducing the money supply reduces inflation. There are several ways governments do this; one example is increasing interest paid on bonds, so more people buy them, giving more money to the government and taking it out of circulation. 

How to beat inflation with investments

Investing for inflation means ensuring that your rate of return outpaces the inflation rate. Certain types of assets may beat inflation better than others.

• Stocks: There are no guarantees with the stock market, but overall and over time, share prices appreciate at a rate that typically exceeds the inflation rate. Most index funds also post returns better than inflation. 
• Inflation-indexed bonds: Most US Treasuries pay the same fixed amount of interest — whose value erodes if inflation is rampant. However, with one type of bond, called Treasury Inflation-Protected Security (TIPS), interest payments rise with inflation (and fall with deflation). 
• Physical assets and commodities: Alternative investments — often, tangible assets like gold, commodities, fine art, or collectibles — do well in inflationary environments. So does real property: Zach Ashburn, president of Reach Strategic Wealth, notes, "returns on investments in real estate have kept up with, or surpassed, rates of inflation for many periods in the past." That's because these physical assets, unlike paper ones, have intrinsic value, and are sold and priced in markets outside the conventional financial ones.

More generally, Asher Rogovy, chief investment officer at Magnifina, suggests that it's best to avoid nominal assets in favor of real assets when inflation's on the upswing. Real assets, like stocks and real estate, have prices that fluctuate or vary freely. Nominal assets, like CDs and traditional bonds, are priced based on the fixed interest they pay and will lose value in inflationary times.

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The bottom line on inflation

Inflation means costs and prices are rising. When they do, it means that paper money buys less. Low, steady inflation is good for the economy but bad for your savings. Ashburn says, "While having cash available is important for financial security, cash will see its value slowly eaten away by inflation over time."

To beat inflation, don't leave your cash under your mattress — or in any place where it's stagnant. It has to keep earning. 

Instead, aim to structure your portfolio so that it provides a rate of return — one that's hopefully better than, or at least keeps pace with, that of inflation, which is almost always happening. If you do, it means that your investment gains really are making you richer — in real terms.