Inflation is a term we hear in the news regularly, in fact, inflation has a tremendous power over our daily lives and can shape our choices about what we buy at the grocery store or if we take that much-needed vacation. So what is inflation, and why does it have so much power over our lives?
What Is Inflation?
Inflation is an increase in overall prices, and a decline in purchasing power. If inflation in the United States is 5% over the year, the US dollar buys 5% less now than it did a year earlier.
Inflation at 2% has been defined as “healthy” and normal, but when it is over that percentage governments will often take actions to bring it back down. Post-pandemic, European countries and the United States saw inflation over 8%.
If inflation is 8% and wages aren’t increasing as rapidly, you are losing buying power. Your shopping cart at the grocery store now costs you 8% more than it did a year ago. This means you either use more of your income to buy the same amount of goods or you have to buy less.
What Causes Inflation?
Inflation is generally caused when everyone is buying, but there aren’t enough goods to buy. If everyone wants eggs but there aren’t enough eggs in grocery stores, the price of eggs will increase.
While that is the general cause of inflation, the three most specific causes are:
- If wages are rising rapidly, like they did when employers were increasing pay rates at the end of the pandemic, people can buy more. If there are not enough products available to purchase, prices will go up.
- Another aspect might be that certain products have become hard to find or suppliers are having a hard time getting them to stores. During the pandemic people were buying many products online but factories had to deal with much of their staff out sick and couldn’t keep up, so prices rose.
- The last cause is simply that people think prices will rise. If you think an item you want will become more expensive soon, you’ll want to buy it now rather than later. If others think the same thing and buy as well there is now more demand for the product than there is product on store shelves and the prices rise.
How Does Inflation Affect You?
Inflation pushes prices higher, reducing your purchasing power. If the inflation rate is 10%, prices will rise rapidly, eroding the value of your money and making it more challenging to afford goods and services. Even if you received a 3% raise that year, you would still lose 7% of your purchasing power.
Every year that inflation stays higher than your increases in income, your purchasing power declines even further and it becomes harder to budget or save money. Imagine that whenever you visit the store, you start shopping only to learn you can afford far less than the last time you visited.
How Inflation Affects Borrowers and Loans
In the U.S., the Federal Reserve Bank, also known as “The Fed,” monitors financial system risks and works to ensure the economy remains healthy. The Fed uses monetary policy to control the money supply in the economy to achieve its goals.
The Fed considers 2% inflation a healthy number for the economy. During times of high inflation, it will raise the interest rates it charges banks to borrow money overnight to combat inflation. By increasing the rates it charges banks, the banks will raise the rates they charge others to borrow money.
The Fed aims to slow spending and cool down inflation by making borrowing more expensive. It’s a delicate balancing act meant to slow and possibly reverse the supply of money into the U.S. economy without putting it into a recession.
As a result of the Fed’s actions, rates on personal loans, home loans, credit cards, and lines of credit will increase. A borrower will end up paying more for their borrowed money.
What Is the Difference Between Inflation and Deflation?
Whereas prices increase due to inflation, they decrease during times of deflation.
You might think, “Prices going down? That’s great!” but deflation’s economic impacts are potentially more destructive than inflation.
During deflationary periods, consumers tend to tremendously slow spending as they expect the prices of goods to keep falling. Why buy that new stove today for $1,500 if it will be $1,300 soon?
Deflation tends to signal a recession or depression and compounds upon itself, turning into a deflationary spiral. As prices keep falling and consumers keep delaying purchases, prices fall further and further. Ultimately this leads to job layoffs and business closures because too few people buy goods and services for far too little money.
During a deflation period, the Fed seeks to get money into the economy faster and get back to that healthy 2% level of inflation.
- How is inflation measured? In the U.S., inflation is generally measured using the Consumer Price Index (CPI). The CPI measures the average prices consumers pay over time for a market basket of goods and services.
- How can inflation be controlled? Governments and central banks use various measures to control inflation, including adjusting interest rates, regulating the money supply, and implementing fiscal policies that constrain government spending. The goal of each action is to reduce the amount of money going into the system to slow consumer spending but not so much that the economy enters a recession.