What Is Inflation?

What we’ll cover:

• Inflation occurs when purchasing power decreases
• Deflation occurs when the value of a currency goes up, meaning prices go down as there’s a decrease in the supply of money
• Inflation can potentially be a good thing, when it functions to stimulate the economy

Time to run some errands! On our shopping list we have sirloin steak for tonight’s dinner at 77 cents per pound, a loaf of bread for 14 cents and toothpaste for 29 cents a tube. And of course, we’ll need to fill up the gas tank on the way home, which will be about 20 cents a gallon.

If these prices sound a little low to you, don’t worry – you’re not missing out on any deals unless you have the ability to time travel. What you’re seeing are prices quoted from the 1950s. And they’ll kickoff off our discussion of inflation.

You’ve probably heard the term “inflation” – maybe it’s come up in the context of “inflation equals rising prices.” Inflation can help explain why the prices for the goods we mention above have gone up. But inflation can have farther reaching effects, including unemployment, interest rates and more. 

So what is inflation, really? We’ll explain this economic concept, how it works and what it means for your wallet. Kick up your feet, grab a fresh cup of $3 coffee and let’s jump in!

Inflation definition (and how inflation works)

If we take a second to dust off our trusty dictionary, we can start with the formal definition of inflation: a decrease in the purchasing power of a given currency. That’s a pretty loaded sentence, so let’s break it down.

Inflation means that the overall price of goods and services has gone up. If the buying power of a currency doesn’t increase accordingly, the currency loses value. With a devalued currency, you essentially have to spend more money to buy the same thing – that’s what we mean when we say there’s a decrease in purchasing power.

Let’s talk groceries again to illustrate all this. Ever heard a parent or grandparent say that when they were a kid, they could buy a soda for a nickel? As you know, that’s not the case now. Buying a soda at a gas station will usually cost you at least $2. This is an example of inflation and less purchasing power. You now need more dollars to buy the same soda. 

To put it in a simpler way: Inflation means the same amount of money is worth less over time. 

What does this mean, big picture? Rising inflation impacts the general cost of living (by bumping it up) and in the long run, that could slow economic growth since people can’t afford as much as they could previously.

What is the inflation rate?

The inflation rate is, as you may have assumed, a measurement of inflation – so basically the rate of increase in a price index. In the US, inflation rate is calculated using the consumer price index. That index tracks how prices of preselected markets change over time, such as food and beverages. 

As of February 2021, the current inflation rate is roughly 1.7% for the past 12 months. That means that prices have gone up approximately 1.7% from February 2020 to February 2021, based on the consumer price index.

Understanding deflation

Now that we’ve covered inflation, your next question might be: what is deflation? 

Deflation is essentially the opposite of inflation. Deflation occurs when the overall price of goods, labor and services goes down. It’s caused by a decrease in the supply of money/credit without an equal decrease in economic output. So the purchasing power of currency goes up, and less money is required to buy the same things.

While lower costs might sound like a good thing (who wants to pay more for things?) there can be some downsides. For example, folks who have their money in savings accounts might feel deflation at work, since interest rates tend to go down during periods of deflation meaning money you have in deposit accounts might earn less. 

Borrowers are another group of people who could be potentially hurt by deflation. Think about it this way: say you got a loan to make a large purchase, and the following year that same item is listed at a lower price as a result of deflation, you’re still on the hook to pay back your loan for the higher price you purchased the item at (even though you could buy that item for less money now.)

Rising prices aren’t necessarily the end of the world

All this talk of rising prices and dropping currency values might sound pretty concerning. After all, no one wants to pay more for the same items. But the central bank, or other monetary authority in a country, typically take measures to keep inflation within certain limits, like wage and price controls.

Central banks may also adjust the supply of money so there’s less to go around. One way to do this is by increasing interest rates. This can help regulate inflation since people who have money want to hold on to it and thus spend less, which could help stop the rate of inflation. 

Something else that can help with inflation is that average salaries also tend to increase over time, which can potentially help mitigate some of the added financial pressures of inflation. 

So while inflation does decrease purchasing power and cause prices to increase, salaries (hopefully) increase as well.

Is inflation good for the economy?

The answer may surprise you: Inflation could be good (depending on a few factors). When inflation is mild, the possibility of prices going up in the near future can increase demand for things right now, which can boost economic growth. 

So what exactly is “mild” inflation? While the Federal Reserve doesn’t have a target they try to hit when it comes to an exact inflation rate, it’s generally believed that an inflation rate around 2% (and a little lower) is “acceptable.” Not only is a little inflation normal, it’s even considered necessary by many economists today.

Inflation can also be a good thing by removing the risk of deflation. When deflation occurs, people might expect prices to continue dropping, so they’re less willing to pay for something now if they think the price will be even lower in the near future. That decreases demand, which in turn decreases output from producers, and could lead to worker layoffs. Unemployment may then rise, leading to falling wages since unemployed folks desperate for a job may be willing to be paid less if it means they at least have something coming in. (And yes, that can be a lot of negatives to wrap our heads around!)

Of course, if inflation is too high, we can see the same problems we see with deflation: rising prices, increased unemployment and a slowed economy. This is when “stagflation” occurs – a bad combination of rising inflation and unemployment. (Folks in the US might remember this combination from the late 1970s).

When it comes to inflation, it’s about balance. The economic growth that can accompany inflation can be beneficial, but exorbitant prices and skyrocketing unemployment can be hard to swallow. 

While we may never see 20-cent gallons of gas again, it helps to know there are measures in place to use (mild) inflation for good and keep the economy in check.