What Is Inflation?

What we’ll cover:

• Inflation happens when there’s a broad increase in the prices of goods and services, which can reduce purchasing power.
• Rising inflation can increase the general cost of living over time.
• While mild inflation could be helpful, a high rate of inflation could spell economic trouble. 

In the 1950s, you could buy a loaf of bread for 14 cents, toothpaste for 29 cents a tube and a tank of gas for about 20 cents a gallon. 

Sounds like a deal in today’s dollars, right? 

Most of us are probably familiar with the term “inflation,” which can help explain why the prices for goods and services have gone up over the years. 

In this article, we’ll go over how inflation works and what it means for your wallet. 

What is inflation?

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 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 anymore. Buying a soda at a gas station these days will usually cost you at least $2. This is an example of how inflation can reduce purchasing power. You now need more dollars to buy the same soda. 

In this way, rising inflation can increase the general cost of living over time. And in the long run, that could slow economic growth since people can’t afford as much as they could previously. 

But not only do customers feel the pinch in times of rising inflation. Businesses can feel the squeeze, too. 

Say you’re the grocery store owner in the example above. Rising inflation can mean higher business operating expenses, as the cost of equipment, supplies and utilities become more expensive. All of which can affect a business’s bottom line. Businesses could then, in turn, raise their prices to help offset those higher expenses. 

What is the inflation rate?

The inflation rate is a measurement of inflation. In the US, one popular way of measuring the inflation rate is using the consumer price index. That index tracks how prices of a preselected basket of goods and services change over time.

Inflation can also be necessary because it helps counter the risk of deflation.

Deflation is essentially the opposite of inflation. Deflation occurs when the overall price of goods, labor and services goes down. So the purchasing power of currency goes up, and less money is required to buy the same things.

When deflation occurs, people might expect prices to drop, so they’re less willing to pay for something now if they think the price will be even lower in the near future. That expectation could decrease demand, which in turn could decrease output from producers and could lead to layoffs. Unemployment may then rise, leading to falling wages.

Bottom line? When it comes to inflation, it’s all about finding balance. While mild inflation can be helpful, a high rate of inflation can spell economic trouble, such as rising prices and a slow economy.

Keeping inflation under control

In times of rising inflation, we often look to the Fed for help in keeping prices under control. For example, they may adjust the supply of money, so there’s less in circulation. One way to do this is by raising the federal funds rate,  which can impact the interest rates that bank offer on their financial products, such as savings accounts, mortgages and personal loans.  

Because inflation can mean higher interest rates, you may want to think carefully about taking out any new loans in times of high inflation.

4 tips to help you look after your money in times of high inflation

While at the individual level we may not be able to do much about the rate of inflation, there are a few things we could do to help limit its impact on our finances:

1. Prioritize your spending, reducing nonessential purchases.
2. Pay down debt, especially loans with variable rates.
3. Continue to invest for the long term if you can.
4. Explore ways to increase your income; for example, consider asking for a raise or adding a side gig.