Growing up, you may have heard your parents reminisce about how gas was only a quarter per gallon or that spending a night at the movie theaters only cost a nickel. This may leave you wondering why gas is now up to $3 per gallon in some areas, or that some movie theaters can charge a whopping $15 for a screening. The answer is simple: inflation.
A simple inflation definition states that inflation is the overall increase in the price of goods in the economy. This could be a rise in price for everyday products like milk, a car, and fruits and vegetables. However, there’s a lot more to inflation than meets the eye.
Below, we’re going to cover the basics of inflation, what causes inflation, types of inflation, how to measure inflation, and the pros and cons of inflation. For a full grasp on inflation and inflation rates, read end-to-end. Or, if you know what you’re looking for, use the provided links to jump to a specific section.
- What Is Inflation?
- Types of Inflation
- What Causes Inflation?
- Measuring Inflation
- Pros and Cons of Inflation
- Key Takeaways on Inflation
What Is Inflation?
According to the Department of Labor’s inflation definition, inflation is the overall general increase in the price of goods and services in an economy and shows the decrease in purchasing power of a country’s currency, such as the U.S. dollar. In the United States, the U.S. Department of Labor uses various indexes to measure different aspects of inflation.
Inflation, which is often conveyed as a percentage, reduces the value of a currency. As the prices of common goods and services rise, the money you have in your wallet buys less. This is why the amount of money your parents spent on gas or a ticket to see a movie when they were your age was much cheaper than the amount you pay today for those same everyday goods.
Inflation is the opposite of deflation. Deflation is the overall general decrease in the price of goods and services in an economy and shows the increase in the purchasing power of a country’s currency. Deflation is often caused by a decline in the supply of money or credit, without a corresponding reduction in economic output, causing the price of goods and services to fall. Deflation can also be caused by a lack of demand or an increase in productivity, such as technological advances making the cost of goods and services cheaper.
Types of Inflation
Inflation is important because it can tell you how much to expect the price of a good or service to increase or decrease in a specified time period. Most country’s central banks, such as the United States’s Federal Reserve central banking system, try to maintain interest rates between 2 and 3 percent. For example, if the annual inflation rate of a gallon of milk is 2 percent per year, then milk prices will be 2 percent higher next year. However, sometimes there are extreme cases of inflation, which can lead to hyperinflation and stagflation.
- Hyperinflation: Hyperinflation is a period of rapid inflation, where inflation goes above 50 percent or more in a month. Although hyperinflation is rare, it has happened a few times throughout the course of history. A famous example is Germany in the 1920s, where they were forced to pay war reparations set forth by the Treaty of Versailles. Due to the amount of money owed, Germany printed endless unbacked currency, which then made their currency worthless. When hyperinflation occurs, a country’s currency is either reformed, discarded, or replaced.
- Stagflation: Stagflation is a period of economic inactivity paired with inflation. This double whammy can cause economic adversity, which is fueled by poor economic growth, high unemployment rates, and an increase in inflation. A famous example is The Great Inflation the United States experienced between 1965 and 1982, where four economic recessions, two energy shortages, and wage and price controls caused a rise in inflation and unemployment. Stagflation can be difficult to manage, as monetary policymakers have to determine whether raising interest rates will reduce stagflation or further spike unemployment.
Currently, the coronavirus pandemic is creating economic hardship for countries across the world, including the United States. Millions of working Americans have lost their jobs, businesses are closing their doors, and this public health crisis is claiming the lives of hundreds of thousands of people. To weather this storm, the Federal Reserve is working hard to support the U.S. economy. In an emergency response to the global pandemic, the Federal Reserve agreed to maintain the target range for the federal funds rate at 0 to 0.25 percent. Along with this measure, the federal government implemented the following responses to COVID-19:
- Paycheck Protection Program and Health Care Enhancement Act: This program allocated $321 billion Small Business Administration loans that are eligible for forgiveness to help small businesses retain workers, among other measures.
- Coronavirus Aid Relief and Economy Security (CARES) Act: This act provided one-time tax rebates to individuals, increased unemployment benefits, provided a food safety net to those most vulnerable, issued loans to prevent corporate bankruptcy, and gave money to hospitals and local governments, among other measures.
- Coronavirus Preparedness and Response Supplemental Appropriations Act and Families First Coronavirus Response Act: These acts both work to increase virus testing, provide transfers to states for Medicaid funding, fund the development of vaccines, therapeutics, and diagnostics, provide sick leave to those infected, and support the CDC responses, among other measures.
Together, these measures were put in place to help mitigate the coronavirus’s disruption to the economy. With the Federal Reserve injecting more money into the economy to help stimulate it, they need to be wary of inflation. This is because if money dries out, there will be a lack of funds for banks to loan to businesses.
What Causes Inflation?
Inflation can occur in nearly any industry you can imagine, such as food, housing, cosmetics, stocks, and cars. These changes in price can occur at virtually any time, and in different directions. While the price of one commodity rises, another could drop, and vice versa.
One reason inflation is important is that it allows consumers to understand their risk tolerance when buying a particular good or service. For example, many homebuyers look at inflation rates to determine whether it’s smart to buy a home in that specific period of time.
Another reason why understanding inflation is important is that it can help consumers make investment decisions. For example, consumers looking to invest their money in a savings account will have to remember that a traditional savings account might not be able to keep up with inflation. Instead, they may want to consider an investment account with compounding interest.
So, what causes inflation? At its root, the rising cost of goods and services causes inflation. However, there are a variety of factors that can lead to inflation, which are classified into three different types of inflation: demand-pull inflation, cost-push inflation, and built-in inflation. Take a look at each type of inflation below:
One cause of inflation is demand-pull inflation. Demand-pull inflation is when the demand for goods and services within the economy outweighs the economy’s ability to produce these goods and services. Due to an increase in demand and limited supply, consumers might be more willing to pay more money for a good or service, resulting in inflation. Demand-pull inflation can occur for a variety of reasons, such as a growing economy where more consumers take on debt and spend more, or when government spending increases.
For example, let’s say farmers begin to cut back on milk production. As the supply for milk decreases, the demand increases. This can lead consumers to pay more money for milk, which will cause farmers to charge more money for their milk.
Demand-pull inflation can also occur when more money is put into the economy. This is evident with the federal government’s passing of the CARES Act in response to the coronavirus pandemic. Taxpayers were given a one-time stimulus check up to $1,200. One of the reasons for these economic impact payments was to put more money in the hands of American consumers to put back into the economy to help keep inflation rates at bay.
Cost-push inflation is another cause of inflation. Cost-push inflation is when an increase in the price of the production of goods and services results in inflation. When the cost of manufacturing or producing a good increases, the overall cost of the good increases, which leads to inflation. There are a variety of factors that can lead to cost-push inflation, such as an increase in land, capital, or labor that are needed to produce goods.
A common example of cost-push inflation is oil shock, where a decrease in oil supplies increases the price of oil. A variety of sectors in the U.S. economy rely on oil. When oil has a price increase, it can have an impact on the whole economy. This is because other industries might have to raise the price of their goods and services to account for the increase in oil price. Typically, cost-push inflation results in a temporary increase in inflation, which can be remedied by monetary policy.
A third cause of inflation is built-in inflation. Built-in inflation occurs when workers expect their salaries or wages to increase when prices of goods and services increase to help maintain their living costs. Built-in inflation can be viewed as a double-edged sword. As laborers demand higher pay, the cost of production increases, which can raise the cost of living. When the cost of living increases, laborers might begin to demand higher pay. Each factor influences the other, resulting in a cycle. However, built-in inflation doesn’t happen on its own. It can either be influenced by demand-pull inflation or cost-push inflation.
Measuring inflation is essential for a variety of reasons. Doing so allows the government to form monetary policies that can help boost the economy, set interest rates, wages, and welfare benefits, and help individuals plan for their financial future. There are numerous ways you can measure inflation, such as indices, formulas, and even inflation calculators. Take a look at how each inflation measurement works below.
Inflation is often measured using price indices. These indices measure changes in the average price of market baskets, such as a set of goods and services (e.g., cosmetics, meat, fruits, and vegetables). Below are two popular price indices.
Consumer Price Index (CPI)
The Consumer Price Index (CPI) is the most common index and is used by the U.S. Bureau of Labor Statistics. The CPI measures the average change over time in the prices consumers pay for a market basket of services and goods. The eight most common expenditure groups include:
- Medical care
- Education and communication
- Food and beverages
- Other goods and services
Over 200 categories spread across each of the eight major groups, and the BLS records about 80,000 consumer prices each month.
The CPI is calculated by dividing the price of a market basket in a particular year by the price of the same market basket in the base year. Inflation is then measured by calculating the change of price between the market basket of each year. The CPI measures the retail price of a product or service that’s available to individual consumers. The CPI is often the most-used indicator of inflation or deflation because it’s associated with the cost of living.
CPI data is usually collected during in-person visits by BLS staff. However, due to COVID-19, the BLS suspended in-person data collection on March 16, 2020, and is now relying on telephone interviews and online surveys, which may impact CPI data. Recent data from the U.S. Department of Agriculture looked at the impact the coronavirus has had on the CPI of food. As of April 2020, the CPI of eggs was up 17.3 percent from April 2019, while meats, poultry, and fish were up to 6.2 percent in April 2020 compared to April 2019. A takeaway from this data shows that an increase in demand for these products is leading to inflation.
The Producer Price Index / The Wholesale Price Index
The Wholesale Price Index (WPI) was the original name of this index from 1902 to 1978 but was then renamed the Producer Price Index. The Producer Price Index (PPI) is a family of indices that measures the price change over time received by domestic producers of services and goods. The PPI differs from the CPI because it measures the price changes in farm and wholesale prices from the perspective of the seller. Rather than looking at the changes in retail prices paid for by consumers, the PPI measures the average change in price that domestic producers are paid for their output.
The PPI is used for a variety of reasons, such as:
- Making contract adjustments for purchases and sales
- Indicating the overall price movement at the producer level
- Comparing input and output costs
Each month, roughly 10,000 PPIs are released for individual products and groups of products across nearly all industries in the economy, such as forestry, fishing, electricity, gas, and so forth.
The above indices use formulas to calculate the value of inflation between two different months or years. Understanding how these formulas work can help give you a better working knowledge of inflation. The basic inflation formula goes as follows:
Change in Inflation = (Final CPI Index Value / Initial CPI Value)
Let’s say you want to know the change in the purchasing power of $20,000 between January 1980 and January 2020. You can start by looking at Historical Consumer Price Index Data. In the table, look at the CPI of January 1980 and January 2020. The Initial CPI Value (January 1980) is 77.8, and the Final CPI Value (January 2020) is 257.971. Using the formula:
Change in Inflation = (257.971 / 77.8) = 3.3158 = 331.58%
Because you want to know how much $20,000 in January 1980 is worth in January 2020, you need to determine the change in dollar value by multiplying the change in inflation factor with your set dollar amount:
Change in Dollar Value = (3.3158 X $20,000) = $66,316
Lastly, you need to determine the final dollar value of the end period. This can be done by adding the original dollar amount ($20,000) to the change in dollar value ($66,3016)
Final Dollar Value = $20,000 + $66,316 = $86,316
Using this formula, you’ll find that $20,000 in 1980 will be worth $86,316 in 2020. For example, if you were looking at a basket of securities or goods worth $20,000 in January 1980, such as a car, the same basket would cost you $86,316 in January 2020.
A simple solution to finding the inflation rate change is by using an online inflation calculator. The Bureau of Labor Statistics has their own CPI inflation calculator where you enter a dollar amount, select a starting month and year, and select an ending month and year. An inflation calculator can help you calculate the buying power of the U.S. dollar and see how the buying power has changed over time.
At Mint, you’ll find a few financial calculators that you can use for a variety of purposes. With our investment calculator, you can monitor your investment income, create new investment goals, look for new investment opportunities, and forecast investment growth. Our budgeting calculator, on the other hand, can help give you a better picture of your monthly finances to determine whether you’re spending over or under your budget.Those planning for their retirement years can benefit from our retirement savings calculator, which makes it easy to set retirement goals and keep tabs on progress.
Pros and Cons of Inflation
Inflation can be looked at in a positive or negative light, depending on the circumstances and how fast prices change. Below, you’ll find the pros and cons of inflation:
- Value of tangible assets rises: Many individuals with tangible assets look for moderate inflation because it raises the value of their assets, which means they can sell their assets at a higher price.
- Economic growth: Moderate inflation can lead to economic growth. On the other hand, deflation can result in consumers spending less, which can cause a recession.
- Adjustment of wages: Moderate inflation allows for the adjustment of real wages.
- Adjustment of prices: Moderate inflation rates can allow prices of goods and services to adjust and achieve their real value.
- Increased investments: Moderate inflation encourages businesses and individuals to invest in stocks of companies in hopes of getting a better return.
- Higher costs for consumer goods: Consumers might not be happy with inflation because it means they might have to spend more money on goods and services.
- Lower economic growth: If inflation is too high, it can lead to lower economic growth and instability.
- Decrease in cash value: For investors who hold onto cash, inflation can decrease the value of their cash holdings.
- Slowed economic activities: High inflation can cause businesses and individuals to spend less, which will decrease money circulation in the economy.
- Higher unemployment rates: High inflation can also lead to higher unemployment rates because businesses might not be able to employ workers.
- Hoarding: High inflation rates can lead to fear, which might cause consumers to hoard necessary goods in fear of increasing prices.
Key Takeaways on Inflation
- Inflation is the general increase in the price of goods and services in an economy and decreases the purchasing power of a country’s currency.
- Hyperinflation and stagflation are two different types of extreme inflation. Hyperinflation is a period of rapid inflation, whereas stagflation is a period of economic inactivity paired with inflation.
- Due to the coronavirus pandemic, the Federal Reserve brought federal interest rates down to 0 to 0.25 percent to help avoid high inflation rates.
- There are three leading causes of inflation. Demand-pull inflation is when the demand for goods within the economy outweighs the economy’s supply. Cost-push inflation is when an increase in the price of the production of goods and services causes inflation. Built-in inflation occurs when workers expect their wages or salaries to increase when the prices of goods and services increase.
- There are four ways you can measure inflation, including the Consumer Price Index and Producer Price Index, an inflation formula, and an inflation calculator.
- The pros of inflation include an increase in businesses and consumers investing, a rise in the value of tangible assets, economic growth, adjustment of wages, and adjustment of prices.
- The cons of inflation include higher costs for consumer goods and services, lower economic growth if inflation is too high, a decrease in cash value, slowed economic activities, higher unemployment rates, and an increase in hoarding necessary goods.