If you’ve walked out of a grocery store having paid $100 and felt like you bought almost nothing, you’ve felt inflation in action. Inflation refers to a decline in purchasing power of a single unit of money, such as a dollar. Inflation is tied to rising prices, which is what consumers first notice, but there are more complicated dynamics at play.
As purchasing power drops on goods and services over time, there are significant impacts for both consumers and the larger economy. Inflation macroeconomics is usually measured by the average price increase of a basket of goods. The two most common inflation indices are the wholesale price index and the consumer price index (CPI).
While some inflation is good — even healthy — too much can cripple an economy. Here’s everything you need to know about current inflationary trends.
Inflation explained
Inflation is usually driven by demand-pull, cost-push or built-in inflation (more on the first two below). Built-in inflation is the consequence of workers demanding higher wages to keep up with a higher cost of living. Built-in inflation causes an upward spiral. As businesses raise their prices to compensate for higher wages, workers again require higher pay.
The causes of inflation build on each other. Right now a combination of inflationary factors are leading to a cycle of built-in inflation. The current cycle of inflation began with demand-pull inflation from rising wages in the U.S.
As Americans had more in savings and consumer spending increased, demand-pull inflation set in. This set off cost-push inflation as prices rose and businesses offset costs by raising prices. This can lead to a cycle of built-in inflation if employers are not able to maintain competitive wages. That, combined with other market factors like supply chain issues and the energy crisis, are pulling in the direction of inflation.
Consumers see inflation every day. When your favorite restaurant or coffee shop raises its prices, you’re seeing cost-push inflation in action. And if you choose to pay the prices even if they’re too high for you, you’re engaging in demand-pull inflation. The same is true for all goods and services.
Is inflation good or bad for the economy?
Economists generally agree that a little inflation is good. The established average ideal of the Federal Reserve is 2% inflation per year. In contrast, the change in the CPI for all consumers over the 12-month period ending in June was 9.1%.
What are the consequences of high inflation?
The most immediate consequence of inflation going too high is reduced purchasing power. People with significant savings will see them lose value over time. For consumers with debt, inflation reduces the amount to be repaid over time.
For example, a person who had $100,000 in savings in 1980 would have the same purchasing power as if they had $360,204 in savings today. Someone who keeps their funds in a savings account will lose purchasing power if inflation is higher than the interest rate earned.
If the same person takes out a fixed-interest mortgage for $100,000 in 1980, the set payments would be proportionately less in the later years of the repayment periods.
But the influence of inflation extends beyond that. When inflation is too high, it feeds on itself, leading to a spiral of upward inflation.
Other effects of inflation include:
- Rising interest rates
- Lower debt-service costs
- Short-term employment growth
- Reduced value of bonds and growth stocks
- Recessions often result
Inflation and purchasing power
What does inflation do? Inflation’s most direct consequence is in purchasing power. In 1900, the purchasing power of $1 was equivalent to about $35 today. By 1980, $1 was equivalent to the purchasing power of about $3.60 today. And in 2000, $1 was approximately equivalent to $1.72 today. When prices rise, your dollar buys less.
What causes inflation?
Inflation is caused either by demand that is higher than the available supply or by rising costs. This is called demand-pull inflation or cost-pull inflation. However, the causes of inflation are usually interrelated.
Demand-pull inflation
Demand-pull inflation is caused by a shortage in supply. It is the natural consequence of high demand and low supply. Demand pulls prices higher. Consumers see demand-pull inflation whenever prices rise disproportionately — and they pay them.
Demand-pull inflation is not isolated to one good or service but is seen across the economy. If the cost of tires doubles and you get a flat tire, you’ll probably pay the price even if it hurts. When you make the purchase, you’re participating in demand-pull inflation.
Cost-push inflation
Cost-push inflation is the overall price increase that happens with an increase in raw materials and wages. Costs push prices up.
Recently the electricity supply has seen cost-push inflation. Natural gas is needed to make electricity. While electricity demand is stable, the cost of energy has increased because of shortages related to global policies, war or natural disasters. This, in turn, leads to the cost of electricity being pushed higher.
How is inflation measured?
The CPI is typically used to measure inflation. The Bureau of Labor services calculates the CPI by collecting data on 94,000 items to assemble a representative basket monthly. The CPI includes detailed expenditure information from families and individuals on what they are actually purchasing.
Why is inflation today so high?
Increased prices are the result of various factors, including the energy crisis that’s creating cost-push inflation. Overaggressive stimulus funding during the pandemic led to demand-pull inflation. That, combined with supply chain disruptions that have persisted since early in the pandemic, are also creating cost-push inflation.
Interest rate increases are used to combat inflation. In theory, if it’s more expensive to borrow money, either through mortgages, loans or on credit cards, consumers will spend less. This, in turn, will cause demand to fall, eventually leading to lower prices and decreased inflation. Governments may control the money supply, alter supply-side and fiscal policies and implement wage/price controls to try to combat inflation.
How to safeguard your finances during periods of high inflation
Periods of high inflation affect everyone, but that doesn’t mean you can’t safeguard your finances and weather the financial storm. In the long term, you can expect inflation rates to normalize. In the meantime, focus on saving and bringing in more money while investing for the long term. Here’s how:
Cut excess spending and look for savings
Now may not be the time to splurge on a special vacation or switch to expensive food plans. Instead, focus on cutting excess spending where possible.
A few ways to do this include:
- Looking for coupons and discounts on activities
- Taking advantage of free activities or events for locals
- Focusing on using what you have in the house before buying new
- Reducing spending on clothing, travel and entertainment
- Reducing food purchases to necessities with a set number of weekly treats, shopping sales and choosing in-season produce
Find ways to bring in more money
The best way to combat inflation is to bring in more money. Consider a side hustle, an additional part-time job or turning a hobby into a profession. Think of the skills you have and how you can offer value, then get to work promoting your goods or services.
Invest in assets that hedge against inflation
Assets that hedge against inflation have enduring value. The classic inflation-resistant investment is gold. However, real estate typically performs well with inflation, as do interest-bearing government-issued savings bonds.
Look for an inflation-matching savings account
You can also consider a savings account with a high yield that will protect your money. You can find online banks that offer savings accounts with inflation-matching rates or nearly inflation-matching rates. Even if they do not stay ahead of inflation, they will be much closer than a standard savings account.
Final thoughts on inflation
Reasons for inflation vary but, the result is the same: a rise in consumer prices and lower spending power. Regardless of its causes, the way to get through a time of high inflation is to save, increase streams of income and invest carefully. With careful consumer planning and investment strategies, you can continue to build wealth and financial growth in times of high inflation.
FAQs
How can inflation be reduced?
Governments fight inflation in different ways. Monetary policy like higher interest rates is one option. Other strategies include control of the money supply, supply-side policies, fiscal policy and wage/price controls.
Who benefits from inflation?
In the long term, equity and commodities investors can benefit from inflation. Borrowers with fixed-interest loans also benefit. The energy industry, food industry, electric vehicle manufacturers and collectors also can benefit from inflation.
Who is hurt by high inflation?
To some extent, everyone is hurt by high inflation, but the poor and small businesses usually suffer the most from inflation and its causes.
