What Is Inflation?

What Is Inflation? loading="lazy"

Inflation happens when the overall cost of goods and services goes up. So, if only the price of gas were rising, that would not necessarily qualify as inflation. Instead, inflation refers to the broad and climbing cost of things like gas, housing, clothing and other goods and services. If you're paying more to put gas in your tank, put a roof over your head, put clothing on your back and put food on the table, inflation could be a factor.

If you hear that the inflation rate stands at 2%, this means that $1 buys an average of 2% less in goods and services than it did last year.

What Causes Inflation?

Three key factors can drive up inflation:

  1. Demand for goods and services exceeds the supply, which can lead to higher prices.
  2. The cost of producing goods and services goes up, with providers of goods and services passing along the extra expense to buyers.
  3. A lot of money is floating around in the economy. When the pool of money available to spend deepens, it can pave the way for higher demand for goods and services. This, in turn, can trigger an uptick in the cost of producing those goods and services. For instance, that uptick might include a jump in wages paid to workers who generate those goods and services.

Many economists sum up the cause of inflation as "too much money chasing too few goods."

Economists and others measure inflation by tracking the following:

  • Consumer Price Index (CPI): This closely watched monthly index measures the average change, over time, in the prices paid by urban consumers in the U.S. for a big basket of goods and services. Among the many items in that basket are milk, chicken, rent, gas, prescription drugs, clothing, cable TV service and haircuts. From June 2020 to June 2021, the CPI jumped 5.4%. That was the biggest year-over-year increase in the CPI since August 2008, in the midst of the Great Recession.
  • Producer Price Index (PPI): This monthly index measures the average change, over time, in the prices that producers fetch for their goods and services.
  • Personal Consumption Expenditures Price Index (PCE): This monthly index reflects changes in the prices of goods and services that U.S. consumers purchase. It's similar to, but not the same as, the CPI.

How Inflation Affects Your Money

Inflation weakens the purchasing power of your dollar. This means you pay more to buy goods and services than you did, say, in the previous month or previous year. For instance, Americans might see the price of a gallon of whole milk rise 30 cents in a one-year period. Or motorists may feel the pain at the pump, with the price of a gallon of unleaded gas soaring $1 during a one-year span.

Inflation can also harm people who keep cash in savings accounts. Why? Because the value of the saved money goes down when inflation is high. Even though your money will earn more if inflation pushes interest rates up, you may have to use your savings to compensate for the higher prices of goods. Inflation also can water down the value of money you've been holding in fixed-income investments like bonds and certificates of deposit (CDs).

Who Benefits From Inflation?

While inflation can hurt consumers, it also can help some people.

Those who can benefit from inflation include borrowers who have existing loans. How so? When inflation is high, the value of debt decreases. As the inflation rate goes up, the burden of future interest payments on that debt goes down.

Generally, investors in the stock market and real estate sector also may see a positive effect from inflation. Historically, stock prices have increased along with inflation. Meanwhile, owners of real estate might witness a spike in the value of their property when inflation spikes.

And businesses might benefit from rising inflation if they wind up bumping up prices due to increased demand. Businesses also might end up paying more for materials or labor amid increasing inflation, however, which can erode their profits.

How to Protect Your Money From Inflation

You can't completely safeguard your money from being battered by inflation. But you can take action to help ease the financial blow.

When inflation is on the rise, you might consider diversifying your investment portfolio to help protect your money. For instance, you may look at expanding the share of stocks and shrinking the share of bonds you're holding.

Furthermore, you can commit to being better about budgeting. Creating and sticking to a budget can help you get a better handle on everyday expenses, lower your cost of living—and help loosen inflation's grip on your finances.

The Bottom Line

Regardless of whether the economy is experiencing inflation or the opposite (deflation), it's always a good time to make sure your credit is in the best shape possible. You can do this by getting your free credit score and free credit report from Experian.

Related Articles: