Inflation refers to the trend of prices rising in an overall economy. As a result of rising prices, purchasing power diminishes — in short, each dollar you have buys less. 

The opposite of inflation is deflation, which occurs when general prices in an economy drop.

For inflation (or deflation) to occur, price trends can be limited to a single sale, type of good, or even category of good. For example, automobile prices skyrocketing could be attributed to supply and demand issues and not inflation, especially if the prices of other types of goods and services are not rising.

Keep reading to learn more about what causes inflation, how to measure inflation, and other important information about this critical economic force. 

Impact of inflation

Inflation impacts your personal finances because it reduces your buying power. When food, fuel, utilities, and other goods are more expensive, you will want to buy less of them. Sometimes, that leads to households not having enough left over at the end of the month to save money or invest for the future.

Often, inflation makes people more aware of the need to save, so they cut their discretionary and optional spending so they can save. That leads to reduced overall spending in the economy. If inflation is high enough and/or the impact is long enough, this stagnation in the economy can lead to other issues, including low job growth, stock market fluctuations, and a recession.

Worried about inflation eating into the value of your savings? Use our Retirement Planner to model different scenarios based on inflation.

What drives inflation?

Inflation can be caused or driven by a variety of economic factors. In many cases, inflation in the overall economy is a result of multiple factors occurring at or around the same time.

Supply-related inflation

Changes in supply and demand can drive inflation. Again, if the supply and demand issue is in a single niche, this doesn’t tend to drive inflation. The issues have to impact enough sectors of major goods and services — such as groceries — to cause overall inflation in the economy. 

Cost-push inflation

Cost-push inflation occurs when the demand for goods and services is the same or growing, but a supply issue of some type means there isn’t enough to meet existing demand. The supply shortage might be caused by issues with supply chains, such as transportation strikes. They might also be caused by geopolitical instability, natural disasters, and other large-scale issues.

To address what may be seen as a temporary supply issue, manufacturers, wholesalers, and retailers may increase prices. They do this to slow down purchasing and try to stretch the existing supply over the demand. If demand doesn’t go down with that price increase, prices may continue to rise. That can lead to inflation.

Demand-pull inflation

Demand-pull inflation is a slightly different type of supply-related inflation. It occurs when there is not necessarily a shortage or issue impacting existing supply chains. However, because of other forces in the market, including consumer trends or growing populations, demand for goods and services rises to eclipse existing supplies. This drives up prices in a similar way that cost-push inflation does; the initial trigger just comes from the demand side.

Devaluation occurs when a government makes a decision to devalue its currency in comparison to another currency. For example, in early November 2022, the U.S. dollar was worth around 146 Japanese yen. If the United States government decided to devalue the dollar compared to the yen, it would take action to lower that ratio, perhaps seeking to create a situation where, hypothetically and unrealistically, the U.S. dollar was worth 125 yen. 

Reasons governments might devalue their own currency can include making their exports more cost-competitive globally or working to reduce deficits.

The end result, however, is that the currency in the country has less purchasing power, which can lead to inflation. 

Rising wages

When wages increase across large sectors of an economy, prices tend to go up. That’s true whether governments enact new minimum wage laws or employers simply choose to raise wages so they can hire and keep good workers.

Companies that pay more to employees incur more costs. They typically pass those costs along to consumers in the form of increased prices. Again, this creates a situation where every dollar buys less due to inflation.

In extreme cases, this can lead to a cycle. Consumers may buy less because of inflation, leading to company losses that become layoffs. Unemployment affects taxes and reduces average earnings across the nation, which cuts back even more on buying power.

The housing market

Supply and demand in the housing market can drive inflation overall. That’s due in part to the fact that housing expenses make up such a large part of the average American’s monthly expenses. If that one expense rises, the entire budget may need tweaking.

Here’s one example of how the housing market can lead to inflation:

Rental rates go up. Because there’s a large demand for rentals — one that might outpace the supply — landlords could charge more for each rental. 

More people rent. This could occur if there aren’t enough homes for sale to meet demands, or rising mortgage rates push people out of the home-buying market. 

• People spend less in other areas. People may cut down on discretionary spending to cover housing. 
• Companies raise prices. Companies that see a reduction in revenue due to decreased discretionary spending raise prices to support profitability. The cycle eventually leads to overall inflation. 

How to measure inflation

Inflation is measured via a number of economic tools.

Consumer Price Index (CPI)

Perhaps the most widely used and well-known measure of inflation is the Consumer Price Index. The CPI measures the cost of a variety of goods to understand the overall impact of pricing in the marketplace.

The United States creates a CPI for each period based on the Consumer Expenditure Survey.¹ This survey determines what types of goods and services are included in the CPI basket and how much weight each is given. The CPI is generally based on:

• Food and beverages
• Transportation
• Housing
• Medical care
• Recreation
• Other types of goods and services

Economists apply specific formulas to these data points to come up with the CPI. The CPI is then used as an overall metric to understand what is happening with inflation.