If you're just starting to learn about investing and managing your money, you've likely heard about inflation, but you may not be entirely sure what it means. Put simply, inflation is the rate at which prices increase over time. While it may not seem initially like a big deal, inflation can have a significant impact on your investments and savings over time, so it is essential to understand what it is and what causes it.
In this article, we'll explain what inflation is, and provide you a starting point to explore related topics on the different types of inflation, what the inflation rate means and how inflation can affect your finances.
- Inflation is the rate of increase in prices over time
- A level of inflation between 2-3% is generally considered healthy
- A variety of economic factors can cause inflation, such as increased demand and rising costs
Inflation and its causes
What is a simple definition of inflation?
Imagine that you have a dollar today, and you can use that dollar to buy something for yourself, let's say a candy bar. However, if you wait a year, you might find that the same candy bar costs $1.10 instead of just $1. That's inflation!
Inflation happens when prices go up over time. This means that the things you buy become more expensive: in essence, you get "less bang for your buck" than you did yesterday.
Therefore, a very basic definition of inflation could be that inflation is the rate of increase in prices over a given period of time.
Inflation is typically a broad measure, such as the overall rise in the prices of goods or services across an entire economy over time, not just of individual items. By buying less than you could before, inflation reduces the value of your currency and leads to an increase in the cost of living in a country.
Inflation and its causes
Is inflation good or bad?
Whether inflation is good or bad is not straightforward as it depends on the context and degree of inflation. Some level of low, stable and predictable inflation is generally considered healthy for an economy, as it indicates that demand for goods and services is growing, which can lead to economic growth and job creation.
An acceptable and desirable rate of inflation is usually considered to be between 2% and 3% a year. A moderate level of inflation encourages spending and investment while keeping prices stable enough for people to make financial plans.
This rate is often targeted by central banks, such as the Federal Reserve in the United States and the European Central Bank (ECB) in the EU, who as of this writing both targeted 2% inflation over the medium term as acceptable. Some countries however may have higher inflation targets if they have high unemployment or a weaker currency.
However, high levels of inflation can be harmful. When prices increase quickly and unpredictably, people may struggle to afford basic necessities, leading to a decrease in their standard of living.
In addition, high inflation can reduce the value of savings: if you're saving up your money to buy something, you could find that it costs more than you thought it would when you started saving.
Inflation and its causes
What causes inflation?
There are a variety of factors, and often several factors at the same time, that can cause inflation. Some of the main causes of inflation include:
- Increased demand: When there's more demand for goods than there are goods available, prices go up.
- Rising production costs: Prices can rise due to increases in production costs such as raw materials and wages.
- Increase in the money supply: If there's too much money chasing too few goods, that can lead to inflation.
- Exchange rate changes: If the value of a country's currency decreases relative to other currencies, the prices of imported products can increase, causing inflation.
- Infationary expectations: If people expect prices to go up in the future, they may adjust their spending habits accordingly, in itself leading to higher prices.
A REAL-LIFE EXAMPLE: POST-COVID INFLATION
Let's look at a specific example from the recent past for a period of high inflation and its underlying causes. The coronavirus pandemic of 2020-2022 created an unusual set of circumstances that contributed to inflation, some of which were the following:
- Supply chain disruptions: The pandemic led to disruptions in global supply chains, which made it harder for companies to get the materials they needed for their products. This led to a decrease in the supply of goods, which caused prices to rise.
- Rise in demand for certain goods: As people spent more time at home they shifted their spending towards certain goods (e.g. home improvement products, groceries), and this increase in demand led to shortages and price increases.
- Government stimulus programs: In response to the pandemic, many governments enacted stimulus programs to support their economies. This injection of cash into the economy also contributed to inflation.
- Labor shortages: Some industries experienced labor shortages, which led to higher wages and increased production costs, fueling inflation.
- Energy prices: The price of oil and other energy products increased during the pandemic, leading to higher prices for goods that rely on these for production and transportation.