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Up, Up and Away – Understanding Inflation

We’ve all observed at some point that the cost of everything is going up. Most of us have either said or been told, “When I was a kid you could buy a loaf of bread for…” followed by a price that seem incomprehensibly low by current standards. Everyone knows prices go up because of inflation, and we shake our heads and curse it as though it’s something tangible that we can sit down and talk some sense into. The reality, however, is that raising prices is what inflation does, but it says nothing about what it is, what causes it or even how it’s measured.

Find out now: How much do I need to save for retirement?

But What Is Inflation?

It means the same thing in economic terms as it does in relation to a balloon: an increase in size due to an increase in internal pressure. Balloons become larger when air is blown into them, and prices increase as a result of economic pressures. Economists love to debate the nuances of what drives inflation, but there are two dominant theories that offer the best explanations:

Demand-Pull Inflation: This is when demand is greater than supply. It’s what drives inflation when an economy is growing and consumers have lots of money to buy things.

Cost-Push Inflation: When the cost to produce a product increases, companies increase prices in order to maintain their profit margins. Increased costs can be the result of higher wages, taxes, transportation or virtually any expense that a company incurs in getting their goods to market.

Let’s Talk About GDP

For us consumers, the result is the same: we are paying more today than we did yesterday. And to make matters worse, inflation occurs more often than its alter ego, deflation (where prices go down). When inflation grows at a moderate pace and wages increase along with it, we tend not to notice because we are able to buy the things we could before at roughly the same price. There are two other types of inflation, however, that can have a negative effect on consumers.

Hyperinflation: This is when inflation occurs at an exceptionally quick pace. Prices can rise by hundreds or thousands of percent a year. It happens most often when a country’s monetary system is failing.

Stagflation: A double hit for consumers, stagflation occurs when inflation is high and economic growth is flat. The “stag” part refers to the stagnation of consumer wages combined with an increase in prices. The result is we can buy less with what we earn.

Find out now: How should I save for retirement?

How Is Inflation Measured?

Government statisticians look at the prices of a variety of items that represent the economy. They call their collection of goods and services a market basket, as they are supposed to represent different segments of the economy. They then compare the cost of those items over time to determine a percentage change over a set period, such as a year. The U.S. Bureau of Labor Statistics creates two different price indexes that measure inflation:

Consumer Price Index: This is the one you hear about most often on the news. CPI measures changes in prices of consumer goods and services. It includes things like food, clothing, gas, oil and cars. The Bureau publishes the results monthly on its website.

Producer Price Index: Actually a combination of indexes, the PPI measures manufacturer and wholesale costs. Changes in the PPI are not always reflected in the CPI because some fluctuation is already factored into retail prices, and some changes are temporary. The PPI can be found on the Bureau’s site, as well.

Photo credit: flickr

Frank Addessi Born and raised in the center of the known universe, Brooklyn NY, and currently hiding out in the bucolic hills of northeast Pennsylvania writing about personal finance. His expertise includes personal loans, credit cards and retirement. It's not easy living the American Dream but someone has to do it!
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