PART OF

Guide to Economics








































ECONOMY   ECONOMICS
Inflation
By JASON FERNANDO
 Updated Nov 18, 2020
TABLE OF CONTENTS
EXPAND

 What Is Inflation?
 Understanding Inflation
 Causes of Inflation
 Types of Price Indexes
 Formula for Measuring Inflation
 Pros and Cons of Inflation
 Controlling Inflation
 Hedging Against Inflation
 Extreme Examples of Inflation
 Frequently Asked Questions

What Is Inflation?
Inflation is the decline of purchasing power of a given currency over time. A quantitative
estimate of the rate at which the decline in purchasing power occurs can be reflected in the
increase of an average price level of a basket of selected goods and services in an economy over
some period of time. The rise in the general level of prices, often expressed a a percentage means
that a unit of currency effectively buys less than it did in prior periods.

Inflation can be contrasted with deflation, which occurs when the purchasing power of money
increases and prices decline.

KEY TAKEAWAYS

 Inflation is the rate at which the the value of a currency is falling and consequently the
general level of prices for goods and services is rising.
 Inflation is sometimes classified into three types: Demand-Pull inflation, Cost-Push
inflation, and Built-In inflation.
 Most commonly used inflation indexes are the Consumer Price Index (CPI) and the
Wholesale Price Index (WPI).
 Inflation can be viewed positively or negatively depending on the individual viewpoint
and rate of change.
 Those with tangible assets, like property or stocked commodities, may like to see some
inflation as that raises the value of their assets.
 People holding cash may not like inflation, as it erodes the value of their cash holdings.
 Ideally, an optimum level of inflation is required to promote spending to a certain extent
instead of saving, thereby nurturing economic growth.
What Is Inflation?

Understanding Inflation
While it is easy to measure the price changes of individual products over time, human needs
extend much beyond one or two such products. Individuals need a big and diversified set of
products as well as a host of services for living a comfortable life. They include commodities
like food grains, metal and fuel, utilities like electricity and transportation, and services like
healthcare, entertainment, and labor. Inflation aims to measure the overall impact of price
changes for a diversified set of products and services, and allows for a single value
representation of the increase in the price level of goods and services in an economy over a
period of time.

As a currency loses value, prices rise and it buys fewer goods and services. This loss of
purchasing power impacts the general cost of living for the common public which ultimately
leads to a deceleration in economic growth. The consensus view among economists is that
sustained inflation occurs when a nation's money supply growth outpaces economic growth.

Image by Julie Bang © Investopedia 2019

To combat this, a country's appropriate monetary authority, like the central bank, then takes the
necessary measures to manage the supply of money and credit to keep inflation within
permissible limits and keep the economy running smoothly.

Theoretically, monetarism is a popular theory that explains the relation between inflation and
money supply of an economy. For example, following the Spanish conquest of the Aztec and
Inca empires, massive amounts of gold and especially silver flowed into the Spanish and other
European economies. Since the money supply had rapidly increased, the value of money fell,
contributing to rapidly rising prices.

Inflation is measured in a variety of ways depending upon the types of goods and services
considered and is the opposite of deflation which indicates a general decline occurring in prices
for goods and services when the inflation rate falls below 0%. 

Causes of Inflation
An increase in the supply of money is the root of inflation, though this can play out through
different mechanisms in the economy. Money supply can be increased by the monetary
authorities either by printing and giving away more money to the individuals, by
legally devaluing (reducing the value of) the legal tender currency, more (most commonly) by
loaning new money into existence as reserve account credits through the banking system by
purchasing government bonds from banks on the secondary market. In all such cases of money
supply increase, the money loses its purchasing power. The mechanisms of how this drives
inflation can be classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-
In inflation.
Demand-Pull Effect
Demand-pull inflation occurs when an increase in the supply of money and credit stimulates
overall demand for goods and services in an economy to increase more rapidly than the
economy's production capacity. This increases demand and leads to price rises.

 Melissa Ling {Copyright} Investopedia, 2019

With more money available to individuals, positive consumer sentiment leads to higher
spending, and this increased demand pulls prices higher. It creates a demand-supply gap with
higher demand and less flexible supply, which results in higher prices.

Cost-Push Effect
Cost-push inflation is a result of the increase in prices working through the production process
inputs. When additions to the supply of money and credit are channeled into commodity or other
asset markets and especially when this is accompanied by a negative economic shock to the
supply of key commodity, costs for all kind of intermediate goods rise. These developments lead
to higher cost for the finished product or service and work their way into rising consumer prices.
For instance, when the an expansion of the money supply creates a speculative boom in oil
prices the cost of energy of all sorts of uses can rise and contribute rising consumer prices, which
is reflected in various measures of inflation.

Built-In Inflation
Built-in inflation is related to adaptive expectations, the idea that people expect current inflation
rates to continue in the future. As the price of goods and services rises, workers and others come
to expect that they will continue to rise in the future at a similar rate and demand more
costs/wages to maintain their standard of living. Their increased wages result in higher cost of
goods and services, and this wage-price spiral continues as one factor induces the other and vice-
versa.

Types of Price Indexes

Depending upon the selected set of goods and services used, multiple types of baskets of goods
are calculated and tracked as price indexes. Most commonly used price indexes are
the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).

The Consumer Price Index

The CPI is a measure that examines the weighted average of prices of a basket of goods and
services which are of primary consumer needs. They include transportation, food, and medical
care. CPI is calculated by taking price changes for each item in the predetermined basket of
goods and averaging them based on their relative weight in the whole basket. The prices in
consideration are the retail prices of each item, as available for purchase by the individual
citizens. Changes in the CPI are used to assess price changes associated with the cost of living,
making it one of the most frequently used statistics for identifying periods of inflation or
deflation. In the U.S., the Bureau of Labor Statistics reports the CPI on a monthly basis and has
calculated it as far back as 1913.1
The Wholesale Price Index
The WPI is another popular measure of inflation, which measures and tracks the changes in the
price of goods in the stages before the retail level. While WPI items vary from one country to
other, they mostly include items at the producer or wholesale level. For example, it includes
cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing. Although many
countries and organizations use WPI, many other countries, including the U.S., use a similar
variant called the producer price index (PPI).

The Producer Price Index

The producer price index is a family of indexes that measures the average change in selling
prices received by domestic producers of intermediate goods and services over time. The
PPI measures price changes from the perspective of the seller and differs from the CPI
which measures price changes from the perspective of the buyer.2

In all such variants, it is possible that the rise in the price of one component (say oil) cancels out
the price decline in another (say wheat) to a certain extent. Overall, each index represents the
average weighted price change for the given constituents which may apply at the overall
economy, sector, or commodity level.

The Formula for Measuring Inflation

The above-mentioned variants of price indexes can be used to calculate the value of inflation
between two particular months (or years). While a lot of ready-made inflation calculators are
already available on various financial portal and websites, it is always better to be aware of the
underlying methodology to ensure accuracy with a clear understanding of the calculations.
Mathematically,

Percent Inflation Rate = (Final CPI Index Value/Initial CPI Value)*100

Say you wish to know how the purchasing power of $10,000 changed between Sept. 1975 and
Sept. 2018. One can find price index data on various portals in a tabular form. From that table,
pick up the corresponding CPI figures for the given two months. For Sept. 1975, it was 54.6
(Initial CPI value) and for Sept. 2018, it was 252.439 (Final CPI value).3 Plugging in the formula
yields:

Percent Inflation Rate = (252.439/54.6)*100 = (4.6234)*100 = 462.34%

Since you wish to know how much $10,000 of Sept. 1975 would worth be in Sept. 2018,
multiply the percent inflation rate with the amount to get the changed dollar value:

Change in dollar value = 4.6234 * $10,000 = $46,234.25

This means that $10,000 in Sept. 1975 will be worth $46,234.25. Essentially, if you purchased a
basket of goods and services (as included in the CPI definition) worth $10,000 in 1975, the same
basket would cost you $46,234.25 in Sept. 2018.

Pros and Cons of Inflation

Inflation can be construed as either a good or a bad thing, depending upon which side one takes,
and how rapidly the change occurs.

For example, individuals with tangible assets that are priced in currency, like property or stocked
commodities, may like to see some inflation as that raises the price of their assets which they can
sell at a higher rate. However, the buyers of such assets may not be happy with inflation, as they
will be required to shell out more money. Inflation-indexed bonds are another popular option for
investors to profit from inflation.

On the other hand people holding assets denominated in currency, such as cash or bonds, may
also not like inflation, as it erodes the real value of their holdings. Investors looking to protect
their portfolios from inflation should consider inflation-hedged asset classes, such as gold,
commodities, and Real Estate Investment Trusts (REITs).

Inflation promotes speculation, both by businesses in risky projects and by individuals in stocks
of companies, as they expect better returns than inflation. An optimum level of inflation is often
promoted to encourage spending to a certain extent instead of saving. If the purchasing power of
money falls over time the, then there may be a greater incentive to spend now instead of saving
and spending later. It may increase spending, which may boost economic activities in a country.
A balanced approach is thought to keep the inflation value in an optimum and desirable range.

High and variable rates of inflation can impose major costs on an economy. Businesses, workers,
and consumers must all account for the effects of generally rising prices in their buying, selling,
and planning decisions. This introduces an additional source of uncertainty into the economy,
because they may guess wrong about the rate of future inflation. Time and resources expended
on researching, estimating, and adjusting economic behavior around expected rise in the general
level of prices, rather than real economic fundamentals, inevitably represents a cost to the
economy as a whole.

Even a low, stable, and easily predictable rate of inflation, which some consider otherwise
optimal, may lead to serious problems in the economy, because of how, where, and when the
new money enters the economy. Whenever new money and credit enters the economy it is
always into the hands of specific individuals or business firms, and the process of price level
adjustment to the new money supply proceeds as they then spend the new money and it
circulates from hand to hand and account to account through the economy.

Along the way, it drives up some prices first and later drives up other prices. This sequential
change in purchasing power and prices (known as the Cantillon effect) means that the process of
inflation not only increases the general price level over time, but it also distorts relative prices,
wages, and rates of return along the way. Economists in general understand that distortions of
relative prices away from their economic equilibrium is not good for the economy, and Austrian
economists even believe this process to be a major driver of cycles of recession in the the
economy.

Controlling Inflation
A country’s financial regulator shoulders the important responsibility of keeping inflation in
check. It is done by implementing measures through monetary policy, which refers to the actions
of a central bank or other committees that determine the size and rate of growth of the money
supply.

In the U.S., the Fed's monetary policy goals include moderate long-term interest rates, price
stability, and maximum employment, and each of these goals is intended to promote a stable
financial environment. The Federal Reserve clearly communicates long-term inflation goals in
order to keep a steady long-term rate of inflation, which is thought to be beneficial to the
economy.

Price stability—or a relatively constant level of inflation—allows businesses to plan for the
future since they know what to expect. The Fed believes that this will promote maximum
employment, which is determined by non-monetary factors that fluctuate over time and are
therefore subject to change. For this reason, the Fed doesn't set a specific goal for maximum
employment, and it is largely determined by employers' assessments. Maximum employment
does not mean zero unemployment, as at any given time there is a certain level of volatility as
people vacate and start new jobs.

Monetary authorities also take exceptional measures in extreme conditions of the economy. For
instance, following the 2008 financial crisis, the U.S. Fed has kept the interest rates near zero and
pursued a bond-buying program called quantitative easing.4 Some critics of the program alleged
it would cause a spike in inflation in the U.S. dollar, but inflation peaked in 2007 and declined
steadily over the next eight years. There are many complex reasons why QE didn't lead to
inflation or hyperinflation, though the simplest explanation is that the recession itself was a very
prominent deflationary environment, and quantitative easing supported its effects.

Consequently, the U.S. policymakers have attempted to keep inflation steady at around 2% per
year.5  The European Central Bank has also pursued aggressive quantitative easing to counter
deflation in the eurozone, and some places have experienced negative interest rates, due to fears
that deflation could take hold in the euro zone and lead to economic stagnation.6  Moreover,
countries that are experiencing higher rates of growth can absorb higher rates of inflation. India's
target is around 4%, while Brazil aims for 4.25%.7  8

50%
Hyperinflation is often described as a period of inflation of 50% or more per month.
Hedging Against Inflation
Stocks are considered to be the best hedge against inflation, as the rise in stock prices are
inclusive of the effects of inflation. Since additions to the money supply in virtually all modern
economies occur as bank credit injections through the financial system, much of the immediate
effect on prices happens financial assets that are priced in currency, such as stocks.

Additionally, special financial instruments exist which one can use to safeguard investments
against inflation. They include Treasury Inflation Protected Securities (TIPS), low-risk treasury
security that is indexed to inflation where the principal amount invested is increased by the
percentage of inflation. One can also opt for a TIPS mutual fund or TIPS-based exchange traded
fund (ETFs). To get access to stocks, ETFs and other funds that can help to avoid the dangers of
inflation, you'll likely need a brokerage account. Choosing a stockbroker can be a tedious process
due to the variety among them.

Gold is also considered to be a hedge against inflation, although this doesn't always appear to be
the case looking backwards.
9

Extreme Examples of Inflation

Since all world currencies are fiat money, the money supply could increase rapidly for political
reasons, resulting in rapid price level increases. The most famous example is
the hyperinflation that struck the German Weimar Republic in the early 1920s. The nations that
had been victorious in World War I demanded reparations from Germany, which could not be
paid in German paper currency, as this was of suspect value due to government borrowing.
Germany attempted to print paper notes, buy foreign currency with them, and use that to pay
their debts. 

This policy led to the rapid devaluation of the German mark, and hyperinflation accompanied the
development. German consumers responded to the cycle by trying to spend their money as fast
as possible, understanding that it would be worth less and less the longer they waited. More and
more money flooded the economy, and its value plummeted to the point where people would
paper their walls with the practically worthless bills. Similar situations have occurred in Peru in
1990 and Zimbabwe in 2007–2008.

Frequently Asked Questions

What causes inflation?
There are three main causes of inflation: demand-pull inflation, cost-push inflation, and built-in
inflation. Demand-pull inflation refers to situations where there are not enough products or
services being produced to keep up with supply, causing their prices to increase. Cost-push
inflation, on the other hand, occurs when the cost of producing products and services rises,
forcing businesses to raise their prices. Lastly, built-in inflation—sometimes referred to as a
“wage-price spiral”—occurs when workers demand higher wages to keep up with rising living
costs. This in turn causes businesses to raise their prices in order to offset their rising wage costs,
leading to a self-reinforcing loop of wage and price increases.

Is inflation good or bad?

Too much inflation is generally considered bad for an economy, while too little inflation is also
considered harmful. Many economists advocate for a middle-ground of low to moderate
inflation, of around 2% per year. Generally speaking, higher inflation harms savers because it
erodes the purchasing power of the money they have saved. However, it can benefit borrowers
because the inflation-adjusted value of their outstanding debts shrinks over time.

What are the effects of inflation?

Inflation can affect the economy in several ways. For example, if inflation causes a nation’s
currency to decline, this can benefit exporters by making their goods more affordable when
priced in the currency of foreign nations. On the other hand, this could harm importers by
making foreign-made goods more expensive. Higher inflation can also encourage spending, as
consumers will aim to purchase goods quickly before their prices rise further. Savers, on the
other hand, could see the real value of their savings erode, limiting their ability to spend or invest
in the future.

Compete Risk Free with $100,000 in Virtual Cash

Put your trading skills to the test with our FREE Stock Simulator.Compete with thousands of
Investopedia traders and trade your way to the top! Submit trades in a virtual environment before
you start risking your own money.Practice trading strategies so that when you're ready to enter
the real market, you've had the practice you need. Try our Stock Simulator today >>
ARTICLE SOURCES
Compare Accounts
Advertiser Disclosure

Related Terms

Consumer Price Index (CPI) Definition

The Consumer Price Index measures the average change in prices over time that consumers pay
for a basket of goods and services.
 more
What Causes Hyperinflation
Hyperinflation describes rapid and out-of-control price increases in an economy. In this article,
we explore the causes and impact of hyperinflation.
 more
Cost-Push Inflation
Cost-push inflation occurs when overall prices rise (inflation) due to increases in production
costs such as wages and raw materials.
 more
Agflation
Agflation is inflation linked to increasing agricultural prices to manufacture food and alternative
fuels, which can outpace rising prices of other goods.
 more
Price Level
A price level is the average of current prices across the entire spectrum of goods and services
produced in the economy.
 more
Explaining the Wage-Price Spiral and How It Relates to Inflation
A wage-price spiral is a macroeconomic theory to explain the cause-and-effect relationship
between rising wages and rising prices, or inflation. 
more
Partner Links
 Related Articles

MACROECONOMICS
The Difference Between Inflation vs. Deflation

MACROECONOMICS
How CPI Affects the Dollar Against Other Currencies

MACROECONOMICS
Inflation vs. Stagflation: What's the difference?

MACROECONOMICS
Why Is the Consumer Price Index Controversial?

FOREX TRADING STRATEGY & EDUCATION

What Indicators Are Used in Exchange Rate Forecasting?

MACROECONOMICS
What Impact Does Inflation Have on the Dollar Value Today?

 About Us
 Terms of Use
 Dictionary
 Editorial Policy
 Advertise
 News
 Privacy Policy
 Contact Us
 Careers
 California Privacy Notice

Investopedia is part of the Dotdash publishing family.