A Basic Guide to Understanding Inflation

A Basic Guide to Understanding Inflation

Sean Cooper |May 12, 2020

How Is Inflation Measured?

You probably already have a basic idea about what inflation is, but have you ever wanted to know more? In this article we’ll cover the basics of inflation: what inflation is, why it’s important, how it affects the economy and financial markets, why you should care about it, and finally, how it is measured and determined year-to-year.

What Is inflation?

Inflation is a general rise in the average price level of goods and services over a period of time. When inflation occurs, your purchasing power, the amount of goods and services that you can purchase with a unit of currency, is reduced.

Inflation is the opposite of deflation. Deflation is when price levels fall instead of rise over time.

It’s important to understand what inflation is and what inflation isn’t.

Avocadoes are popular with millennials these days. But just because more millennials are eating avocado toast and the prices of avocadoes go up, it doesn’t mean it’s because of inflation. Avocadoes are more popular due to shifting consumer tastes. Inflation is when all goods and services get more expensive, not just one or two items.

Why Inflation Is Important and Inflation Causes

Inflation is important because it has a huge effect on the overall economy. It’s the goal of most governments to keep inflation in line.

But, what causes inflation? Inflation happens when the demand for goods and services exceeds the supply. When this happens over time, prices go up.

If the inflation rate is too low it means that consumer demand is dropping. This may signify that there could be a larger problem with the economy. Low inflation encourages consumers to put off purchasing goods and services, doing further harm to the economy. However, low inflation does help lower the cost of borrowing for consumers, as low inflation means the Federal Reserve is less likely to hike interest rates.

On the other end of the spectrum, if inflation is moving up too quickly, it can negatively impact the purchasing power of consumers and also hurt the economy. This is why a country’s central bank will usually aim to keep inflation around a modest 2%.

How Inflation Affects the Economy and Financial Markets

Inflation can affect the economy and financial markets, too.

If inflation is rising too quickly, it’s possible that it could cause a recession. If the economy is growing too quickly it can cause a government’s central bank to raise interest rates by too much, which can cause growth to slow and subsequently cause a recession.

Low inflation generally signifies a healthy economy. When inflation is low, American consumers are encouraged to buy more goods and services. Waiting to purchase something would mean that you’d have to pay more for the same item later on. Low inflation also means it’s more attractive to borrow money, since low inflation and low interest rates usually go hand in hand.

In terms of financial markets, investing in stocks is usually a good way to combat high inflation. That’s because a company’s earnings should theoretically go up at the same pace as inflation. The reverse is also true. During periods of low inflation, investors tend to earn less from stocks, making it a less appealing time for investors.

Why You Should Care and Know About Inflation

You should care and known about inflation because it affects your daily life.

Let’s say you’re an investor. Taxes are an important consideration in investing, but so too is the inflation rate. If you’re only earning 1% interest on your savings account and the inflation rate is 2%, you’re actually losing money once you factor in inflation. (We haven’t even factored in taxes yet either.) That’s why it’s important to consider both taxes and inflation when investing, to determine your real rate of return.

Inflation also tends to have a big impact on those with fixed incomes. For example, people with disabilities and retirees can be negatively affected by inflation. If the prices of goods and services keep going up, while the income of these individuals stays the same, this could result in some difficult decisions for them to make. Individuals on fixed incomes may be forced to cut back on food and other discretionary spending to get by if inflation rises too quickly.

Inflation doesn’t just affect those on fixed incomes. You’ll notice inflation at work when the prices of goods go up at the supermarket, making it more expensive to feed your family.

How Inflation Is Measured and Determined

We already spoke about what inflation is: it’s the increase in price level of goods and services. Inflation is measured by measuring the rate of change in those prices.

The most common way to measure inflation is the Consumer Price Index (or CPI for short). The CPI measures the change in price of a basket of goods and services that the average family consumes.

Inflation is determined year-by-year by looking at the change in the inflation rate this year compared to last year.

The Basics of the Consumer Price Index (CPI)

The CPI is based on the shopping diaries of average Americans. Americans write down what they purchase and how much it costs. This information is then used to figure out how much prices are changing for certain goods and services.

The CPI gives you a better glimpse of how much prices are going up versus just visiting one grocery store. The CPI isn’t just for items you can purchase at the grocery store; it includes other expenses like utility bills, home insurance and gas.

So, how is CPI calculated? The CPI can be calculated in different ways. It can be calculated overall for the U.S. and it can also be calculated city-by-city to give an idea how expensive it is to live in one city relative to another.

When CPI figures are released, they have the overall rate prices have changed and then a core CPI rate. The core CPI rate strips out food and energy because those tend to fluctuate a lot more over time.

When you read about inflation figures in the news, they’re usually talking about the core CPI figures. Nevertheless, the core CPI figure can be deceiving since it includes housing costs, which can vary a lot depending on where you live in the U.S.

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Katie Macomb | May 12, 2020

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