Inflation is when your purchasing power decreases because the cost of goods or services have increased over a period of time. In simple terms, inflation is when you can’t buy as much with your money as you once could. For instance, if you were able to get a two-bedroom apartment for $1,000 a month ten years ago, but now that same amount will only get you a studio apartment, that could be due to inflation. Likewise, if you could once buy three loaves of your favorite bread for $5 but can only buy one with that amount, inflation is likely the culprit.
Measuring inflation is important because it affects consumer spending, interest rates, employment, businesses, and investment returns among others. When inflation climbs higher than wage growth, it could signal the economy is in trouble. Likewise, when inflation is too low, it can result in deflation, which could also signal trouble in economic paradise. low,
How Governments Measure Inflation
The Consumer Price Index (CPI) is one of the primary ways the government measures inflation and it’s published by the Bureau of Labor and Statistics. The CPI is an average of the price changes of 80,000 services and goods in the U.S. In case you’re wondering which goods and services make the cut, the Consumer Expenditures Survey uses the input of American families to determine that in addition to how heavily each item in the CPI is weighted. The Bureau of Labor and Statistics also conducts a CPI Housing Survey to measure the price change of residences.
To get the rate of inflation, you compare the value of the CPI from one period to another. That period could be month over month to reach a monthly rate of inflation or year over year for an annual rate of inflation.
The ideal inflation rate for the Federal Reserve is around 2%, but it has fluctuated over the years. After World War II, the United States saw historically high levels of inflation with rates creeping as high as 20%.
Causes of Inflation
There are several types of inflation but three of the most common are cost-push inflation, demand pull inflation and built-in inflation. These types of inflation can also double as causes of inflation. Here is an explanation of each accompanied by real-life examples.
Cost-push inflation
Sometimes the price of input goods and services-resources used to create goods and services-goes up. The consequence is often that the price of final goods and services sold to consumers increases too, resulting in what’s known as cost-push inflation.
An example of cost-push inflation is when there are disruptions in the energy sector due to war or natural disasters. If those wars affect oil fields, it causes shortages in services and goods that require energy. Basic supply and demand tells us when there is a lack of supply and high demand, prices likely go up. So, a lack of oil could lead to higher gas prices, higher utility bills, or more expensive clothing if manufacturing costs increase.
Demand pull inflation
When the demand for goods and services is high but the economy can’t meet that demand, it creates what’s known as demand-pull inflation.
In 2023, the price of eggs shot up across the United States. Some may not know one of the causes was the avian flu outbreak, which led to the death of almost 59 million birds as of July 2023. A shortage of birds means fewer eggs to supply. Seeing as eggs are an essential food item for many consumers, the demand remained high. However, the shortages caused by the flu outbreak meant that demand couldn’t be met and prices went up.
Built-In inflation
Inflation drives the cost of living up and if wages don’t go up, it can be financially challenging for consumers. When employees anticipate inflation and expect a pay rise to keep up to pace with the cost of living, that is built-in inflation.
How Inflation Affects the Stock Market
The stock market is one of many things that can be affected by rising or falling inflation. When inflation creeps up, companies’ bottom lines can be negatively affected and this can create uncertainty in the stock market. Investors may sell stock out of fear or hold back from investing until the market stabilizes.
Another way inflation affects the stock market is when central banks raise interest rates. Higher interest rates make borrowing money more expensive, which can also affect businesses and their profit margins. When businesses are less profitable, their stock prices may go down and that can directly impact an investor’s returns.
However, when inflation is in a healthy spot, it usually leads to strong economic growth, increase in corporate profits, and a greater demand for shares in said companies. When the demand for shares increases, stock prices tend to go up and that means greater profits for investors.
