Inflation is a real pain in the wallet. But, why? How does inflation work? How does it cut your buying power? Why could my grandma buy lunch for 25 cents back in 1939? You’re not the only one with these questions! Below, you’ll learn everything you need to know about inflation.
What is Inflation?
Have you ever noticed, the older you get, the more expensive everything seems? That’s inflation, probably. See, a few items going up in price from one year to the next is not necessarily inflation. Instead, inflation occurs when most common items increase in price over a long period.
How is Inflation Measured?
Economists measure inflation a few different ways. The most common ways are by measuring changes in the consumer price index, producer price index, and the gross domestic product price deflator.
Consumer Price Index
The first way to measure inflation is by measuring changes in the Consumer Price Index (CPI). The consumer price index measures changes in consumer goods and services. Food, clothing, beverages, and fuel are common examples, but most things people want to buy would count.
Calculating CPI is pretty simple. First, we decide which group of consumer goods we want to study. Economists group these items into eight major categories:
- food and beverages
- medical care
- education and communication
- other goods and services
Let’s say we want to use CPI to measure the inflation of food and beverage prices. We would start by finding the cost of the food and beverage group in a given year. Then, we would find the cost of the food and beverage group in a previous year. Lastly, we would plug both of those values into the equation below.
This answer would give the percent increase of this group’s prices between these two years. If you want, you can change this equation to find the rate of price changes between any two years. To do this, just change “CPI This Year” to the year you’re interested in, and change “CPI Last Year” to the year you want to compare.
However, CPI inflation is not a perfect measure of real inflation. This equation does not take into account changes in item quality, the addition of new items, and substitutes for old items. Still, CPI is one of the most popular metrics for measuring inflation.
If you want to see up-to-date CPI values, check out the this page about CPI at the Bureau of Labor Statistics.
Producer Price Index
The second way to measure inflation is by measuring changes in the Producer Price Index (PPI). The producer price index measures changes in wholesale prices, which is why it used be called the Wholesale Price Index (WPI). Basically, the producer price index includes the price of materials needed to produce completed products.
The producer price index is different from the consumer price index because of the types of goods it measures. While the consumer price index might include the price of a finished good like a wooden rocking chair, the producer price index would instead include the price of the wood sold so the manufacturer could produce the wooden rocking chair.
Because they’re so similar, calculating changes in the producer price index is similar too. First, we decide which group of wholesale materials we want to study. Producer price index items fall into one of three major categories:
- commodities (i.e. items sold in their raw form, so they can be processed for specific uses)
- intermediate goods (i.e. items sold so manufacturers can create goods for wholesale)
- industry goods (i.e. items sold in large quantities for retailers to resell)
Let’s say we want to use PPI to measure the inflation of intermediate goods. We would start by finding the cost of the intermediate goods group in a given year. Then, we would find the cost of the intermediate goods group in a previous year. Lastly, we would plug both of those values into the equation below.
This answer would give the percent increase of this group’s prices between these years two years. If you want, you can change this equation to find the rate of price changes between any two years. To do this, just change “PPI This Year” to the year you’re interested in, and change “PPI Last Year” to the year you want to compare.
If you want to see up-to-date PPI values, check out the this page about PPI at the Bureau of Labor Statistics.
Gross Domestic Product Price Deflator
The third way to measure inflation is by measuring changes in the Gross Domestic Product (GDP) Price Deflator. The GDP price deflator (GDPPD) measures the ratio between a country’s nominal GDP and its real GDP. This ratio is significant, because a country’s real GDP does not include inflation, while the nominal GDP does.
For clarity, the nominal GDP is the GDP evaluated at current market rates, while real GDP is an inflation-adjusted measure of the goods and services valued in a given year.
Similarly to CPI and PPI, we can calculate the value of inflation using the GDP price deflator by finding the percent difference between the values over different years. To do this yourself, use the equation below.
This answer would give the percent increase of the GDP price deflator between these two years. If you want, you can change this equation to find the rate of price changes between any two years. To do this, just change “GDPPD This Year” to the year you’re interested in, and change “GDPPD Last Year” to the year you want to compare.
If you want to see up-to-date GDP price deflator values, check out the this page about the GDP price deflator at the Bureau of Economic Analysis.
What Causes Inflation?
Okay, so now we know how to measure inflation, but what causes it?
Demand-pull inflation is probably the most common cause of rising prices. It’s based on the principles of supply and demand. When demand for an item increases, but the supply doesn’t increase, the items are worth more. This means the retailers can afford to charge more for the items, because they know people will pay their higher prices. But, what causes this growing demand?
First, a growing economy can increase demand on products. As more people land jobs and have more money to spend, they can afford to buy more things. The better the economy gets, the more confident people become, so they spend (and demand) more.
Second, inflation expectations can increase prices further. As prices begin to increase, people start to expect the price increases, and they buy more now to avoid paying more later. This then increases demand more. Governments like this because it helps spur on more economic growth, but too much can be a bad thing. Because of this, governments typically have an inflation value they try to maintain.
Third, government fiscal policies can influence consumer spending. If they raise taxes or increase interest rates, people have less money to spend. Less money means less demand, which can decrease inflation. But, if they lower taxes and interest rates, the opposite can happen.
Fourth, effective marketing can increase demand on items. If marketing convinces people they need to buy something, demand for that thing will increase. Again, while price hikes for specific items do not indicate inflation, better marketing overall can lead to prices increases across the board.
Fifth, increasing the money supply can decrease the value of the money already out there. This decreased value means retailers want more money for their products since the money is worth less. Money supply increases are also controlled by the Federal Reserve and can be caused by printing more cash and offering larger loans.
While demand-pull inflation is typically caused changes in demand, cost-push inflation is typically caused by changes in supply. If supply drops, there are fewer items to sell, and retailers can charge more for them. But, what would cause supply to drop while demand stays the same?
First, monopolies can cause a decrease in supply, since they directly control the supply. If the only company of a specific product wants to charge more for an item, they can cut how much they produce, making them more valuable.
Second, natural disasters can cause a temporary decrease in supply, since the disaster will often destroy most of the regular supply.
Third, overuse of natural resources can cut the amount of available supply. For example, hunting too many deer can decrease the supply of deer, driving up venison prices.
Fourth, government regulations can cut the supply of imported goods. If the government decides to prevent items from entering the country, or charges higher taxes on the imports, the imports will typically decrease. This decrease lowers the supply.
Fifth, changing exchange rates can increase the cost of imported goods. When cost goes up, people tend to import less, which decreases the supply.
How Does Inflation Affect Me?
Every year, you spend a little more money on the things you buy every day because of inflated prices. Not much more, typically, but it can really add up over time. Did you know you could buy a full lunch at a diner for 25 cents back in 1939? Did you know food and beverage costs increase a couple percent every year? The longer we live, the more expensive living becomes.
And, because of inflation, your money is never truly safe. Not even in a bank! Considering the average bank savings rate is less than 1%, inflation can slowly erode the value of your money in the bank. Suppose you put $100 in a savings account with a 1% interest rate. One year later, your account will have $101. But, with 3% inflation, that $101 is actually worth about $98. That’s less than what you started with!
Because of inflation, there’s nowhere to hide your wealth except in good investments. Think your money is safe in a bank? Wrong. Think your money is safe in your mattress? Wrong again. Inflation will always find it. Instead, you need to find investments that earn a return greater than the rate of inflation. You would need to find an investment return of at least the rate of inflation just to break even.
Beat Inflation with Good Investments
This is one reason many people like investing in the US stock market. Historically, the S&P 500 has returned nearly 10% annually for decades. If you invest in the stock market and make 10% returns annually, you will outpace inflation.
Suppose inflation is at 3%. While you might have 10% more money from your investment after one year, it will really only be worth 7% (10% – 3%). Still, 7% is better than nothing, and way better than losing money!
This is one way the wealthy are able to keep more money than the less wealthy. having more money means they can afford to put more money in the market, so less of their money’s value is lost to inflation.
Some say inflation is the one true tax on wealth. So, the only way to keep your wealth is to outpace inflation. Stock market investing is one way to do that, but everyone has their favorites. Some people prefer investing in real estate. Others prefer starting their own businesses. Still others buy Bitcoin (not advised).
If you can find a way to make high returns on your money, you don’t need to worry about rising prices destroying the value of your wealth. But remember, bad investments can make the problem worse. Combining investment losses with inflation can be even worse than inflation by itself.
Therefore, investments aren’t just about making money. It’s also about making sure your money survives the continued increase in inflation.
Inflation occurs when the price of a group of items increases over time. Measuring changes in the Consumer Price Index (CPI) and the Producer Price Index (PPI) are common measurements of price changes. Price increases can be caused by an increase in demand, a decrease in supply, or both. These supply and demand changes are usually influenced by economic growth, government policies, marketing, monopolies, and natural disasters. Inflation can impact your money anywhere, even in the bank. Because price rate increases typically outpace the interest rate in savings account, your money can still lose value in the bank. The best way to beat inflation and keep up the value of your wealth is by investing in things that have higher returns than inflation. Common investments for this are the stock market and real estate. Inflation is basically a natural tax on wealth, and only good investments can help you beat it.