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What Is Inflation?

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Higher Gas Prices Spur Rise In Consumer Price Index
Kevork Djansezian/Getty Images News/Getty Images
small dollar

Inflation means the dollar can purchase less.

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bubble

Traditional measures of inflation don't take into account asset bubbles.

Photo: Don Farrall/Getty Images

Question: What Is Inflation?

Answer: Inflation is when the prices of most goods and services continue to creep upward. When this happens, your standard of living falls. That's because each dollar buys less, so you have to spend more to get the same goods and services.

If inflation is mild, it can actually spur further economic growth. If prices rise slowly and gradually, it can encourage people to buy now and avoid future price increases. This increases demand, driving further economic growth. In this way, a healthy economy can usually sustain a 2% inflation rate.

What Causes Inflation?

There are three causes of inflation. The first cause is called demand-pull inflation. This occurs when demand for a good or service rises, but supply stays the same. Buyers become willing to pay more to satisfy their demand. Demand-pull inflation can be accompanied by irrational exuberance.

The second cause is cost-push inflation. It starts when the supply of goods or services is restricted for some reason, while demand stays the same. When the supply of labor is not enough to meet demand, it can create wage inflation. In the past, inflation in prices generally led to wage inflation, so that companies could retain good workers. However, competition from technological alternatives (such as robotics) and lower-income countries means that wages haven't kept up with prices. Higher prices combined with stagnant wages means your standard of living has decreased. It's another reason for income inequality in the U.S.

The third cause is overexpansion of the money supply. That's when a glut of capital in the market chases too few opportunities. It's often a result of expansive fiscal or monetary policy, creating too much liquidity in the form of dollars or credit.

Types of Inflation

It's important to understand the difference between the many different types of inflation. If inflation is more than 50% a month, that's known as hyperinflation. This hasn't happened in the U.S. since the Civil War, but occurred in Germany before World War II, and in Zimbabwe in the 2000s. Stagflation is when inflation occurs despite slow economic growth. The last time this happened in the U.S. was in the 1970s.

When inflation affects different parts of the economy, it's known as asset inflation because it affects just one asset. This occurred with stock portfolios when the Dow reached its peak of 14,164.43 on October 9, 2007.

Asset inflation also occurs each spring with oil prices. That's because commodities traders anticipate that demand for gas, and oil, will go up during the summer vacation driving season. If traders become concerned that the oil supply may be cut off, as during the Iran threat to close the Straits of Hormuz in 2012, traders will up the price of oil futures contracts. As a result, gas prices have spiked significantly in the springs of 2011 and 2012. These volatile gas prices can drive up the price of food, which is usually transported long distances.

How Is Inflation Measured and Managed?

Inflation is measured by the Bureau of Labor Statistics (BLS) using the Consumer Price Index (CPI). The Index is based on a survey of 23,000 businesses, and records the prices of 80,000 consumer items each month. The CPI will tell you the general rate of inflation. Check out the current inflation rate.

Inflation is also measured by the Personal Consumption Expenditures price index, or PCE price index. This includes more business goods and services than the CPI. For instance, it includes health care services paid for by health insurance, whereas the CPI only includes medical bills paid for directly by consumers.

Since oil and food prices can be so volatile, they are omitted from the core inflation rate. As of January 2012, the Federal Reserve decided to use the core PCE price index as its measurement of inflation. If the core inflation rate rises above the Fed's 2% target inflation rate, the central bank will launch contractionary monetary policy. This raises interest rates, reducing the money supply and slowing demand-pull inflation.

The Fed usually only addresses general inflation. However, contractionary monetary policy can attack asset inflation, as well. High interest rates can slow demand for housing if asset inflation poses a threat. Unfortunately, the Fed didn't raise interest rates during the housing boom in 2005. It thought that asset inflation would remain confined to housing, and not spread to the general economy. True enough, inflation didn't spread. However, when the housing bubble burst, it led to the subprime mortgage crisis and the 2008 financial crisis, instead.  Article updated May 2, 2014

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