What Is Inflation in Economics? Definition, Causes & Examples

Plenty of us have, at some point or another, heard a grandparent talk about the days of their childhood when a candy bar cost barely anything. In 1908, a Hershey's chocolate bar cost a mere 2 cents. Today that same chocolate bar costs $1.34 at Walmart. How does such a massive increase happen? Inflation, the rise in the price of goods and services over a period of time.

Inflation has a major effect on the entire country's economy. It impacts not only the government, but the little things in the average person's daily life. Both a cause and effect of how the economy is doing, inflation has both its fans and detractors. Many think that certain amounts of inflation are good for a thriving economy, but that larger rates raise concerns. It can devalue the currency significantly and, at worse, has been a key component to recessions.

So the U.S. Federal Reserve tries to keep inflation under control while still allowing it to happen. But what exactly is inflation, what causes it and what happens in times with significant inflation?

What Is Inflation?

Inflation, as mentioned, is the rate a price rises, and essentially how much the dollar is worth at a given moment with regards to purchasing. The idea behind inflation being a force for good in the economy is that a manageable enough rate can spur economic growth without devaluing the currency so much that it becomes nearly worthless.

The Fed generally sets an inflation target of about 2%. Let's say that's the inflation rate that actually occurs on a year-to-year basis. If that inflation rate affects gas, you could pay $2.75 per gallon this year and expect to pay about $2.81 the same time next year. The inflation rate does not always works the way the government would like it to. If it did, a candy bar today wouldn't cost 6,700% what it did 110 years ago.

Inflation can also vary from asset to asset. Depending on the time of year, the price of gas could go up separately from overall inflation as it often does as summer approaches. In fact, there is even a term - core inflation - for inflation that factors in everything except food and energy (gas and oil), as these sectors have separate factors that contribute to them.

There are many different types of inflation, depending not only on what good is being priced but what the inflation rate actually is. For example, what happens if the inflation rate is well above the Fed's intended target? At a higher rate, yet still in the single digits, that's known as walking inflation. It is seen as concerning yet manageable.

Once the rate hits double digits and ends up in the 10%-20% range, it becomes running inflation. This is of much greater concern for a country's citizens, as the currency is devaluing much faster than it needs to be. Prices going up that drastically can have a devastating effect on the lower and working class populations, who were already struggling financially. Incomes don't rise in tandem with prices, and fewer goods are purchased, throwing the economy into chaos.

Hyperinflation is the rarest, but most disastrous iteration of inflation within an economy. A totally unmanageable rise of 50% or more within a month, this can send an economy plummeting. Recessions turn to depressions. People lose faith in fiat currency and begin hoarding gold instead, leading to a significant decrease in an exchange of goods. Financial institutions, with their money now essentially worthless, fail. Hyperinflation is very rare, but has happened before.

There can also be a form of inflation known as "stagflation," where inflation rates rise despite the fact that the economy is in a stagnant period. Special circumstances cause stagflation, such as the U.S. in the 1970s, when despite high unemployment rates and negative economic growth the price of oil skyrocketed.

How Is Inflation Measured?

How can you measure inflation as a single number when so many different goods and services exist? It's not easy. The U.S. government has a couple of different methods for calculating the current inflation rate:

Consumer Price Index. The CPI is how the U.S. Bureau of Labor Statistics, BLS, measures retail prices of goods and services in the United States, putting more than 80,000 purchasable items from hundreds of different categories into a "market basket" that groups them together. This index is measured every month, and every month the BLS publishes the change in price. In August, the BLS published its report detailing how in July, the combined prices of these goods and services rose 0.2%.

Personal Composition Expenditures. Some analysts prefer to use PCE to CPI when measuring the inflation rate. The Personal Composition Expenditures price index measure the aforementioned core inflation, which is the inflation of goods and services excluding food, gas and oil. These are volatile goods with unique factors other goods do not have. Measured by the U.S. Bureau of Economic Analysis, BEA, it is the index the Federal Reserve uses as their primary source for the inflation rate.

Causes of Inflation

There are many different ways the inflation rate can rise, and they can be lumped into two different categories: Cost-push inflation and demand-pull inflation.

In the event of cost-push inflation, prices are driven up by the rising costs to make or provide the goods and services. This can cause a supply shortage, but the demand for the goods and services has not decreased.

Sometimes in cost-push inflation, the price of the materials themselves have gone up, leading to the price of related goods increasing as well. This often happens if there is a shortage of a material like oil; the price is driven up significantly. Similarly, natural disasters can make some materials scarce, and that is often taken advantage of by driving the price up.

Another way prices rise is if wages also rise. Many companies will increase prices in the wake of higher wages to their employees to try and offset the new costs. This is also referred to as wage push inflation.

While cost-push inflation is the result of shrinking supplies unable to reach the average level of demand, demand-pull inflation is when the demand skyrockets, and the price goes up so that companies can attempt to make enough supplies to meet that demand.

In one sense, demand-pull inflation can be the sort of inflation businesses dream about. A potential sign of a thriving economy, people have money and want so badly to spend it that they have to raise prices not to cover costs in a stagnant market, but to afford to make more of a popular product. It has also been theorized that demand-pull can happen as a result of high employment, meaning the people have more disposable income.

On the other hand, though, often demand-pull inflation can develop as a result of too much money being made, devaluing the currency and requiring an increase in price.

Government spending can also result in a price increase, particularly selling military products after an increase in military spending. Another factor that can cause a rise in the inflation rate? Just a general assumption that it will rise. If there's a prediction that inflation is about to happen, businesses may up their prices in anticipation, turning it into a self-fulfilling prophecy.

Effects of Inflation: How Does It Affect You?

The impact of inflation affects many different groups when it hits. Not every group is affected the same way. Who benefits from inflation, and who doesn't?

Generally in a period of mild inflation, job-seekers can benefit. Increased spending can mean increased demand, and companies may decide to hire new employees to better manage the new demand. If you have borrowed money from a lender, inflation could be convenient for you. With the currency devalued, what you borrowed a year or two ago is now the equivalent to a lower amount of money.

In this assumed manageable level of inflation, businesses that sell goods and services can benefit as well. A healthy amount of inflation is said to increase and incentivize spending more; at its best, that can work in a way that the increased costs are offset by an increase in sales.

An unhealthy, unmanageable level, however, is disastrous for nearly everyone. If inflation spirals out of control, people lose faith in their currency. Financial institutions suffer as people pull their money out of them. Businesses suffer as their goods become too expensive for most people.

Those with low incomes and fixed incomes suffer in any level of inflation. The value of a currency goes down, but incomes haven't necessarily risen. If someone's yearly income is only $25,000 and the inflation rate from one year to the next is 2%, that salary is now the equivalent to what $24,500 was the year prior.

Examples of Inflation

Inflation is constantly happening on a month-to-month basis, even if it's on a smaller scale. In fact, during the infamous Great Recession, when unemployment skyrocketed, there was a surprisingly manageable inflation rate of 1.7% in October of 2009.

Hyperinflation, on the other hand, is a much rarer occurrence. But over the past century, several companies have endured hyperinflation and its dire consequences.

Some notable examples of hyperinflation include:

  • Zimbabwe in the 2000s underwent serious hyperinflation. Many economists point to the country's financing of the Second Congo War by printing more money as a major cause of this. The inflation was so bad that the currency became unsalvageable, and eventually the country's plan became to demonetize their currency entirely and move to foreign fiat currency.
  • Hungary dealt with a severe hyperinflation problem in 1946, after World War II. At its worst, the inflation rate of the pengő (Hungary's currency at the time) was well over 200% a day. Prices doubled every 15 hours. Like with Zimbabwe, the inflation hit an unfixable point where the only solution was to abandon the currency and start a new one altogether. The country reintroduced the forint, the currency they used in the late 1800s, in August 1946.
  • Germany, in the wake of World War I, saw hyperinflation of the paper mark. The Weimar Republic lost the war, and the country had to print more and more hard currency so that they could pay the massive debts they incurred from all the funds they borrowed for the war. The mark became extraordinarily devalued, and borderline worthless.

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