What is inflation?
Prices of goods go UP
Value of goods goes DOWN
Inflation is the increase in the general prices of goods and services. Throughout a given year, the prices of some goods will go up, while others go down. The average of the increases and decreases is the overall inflation rate (if prices have gone up overall) or deflation rate (if prices have dropped on average). It is measured as an annual percentage change.
A healthy economy aims for a 2% inflation rate.
Calculator: How fast can your money grow?
Our grandparents like to reminisce about the days when going to a movie cost a nickel. Nowadays, a movie date for two can put a dent in your wallet upward of $35. In 10 years, it will likely be even more, but how much more depends on the rate of inflation.
If inflation stays steady at 3% per year for the next 20 years, for example, that $35 date night will cost $63.21, and then you will be the one telling stories about what things used to cost!
How inflation works
When the value of the dollar goes down, the price of products goes up.
If the annual inflation rate is 3%, for example, a packet of ramen that costs $1 at the beginning of the year will cost $1.03 by the end of the year. The flipside of this change is that your one dollar bill equaled one packet of ramen back in January, but now, at the end of December, it’s only worth 97% of a packet of ramen.
While the annual rate has fluctuated greatly over the last 70 years, the Federal Reserve Bank (aka “the Fed”) tries to maintain a consistent rate of inflation, which is usually 2%-3% per year.
Types of Inflation
- Creeping Inflation–prices increase gradually over time; 3% a year or less is ideal.
- Walking Inflation–prices increase between 3% and 10% each year; people stock up to avoid higher prices later; businesses can’t keep up with demand; prices go up.
- Galloping Inflation–prices increase more than 10% each year; people avoid spending; business can’t make money; unemployment increases.
- Hyperinflation–prices rise more than 50% each month, which is very bad but very rare.
Other Terms to Know
- Stagflation–continued high inflation during periods of high unemployment.
- Deflation–the opposite of inflation; prices fall, and the value of each dollar increases, but there is less currency in circulation. Supply outstrips demand; business fail; unemployment goes up.
What causes inflation?
Problems With Supply
- Inconsistencies with growth in agriculture due to climate change or natural disasters.
- Shortage of key raw materials (such as oil, corn, sugar) or price increases for items needed to produce goods for sale.
- Inadequate industrial growth.
If enough products aren’t available for sale, each item becomes more valuable. Prices go up, which means the value of each dollar goes down.
Problems With Demand
- Increase in money supply (the total amount of money in circulation)
- Often due to monetary policy. The Fed lowers rates to make borrowing money cheaper, and the increased money supply pushes prices up.
- Increase in disposable income.
When there is too much currency in circulation, prices go up since people can afford to pay more. Prices may also go up if businesses can’t meet the increased demand, meaning supply is low and each item becomes more valuable. As we’ve already learned, when prices go up, the value of each dollar goes down.
What are the effects of inflation?
The impact of inflation isn’t consistent. It can actually have opposite effects depending on global conditions, political events, the specific rate of inflation, and other factors.
Inflation can be very beneficial in the short term or when the rate is fairly low, but if the rate of inflation outstrips actual economic growth, it can spell big trouble down the line.
Effects of Optimal Inflation (less than 3%)
- Lower unemployment and prices go up, but wages don’t increase at the same rate as inflation, so employers can afford to hire more people.
- Cost of living goes up; everyday items cost more.
- Encourages investing and spending–prices may continue to rise, people stock up on necessities now to avoid higher prices later, and they put money in investment accounts to capitalize on the current, higher value of their dollars.
- Decreases the cost of borrowing money (for example, loan rates go down). The Fed may lower rates to encourage people to start businesses, use credit cards, and buy homes.
Effects of High or Prolonged Inflation
- Creates more inflation; excess spending (see above) means there’s too much currency in circulation. Prices go up, and the value of the dollar goes down.
- Increases the cost of borrowing money; the Fed raises rates to discourage borrowing and halt the influx of currency in circulation (trying to put a cap on rampant inflation).
- Financial hardship on workers since wages typically do not rise as quickly as inflation rates.
- Reduces spending; workers can’t afford to spend as much since wages remain the same, but prices have gone up.
- Increases unemployment; as spending decreases due to stagnant wages, supply exceeds demand, and companies lay off workers.
Who is affected?
While everyone is affected, those who are dealt the biggest blow are low-income and fixed-income earners. The federal minimum wage has failed to keep pace with annual inflation over time, which means it has become harder and harder for “unskilled” workers to make ends meet as inflation reduces the purchasing power of every paycheck.
Retirees and others who have a fixed rate of income (for example, from retirement accounts) also suffer since the rate of pay is not adjusted to compensate for the decreasing value of the dollar. Social Security payments, however, are adjusted for inflation every year.
How do you measure it?
Inflation is generally measured by the Consumer Price Index (CPI), which is calculated monthly by the U.S. Bureau of Labor Statistics (BLS).
The BLS gathers prices of a basket of 84,000 goods and services in about 200 categories. They look at the needs of the average consumer in an urban environment and how much things cost for several subsequent years.
Based on the measure of these prices, the inflation rate percentage is determined.
Types of Goods Measured for the CPI:
- Utilities, such as electricity, water, and natural gas
- Household necessities
- Medical care
There is also the Producer Price Index (PPI). Like the CPI, the PPI measures average costs but from the perspective of companies in three areas of production:
- Stage of processing
Is it good or bad?
Economists all have different opinions about whether inflation is good or bad. Depending on whom you ask and what economic theory they follow, you may get wildly different opinions on the potential pros and cons of inflation. Some say it drives the economy, while others say it eventually leads to a recession.
Clearly, some of the short-term benefits of inflation are very positive. Too much inflation, however, can have negative effects.
(Short term, moderate inflation)
- Increase in employment
- Increase in spending money for the average Joe
- Lower interest rates
- Encourages spending, new investments
(Long term, high inflation)
- Business can’t keep up with demand
- Prices go up dramatically
- Average person can’t afford necessities
- Spending goes down, businesses fail
- Increase in unemployment
Like all things, inflation is good in moderation, and its opposite “deflation” can be just as damaging (heard of the Great Depression, anyone?).
The U.S. Inflation Rate Calendar calculates and demonstrates the buying power of the U.S. Dollar.
The annual inflation rate in the United States has fluctuated greatly through history, ranging from less than zero inflation (“deflation”) to nearly 30% inflation in 1778. As the Consumer Price Index and modern inflation calculation weren’t developed until 1913, inflation rates for previous years are only estimates.
The highest rate of inflation since 1913 occurred in 1917, when it hit 19.66%.
See what a dollar has been worth in comparison from 1913 to the present with this calculator.
For example, $100 in 1914 is worth approximately $2,457 in 2017.
Milk price chart
The average milk price below is based on the price of one gallon of fortified whole milk.
Gas price chart
Between 1950 and 1975, the average gas prices were based on a gallon of Regular Leaded Gas. From 1976 to the present day, the average gas prices based on a gallon of Regular Unleaded Gas Prices.
Sources: www.worldbank.org, www.eia.gov
Movie price chart
As with everything else around us, entertainment costs have increased in America as well. The chart below represents the average increase in the price of a movie ticket in the last 100 years.
- Inflation occurs when prices go up and the value of the dollar goes down.
- Inflation occurs for many reasons but is generally based on an imbalance in economic supply and demand.
- Inflation can have both positive and negative effects.
- Generally, an inflation rate of about 2% per year is best.
- High inflation hurts most the poor and those with a fixed income.
Inflation is complicated, and many people have built entire careers around studying its causes and effects. What should be clear is that inflation is neither good nor bad. It can boost the economy or set a country back for decades depending on how quickly inflation grows. Still, the effect of inflation can be felt in your everyday life as you watch food prices and rents go up but hopefully also see cost-of-living increases in your paycheck.
- From August 1945 until July 1946, Hungary experienced such massive hyperinflation that the daily inflation rate was 207%, meaning prices doubled every 15 hours.
- During the Great Depression, deflation was a major issue, with prices dropping an average of 10% a year between 1930 and1933.
- Venezuela currently has the highest inflation rate in the world, clocking in at a whopping 652.67% in 2017.
- Amadeo, Kimberly “Why a Little Inflation Is Good” About.com News. Web. 20 Jan. 2015.
- KhanAcademy.org “Learn Inflation Overview”
- (infographic) http://blog.futureadvisor.com/how-much-does-todays-lifestyle-cost-in-2040-a/
- Examples: http://www.free-bullion-investment-guide.com/price-inflation.html
- http://www.thedigeratilife.com/blog/index.php/2007/09/17/watch-prices-go-up-interesting-facts-about-inflation/US Inflation Rate