When it comes to finance and economics, inflation refers to the general increase of prices of goods and services over time. The practical effect of inflation is that each dollar buys fewer goods and services. For example, if the annual inflation rate is 5%, then $1 worth of candy this year will cost $1.05 next year. In other words, each dollar buys less due to inflation.
Most people have an instinctive negative reaction to inflation, because who wants to pay more for goods and services? But zero inflation is actually a bad thing, because it means the economy is stagnating and isn’t growing.
In the U.S., inflation is measured by the Consumer Price Index, which measures price increases in consumer goods and services from the perspective of the consumer, and the Producer Price Index, which measures the change in selling prices received by domestic producers for their products.
Why is inflation significant?
Inflation is significant because a low, steady rate of inflation in the 2-3% range indicates the economy is growing at a healthy pace.
Lots of inflation – or hyperinflation – can result in the rapid increase of prices, to the point of breaking down the entire monetary system at its extreme.
Deflation, which is the opposite of inflation, is when prices go down, instead of up. It is generally considered to be bad for the economy because it results in an increase in the real value of debt and may cause or aggravate recessions.
For these reasons, governments, including the U.S. government, which acts through the Federal Reserve Board, work hard to maintain inflation within that desirable 2-3% range.
Why you should care about inflation
For most people, inflation affects their lives in the following ways:
Changes in interest rates – When inflation rises, interest rates usually do also. That makes it more expensive to borrow money, which in turn slows down the economy. (This is the relationship that the Federal Reserve Board works so carefully to manage.) For the average consumer, it becomes more expensive to take out a mortgage or buy a car with a loan. Conversely, when inflation is low, so are interest rates, which makes it cheaper to borrow money. For some consumers, like the home or car buyer, that can be good. But for others who have lots of cash saved at the bank, they’ll earn very little in interest.
Cost of goods and services – Inflation can impact how much you pay for food, clothes, medical care, and more. The federal government has an online inflation calculator that can show you how inflation has affected the value of your dollar. For example, $100 in 2008, which is when I first started playing The Drugstore Game, buys the same amount as $108.25 in 2013. Since I have to work so much harder for free oral care and hair care products these days, I believe it.
Increased retirement savings needs – Higher prices years down the line due to inflation means you need to factor inflation into the equation when calculating how much you need to save for retirement. Most online calculators take inflation into account.