What Is Inflation?
Inflation is the rate at which the general level of prices for goods and services rises over time, eroding purchasing power. When inflation occurs, each dollar you have buys fewer goods and services than before.
How Inflation Works
When inflation is 3% annually, something that costs $100 today would cost approximately $103 next year. Over time, this compounds significantly—at 3% annual inflation, prices double roughly every 24 years.
Common Causes of Inflation
Demand-Pull Inflation
When demand for goods and services exceeds supply, prices rise. This often happens during economic booms when consumers and businesses are spending freely.
Cost-Push Inflation
When production costs increase (wages, raw materials, energy), businesses pass these costs to consumers through higher prices.
Monetary Inflation
When the money supply grows faster than economic output, more dollars chase the same amount of goods, driving prices up.
How Inflation Is Measured
The most common measures include:
- Consumer Price Index (CPI): Tracks price changes for a basket of consumer goods and services
- Personal Consumption Expenditures (PCE): The Federal Reserve's preferred inflation gauge
- Producer Price Index (PPI): Measures wholesale price changes
Impact on Your Money
Savings
Money sitting in a savings account earning 1% interest loses purchasing power if inflation is 3%.
Investments
Stocks have historically outpaced inflation over long periods, while bonds may struggle during high inflation.
Fixed Income
Retirees on fixed incomes are particularly vulnerable as their purchasing power declines.
Protecting Against Inflation
Common strategies include:
- Investing in assets that historically outpace inflation (stocks, real estate)
- Treasury Inflation-Protected Securities (TIPS)
- Commodities and precious metals
- I-Bonds (inflation-adjusted savings bonds)
Understanding inflation helps you make better financial decisions and protect your long-term purchasing power.