Inflation

Published Jan 3, 2023

Definition of Inflation

Inflation is defined as a sustained increase in the general price level of goods and services in an economy over a period of time. That means it is a measure of how much more expensive goods and services have become compared to a certain base period and how much the purchasing power of money has decreased accordingly.

Three types of inflation exist: (1) demand-pull inflation, (2) cost-push inflation, and (3) built-in inflation. For a more detailed explanation of these three types, check out our post on the three types of inflation.

Example

To illustrate this, let’s say you bought a cup of coffee for USD 2.00 in January 2020. Now, if the price of that same cup of coffee is USD 2.50 in January 2021, that means the price has increased by 25%. This increase in price is an example of inflation.

In reality, the rate at which prices increase is usually measured by looking at the prices of a selected basket of goods, like the Consumer Price Index (CPI) or sometimes also the Wholesale Price Index.

Why Inflation Matters

Inflation is an important economic indicator, as it affects the purchasing power of consumers. That means if prices increase, people have less money to buy goods and services. This can lead to a decrease in consumer spending, which can have a negative effect on the economy.

In addition, increasing price levels also have a negative effect on the value of money. That means if prices increase, the value of money decreases. This can lead to a decrease in savings, as people are incentivized to spend their money now instead of saving it for the future.

Finally, inflation can also affect the value of investments. That means if prices increase, the value of investments can decrease. This can lead to a decrease in investor confidence, which can have a negative effect on the stock market.