How Does Inflation Work And What Causes It?

Over the past few years, we’ve heard quite a bit about inflation and the effect it has on the economy — and people’s pocketbooks. But how does inflation work, and what exactly causes inflation? We’ll take a deeper look over the course of this article.

What Is Inflation?

Inflation is typically defined as the rising cost of goods and services across the economy, and this increase leads to a decrease in purchasing power for consumers. If an apple cost a dollar last month, for instance, and today it costs $1.25, the bottom line is: your money isn’t going as far as it used to. That’s inflation.

Over time, periods of high inflation can have a detrimental impact on the cost of living. If there are dramatic and long-term price increases, people are unable to maintain the same lifestyle without spending more. This can in turn cause a push for higher salaries.

The Federal Reserve (Fed) is the central bank and chief monetary policy setter for the United States. Congress has set two goals for the Fed: maintain stable prices, and maximize employment. As such, the Fed wants some inflation because that means people will buy today rather than waiting, which in turn keeps the economy moving and people employed. The trick is not to have so much inflation that it erodes earnings.

What Is Deflation?

Deflation is essentially what happens when the cost of goods or services falls over time. At first glance, this might seem like a reprieve to consumers. But deflation is sometimes fueled by a lack of demand, which can eventually cause unemployment to rise.

If you think computer prices will drop soon, for instance, you’re not as likely to buy one today. If enough consumers have this expectation across enough areas of the economy, businesses start to lay people off because they won’t produce goods and services if no one is buying.

What Causes Inflation?

Inflation is caused by a wide variety of economic variables coming together. There are three types of inflation, each brought on by a variety of factors.

Cost-Push Inflation

Cost-push inflation is caused by an increase in production costs, which can lead to a rise in the prices of goods and services. This increase can be brought about by several elements. Here are some examples:

• Monopolies can lead to inflation when dominant companies dictate higher prices due to limited competition. For example, if there’s only one company producing widgets, they can charge whatever they want for the widget without fear of competition. In this situation, the company will charge as much as consumers will tolerate, leading to higher prices.
• Increased wages can be a cause of inflation as businesses pass on higher labor costs to consumers for the same products.
• Decreased natural resources lead to higher production expenses, which can in turn lead to higher prices for consumers. Oil is a good example: Over time, a price increase is likely to happen just because it is a limited resource. Of course, there are also seasonal fluctuations and supply chain issues that can cause price fluctuations, so demand does play a role in pricing.
• Increased tax rates and government oversight can drive up costs for businesses, which often leads them to raise consumer prices.
• Exchange rate fluctuation can exacerbate cost-push inflation, as changes in currency values influence import and export costs and, in turn, impact overall price levels.

Demand-Pull Inflation

Demand-pull inflation happens when inflation rises because there’s more demand for the products and services being produced. If there’s more demand and the same level of supply, prices rise to help create balance. Several factors can cause this type of pricing increase:

• Economic growth means prosperity, which leads to people having more resources and money. People often spend more when they have more, causing increased demand for goods and services.
• Expected inflation is when people thinking there will be more inflation in the future, which can actually lead to inflation. If you think that prices will rise tomorrow, for instance, you’ll be willing to pay a higher price today.
• Increased money supply is when the government physically provides people with more money to spend, giving them more purchasing power. (The United States did this most recently in response to the COVID-19 pandemic, for instance.) More money in the hands of consumers essentially increases demand for goods and services.
• Increased demand can lead to companies charging more for a particular good or service. For example, say your favorite rock star announces this is their farewell tour. Demand for tickets goes through the roof because everyone wants to see them one last time. Of course, by the fifth farewell tour, you realize how well artists understand supply and demand.

Built-In Inflation

Built-in inflation occurs when consumers get used to the current inflationary environment, which leads to more inflation. Think of this as a continuous upward cycle — because prices are higher, people demand higher wages. This leads to greater business costs, which in turn leads to more inflation.

This is the most insidious type of inflation because prices could continue rising indefinitely if it takes hold. And because there’s always a limit to the budget, businesses are unlikely to be able to continue paying employees ever higher incomes. Eventually, you end up with decreased standards of living.

How Is Inflation Measured?

The easiest way to calculate inflation is to take a fixed group of goods and services, and compare the prices from one year to the next. This is often how it’s done in the long term, but you can also use the same procedure to compare one month to the next.

Beyond that, things get a little complicated because the inflation rate depends on who you ask. There are actually three different popular metrics for inflation:

Consumer Price Index (CPI)

The Consumer Price Index (CPI) is a measure used to track changes in the average price of a basket of goods and services consumed and used by households. This helps gauge the inflation rate by comparing the current cost of the basket to a base period, giving insights into how the overall cost of living for consumers is changing.

A rising CPI indicates increasing prices, while a stable or declining CPI suggests a relatively stable or deflating cost of goods and services for consumers.

Producer Price Index (PPI)

The Producer Price Index (PPI) measures the average change in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services.

Personal Consumption Expenditures Price Index (PCE)

The Personal Consumption Expenditures (PCE) Price Index is a way to measure inflation by looking at how the average prices of goods and services are changing. Instead of just examining fixed items like the CPI does, though, the PCE tracks the spending habits of Americans and when people buy different things as prices change. This makes it more flexible in capturing how real-world spending patterns evolve and provides a more comprehensive picture of inflation across the economy than other measurement methods.

How Does The Fed Combat Inflation?

There are several ways the Fed steps up to fight inflation, particularly via specific strategies and governmental actions.

Fiscal Policy

Fiscal policy refers to the Fed’s use of taxation and spending to influence the overall economy by altering the level of demand. If the government increases spending or reduces taxes, it boosts demand (because consumers presumably have more to spend), potentially leading to higher inflation.

Conversely, if the government reduces spending or raises taxes to cool down an overheated economy, it can help control inflation by curbing excessive demand and preventing the economy from operating beyond its sustainable capacity.

Monetary Policy 

Monetary policy refers to the actions taken by the Fed to control the supply of money and credit in the economy. In particular, the Fed can influence inflation by adjusting interest rates — lowering interest rates encourages borrowing and spending, leading to increased economic activity and potentially higher inflation.

On the other hand, raising interest rates restricts borrowing and spending, which can help cool the economy and reduce inflationary pressures.

How Can You Protect Against Inflation?

Inflation can have a strong negative impact on consumers, but there are ways to prepare for and/or protect yourself against inflation. Be sure to consult a financial advisor before making investment decisions.

• Investing in the stock market: Investing in the stock market is one way to inoculate yourself against inflation because stocks have historically shown the potential to provide higher returns than the rate of inflation. By holding a diversified portfolio of stocks, you could benefit from the overall growth of the economy, making it more likely you’ll keep — or perhaps increase — your purchasing power in the face of inflationary pressures.
• Purchasing Treasury Inflation-Protected Securities (TIPS): These securities — which are backed by the federal government — can protect you from inflation by adjusting their principal value based on changes in the CPI. Here’s why: When inflation occurs, the value of TIPS increases. That helps ensure that your investment keeps pace with the rising prices of goods and services.
• Investing in real estate: Investing in real estate can provide a hedge against inflation because real estate is a tangible investment that tends to hold its value even during inflationary periods, and properties often appreciate as prices rise. Real estate investments can also generate rental income, which can provide you with a steady stream of cash that may keep up with the rising cost of living.
• Building an emergency fund: Establishing an emergency fund can offer financial stability and protection from inflation by providing a cushion that covers unexpected expenses. If you have an adequately funded emergency fund, you can avoid taking on high-interest debt if unexpected costs arise.

Inflation FAQs

What is the current inflation rate in the US?

As of this writing, the annual inflation rate in the United States is about 3%. That’s about one-third of the rate in 2022, as the global economy adjusted to the post-pandemic new reality.

Are there benefits of inflation?

Contrary to what you might think, there can be some benefits to inflation. Moderate inflation, for instance, can encourage spending and investment as consumers and businesses aim to stimulate economic activity and growth. Inflation can also reduce the burden of debt, making it easier for borrowers to repay loans with money that's worth less than when they initially borrowed it.

What is stagflation?

“Stagflation,” a term that gained popularity during the 1970s oil crisis, is an economic phenomenon characterized by a combination of stagnant economic growth, high unemployment, and elevated inflation levels. This situation challenges policymakers because the typical tools used to combat inflation, such as raising interest rates, may worsen unemployment, while actions to spur economic growth, like increasing government spending, could exacerbate inflation.

How does inflation affect real estate prices?

Inflation can drive real estate prices upward, as the increasing cost of goods and services can lead to increased construction and operating expenses for properties.

Higher inflation may also prompt investors to seek assets that can act as a hedge against eroding purchasing power, with real estate being a tangible investment that has historically shown the potential to appreciate during inflationary periods.

The Bottom Line

Inflation is a complex economic condition with many causes — and many effects. It can dramatically impact your finances, but there are ways to prepare so its effects can be minimal. You can stabilize yourself against inflation by monitoring your finances via the Rocket Money^SM app, which allows you to view your stocks and investments, control your emergency savings, and more.