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What is Inflation?

inflation
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When talking about money and the price of goods and services, the word "inflation" is used quite regularly.  But few know what it actually means, what it measures and how it is calculated.

Inflation rate

Inflation is the rate at which the cost of goods and services rises over time. When inflation rises, the value of the dollar goes down because consumers aren't able to buy as much as they previously could with that same dollar.

While the annual rate of inflation fluctuates each year, it has historically averaged around 4 percent a year.  That means that something that sells for $100 this year will cost $104 next year. When prices increase, monetary value decreases, which ends in consumers spending less on goods and services.

Inflation is calculated by the Bureau of Labor Statistics using several economic indexes, including the Consumer Price Index (CPI) and the Producer Price Indexes (PPI). The CPI measures price changes from the perspective of the consumer and tracks the price changes in various goods and services. The PPI looks at price changes from the sellers' perspective by measuring the prices that companies pay for the raw materials that are used to produce goods.

The Federal Reserve actively works to maintain an inflation rate near 2 percent. When the rate gets too much higher than the 2 percent target, the Federal Reserve can take several actions to try and slow economic growth, including raising interest rates.

While many may think all inflation is bad, economists argue that a bit of controlled inflation is good for an economy. Higher prices encourage spending, and it also provides companies with enough confidence to hire new employees. Inflation is most dangerous when it is not controlled and unplanned for.

The economy doesn't have to have inflation every year. The opposite of inflation, deflation, is when prices go down and the inflation rate falls below 0 percent. An indicator that economic conditions are deteriorating, deflation often results in lower levels of production and ultimately high rates of unemployment.

Types of inflation

There are two main types of inflation: demand-pull and cost-push. Fueled by income and strong consumer demand, demand-pull inflation occurs when the economy demands more goods and services than are available. This results in higher prices. Cost-push inflation happens when the demand for goods increases because the cost of production costs rises to the point where fewer goods can be produced.

Other types of inflation include hyperinflation, a rapid and out-of-control inflation; pricing power inflation, which occurs when businesses raise prices to increase profits; sectoral inflation, which is when the rising prices are confined to just one industry; and stagflation, which occurs when inflation is rising despite slow economic growth.  

inflation
History of inflation in the United States from January 1914 to March 2009.
Credit: Bureau of Labor Statistics

History of inflation

While the inflation rate has been between 1.5 and 3.5 percent for the past two decades, it fluctuated a great deal in the years before. While inflation rates have only been tracked officially for the past 100 years, it did play a great role in the economy in the years well before that. Between 1775 and 1865, inflation was blamed for two U.S. currency collapses, the Continental Currency during the Revolutionary War and the Confederation notes during the Civil War. In the last century, inflation rates have spiked to 18 percent in 1918, 15.6 percent in 1920 and 14.4 percent in 1947. Inflation in the United States has only risen above 10 percent twice since 1980. It topped out at 13.5 percent in 1980 and a year later, reached 10.3 percent. 

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