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Grow Your Business Finances

What Is Inflation?

What is inflation
Credit: g0d4ather/Shutterstock

Inflation is a buzzword that most people have heard but few really understand. You might know that inflation has much to do with the price of goods and services, but you're not quite sure how they are related. Why does inflation occur, where does it come from and why does inflation matter to small businesses?

In this article, we break down the basics of inflation and dispel common misconceptions about it.

Put simply, inflation is the rate at which the cost of goods and services rises over time. It could also be thought of as a reduction in the value of a dollar, because consumers are now able to purchase less than they once could with the same dollar bill.

While the annual rate of inflation fluctuates each year, from 1913 to 2013, the U.S. experienced an average inflationary rate of 3.22 percent. That means, on average, something that costs $100 this year would cost $103.22 next year.

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 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 PPI is useful, because inflation often begins in the supply chain when the cost of component parts goes up, for example. Manufacturers then charge more for their finished products.

The Federal Reserve actively works to maintain an inflation rate near 2 percent. When the rate gets significantly 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 people may think that all inflation is bad, economists argue that some controlled inflation is good for an economy. Inflation encourages spending, because when dollars are losing value, it provides a disincentive to save those dollars. Inflation also provides companies with confidence to hire new employees. Inflation only becomes dangerous when it is uncontrolled and unexpected, increasing prices quickly to the point it grinds all spending (and, therefore, economic activity) to a halt.

The economy doesn't necessarily experience inflation every year. The opposite of inflation, deflation, is when prices go down, and the inflation rate falls below 0 percent. While you might think, "Oh boy, lower prices," deflation is not usually a welcome thing. An indicator that economic conditions are deteriorating, deflation often results in lower levels of production and ultimately high rates of unemployment.

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. Cost-push inflation happens when the demand for goods increases because production costs rise to the point where fewer goods can be produced. Both drive prices upward.

Other types of inflation include hyperinflation, a rapid and out-of-control form of 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. 

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

While the inflation rate has ranged from 1.5 and 3.5 percent for the past two decades, it has fluctuated a great deal in the years before. While inflation rates have only been tracked officially for the past 100 years, it played a significant 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 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. 

Since the financial crisis in 2008, inflation has remained below 2.5 percent every year. The Federal Reserve aims to remain a target rate of 2 percent inflation annually, and now that the economy is stable and growing at a gradual but healthy rate, the Fed is slowly hiking interest rates in a bid to manage anticipated inflation.

As an entrepreneur, it is important to plan and strategize for inflation, even before it arrives. In a largely recovered economy, now is the time to lay those plans.

Chad Brooks contributed to the reporting and writing in this story.

Adam C. Uzialko

Adam received his Bachelor's degree in Political Science and Journalism & Media Studies at Rutgers University. He worked for a local newspaper and freelanced for several publications after graduating college. He can be reached by email, or follow him on Twitter.