Understanding Inflation Definition and How It Works

If you feel like your money is losing value and you can’t buy as much with it today as you could before, we can assure you you’re not alone. Inflation is a sadly inevitable part of our economic system, and staying on top of it is a constant challenge. While you can’t really influence inflation, there are some steps you can take to prepare for rising prices for goods and services.

So, what is inflation, and what are its causes and consequences for consumers and the economy as a whole? In this article, we tell you everything you need to know about this phenomenon and provide tips to help you protect your finances from depreciation.

What Is Inflation?

The exact inflation definition is more complex than you might think. In general terms, it is an indicator that measures how quickly and by how much the prices of goods and services are rising, but it also reflects the economic situation in a country and the strength of its currency on a global market.

Inflation occurs when the purchasing power of the population decreases as a result of the increase in prices for goods and services—the faster and stronger the price increase, the higher the level of inflation. To get a general picture of the level of currency devaluation in the country’s economy, you can track changes in its inflation index.

How Does Inflation Work?

As we’ve already mentioned, currency devaluation occurs when money loses its purchasing power—you can buy less than you used to for the same amount of money. However, it is not simply a situation when one good or service becomes more expensive than it was. Inflation involves the increase in the price of many goods and services over a long period—continuously and simultaneously.

So, what causes inflation? A decline in purchasing power occurs when there is a significant mismatch between supply and demand in an economy. Typically, this imbalance works in such a way that demand exceeds supply, for example, due to limited production, high costs, or supply disruptions, which means that prices for products and services begin to rise.

To define inflation, you need to calculate the price index, which shows how the average price of certain goods and services changes. To measure the price index, economists take essential goods and services that the population buys on a regular or daily basis. If the index exceeds at least 2%, the inflation is on the rise.

Types of Inflation

While monetary depreciation is influenced by numerous factors, there are three broad types of inflation: demand-pull inflation, cost-push inflation, and built-in inflation.

Demand-pull inflation

This type of inflation occurs as a result of an increase in overall consumer demand. In more practical terms, it happens when consumers begin to spend more money on goods and services, and consumer demand becomes greater than the economy’s production capacity. In such an environment, businesses simply cannot meet the ever-increasing demand, creating a scarcity that naturally leads to an increase in prices.

Demand-pull monetary depreciation is associated with a low unemployment rate, a good standard of living for the population, and high salaries.

Cost-push inflation

Cost-push inflation occurs when there is an increase in production costs. When production processes become more expensive for businesses, they have to increase the prices of their products to cover the costs and continue to make a profit.

Typically, cost-push inflation occurs when basic supplies become more expensive for one reason or another, when electricity prices rise, and when production processes become more costly.

Built-in inflation

Built-in currency devaluation goes hand in hand with the population’s expectations that the current inflation rates will continue in the future. When prices increase, employees respond by demanding higher wages. Businesses, in turn, must now compensate for the increased expenses and set higher prices for their goods and services.

It is also worth mentioning that economic events do not always cause currency devaluation. Global or local conflicts, government restrictions, or natural disasters can also make production processes more complex and supplies more difficult. As a result, goods and services become scarcer and more valuable, which naturally leads to higher prices.

How Inflation Affects Prices

As we have already mentioned, inflation affects all sorts of goods and services, even though it is more noticeable when dealing with things like groceries and utilities. Inflation is a devaluation of money, which means price increases at all levels—simply put, you can buy fewer goods and services for the same amount of money.

Currency devaluation destroys the savings of the population and reduces their purchasing power by a few percent, or sometimes even tens of percent, per year. As a rule, the growth of the inflation index can be measured by tracking the prices associated with the consumer basket—when its cost increases, we can talk about inflation. The loss of purchasing power affects not only the prices of goods and services but also the economy as a whole. In order to maintain financial stability, the federal government does everything possible to keep inflation within acceptable limits.

Pros and Cons of Inflation

Interestingly, inflation has some positive consequences for the economy. To truly explain inflation, we must analyze it even from this seemingly counterintuitive perspective.

Advantages of inflation

As paradoxical as it may sound, inflation has a positive side that improves our lives in the long run. If held in check, inflation actually stimulates a country’s economy—the more money is in circulation, the more of it needs to be spent.

Purchasing power decline also protects the economy against the “paradox of thrift”—a situation when, during deflation, buyers postpone their purchases. In this situation, money is not spent, demand falls, and production decreases. A healthy level of inflation encourages spending instead of saving, which in turn stimulates economic activity.

In addition, the part of the population that has tangible assets can benefit from a purchasing power decline since it increases the price of their assets. The questions about the somewhat dubious morality behind this aspect of inflation are beyond the scope of this article.

Disadvantages of inflation

Inflation has rather obvious negative consequences for both consumers and the economy as a whole. As for the population, they lose purchasing power, which heavily impacts their quality of life and have to cope with losing their savings over time. What is important is that the low-income part of the population suffers the most because the prices of basic and vital goods are often the first to increase.

High monetary depreciation can also have very serious consequences for the state-level economy. As the prices of goods and services increase, the reasonable standards of living get harder to maintain, which can devastate entire economic sectors in any sufficiently developed nation.

3 Ways to Prepare for Inflation

You can’t influence monetary depreciation, but you can prepare for it. Here are some practical tips and tricks to help you protect your money from losing value.

• Save money: To stay prepared for any economic shock, you should always have at least some savings—you may want to consider savings accounts with good interest rates.
• Invest Money: You can make your money work for you by investing it for passive income or putting it into retirement accounts.
• Budget wisely: When faced with monetary depreciation, you should review your expenses and cut back on some things to be able to afford essential purchases and bills.

Conclusion

Understanding inflation is challenging for a number of reasons. As a highly complex phenomenon, it affects both individual consumers and the global economy in a number of ways, not all of them negative.

The most common way we experience inflation is through price increases and money devaluation, which have negative consequences for the general populace. However, there are some steps you can take to lessen the impact of inflation, meaning you can still maintain your current standard of living and protect your finances. Money deprecation also benefits the economy in several important ways, which contrasts with its overwhelmingly negative public perception.