What IS Inflation? How Does it Affect Your Wallet?
If you’ve somehow managed to never hear the word “inflation” in your lifetime, you’ve avoided one of the most common economic buzzwords in existence. However, it’s important to know about this term, even if it’s pretty scary sounding (especially because it describes an economic phenomenon that can impact a lot of different aspects of our society). So, what is it?
What does “inflation” mean?
Generally, inflation occurs when an economy’s goods and services experience an upward price movement, according to the Bureau of Labor Statistics. Another way of looking at it, brought to you by howstuffworks.com, is that inflation means the currency in question is losing value over time. But not all inflation is necessarily bad.
Khan Academy explains how moderate inflation can be present during a good economy. How? Well, on a really simplified level, when employment is up, wages will go up, demand will go up, companies are utilizing more, and thus profit and investment will increase. When this occurs, the companies can take advantage of that utilization by raising prices to gain more profit.
However, inflation can be associated with much worse times in the economy, like in the case of stagflation. Stagflation occurs when there’s a major supply shock in the economy. Supply and price generally have an inverse relationship, so when there’s less of something, the price goes up. The increase of the price of something important that affects the economy (like oil) can lead to a series of economic events, from a drop in demand to a drop in employment.
How is it calculated?
(Okay, not a literal basket, but you get the idea.)
According to the Federal Reserve’s website, you can’t measure inflation just by seeing the increase in cost of one item or service — all of the goods and services have to be taken into consideration. The Federal Reserve keeps track of this kind of increase by studying many different price indexes, which measure price changes for certain groups of goods and services.
One of the main indexes is the consumer price index, or CPI. The CPI reflects the price changes of a representative basket of goods and services paid for by urban consumers. The index is divided into two types: one for urban wage earners and clerical workers, and one for urban consumers, which is the type you’ll usually hear about on TV.
Because inflation can fluctuate pretty dramatically on a month-to-month basis, the Federal Reserve website says policymakers typically consider inflation over longer periods of time, like a year or more. CPI measurements are still measured month-to-month, though, and it’s broken down fairly well, as you can see in this report.
How does it affect your life?
As you’ve already read, a little inflation might be around in a healthy economy, so it’s possible you wouldn’t even notice it. However, other types of inflation can have an effect on the economy in a few different ways. Some might not affect you depending on the way you handle your finances, but others might be unavoidable.
For one, inflation may cause investors to worry a bit. According to Investopedia, during periods of inflation, companies can look like they’re doing well when it’s really just inflation overstating the returns. Furthermore, people who invest and have fixed-incomes probably experience the most negative effects, as what they invested in, say, a Treasury bill, will get a different return down the road if inflation was positive. Try to differentiate your investments, such as trading commodities online, stocks or treasury bills- not just one.
Interest rates can also be affected by inflation in the economy. According to Paul Solman in a PBS article, market interest rate is affected by inflation, as well as waiting and repayment risk.  Focusing on how inflation comes into play, if you lend out money that’s losing value, you’d want to be reimbursed for the value you’re losing (via interest rates).
Conclusion
Inflation might seem like a distant word with no direct impact on individuals, but inflation can affect aspects of the economy and be an indication of other things going on in the economy. In addition, its affects can change other economic phenomena and result in people encountering different investment problems and interest rates.
