Personal Finance

New York Life | August 08, 2022

Updated April 25, 2024

The current inflation rate of 3.48% (as of April 2024) is well below the peak of 9.1% in 2022, but many Americans are still feeling the sting of rising prices of consumer goods. 

Inflation can be a somewhat tricky economic concept, so we've broken it down for you here. What does inflation actually mean? And how can it impact your financial situation?

Below, we answer some of the most frequently asked inflation-related questions.

What is inflation?

In the simplest possible terms, inflation is what happens when prices go up and therefore the purchasing power of money goes down.

A dollar is worth fundamentally less if, overall, goods and services increase in price. You can probably remember how much you could buy for a dollar when you were a kid, and it was a lot more than you can buy now. This is because of inflation.

While there are some pros to inflation (see below), there are also several consequences to both the economy, and the individual, when prices increase dramatically and the value of money decreases. When the inflation rate rises too high, it can play a role in triggering a recession.

How is inflation measured?

There are a few different ways to measure inflation, but typically it is measured using the Consumer Price Index (CPI).

The CPI is calculated by checking the prices of an imaginary “shopping cart of goods and services,” and recording any changes.

In the US, the Bureau of Labor Statistics reports the CPI each month and has been doing so as far back as 1931. It samples about 94,000 products and services to calculate the overall change in prices. The CPI also takes into account changes in product quality and updates the “cart” to match buying trends, adding in popular new products.

The rate of inflation is the pace of which prices are rising, which is typically expressed as a percentage. For example, if a soda costs $1 and that rises by 5 cents compared with a year earlier, then soda inflation would be 5 percent. The national inflation rate is a broad measure that takes into account an overall increase in prices.

Why does inflation rise?

So, what causes inflation rates to go up? There are typically two main causes of inflation. “Demand-pull” inflation occurs when demand for products outstrips supply. This can happen for a number of reasons: when a government or central bank simply creates more money, or lowers interest rates; or, when consumers have increased disposable income and better economic stability.

This means there is fundamentally too much money around for the goods available. The result of this is an overall increase in prices, and a significant devaluation of  currency.

The other main cause of inflation is known as “cost-push” inflation. In this instance, overall prices increase due to a rise in the cost of raw materials, the rising cost of wages, or the cost of manufacturing.

When this happens without an increase in demand for goods or services from the consumer, then prices go up, but wages typically don’t, leaving the consumer out of pocket.

How does inflation impact everyday life?

The main impact on an individual’s everyday life is the increase in the price of goods. Weekly grocery shopping will jump up in cost, and for consumers with less disposable income, the consequences of this can become hugely problematic. Families could be plunged into financial difficulty as a result.

Combine the increase in the price of everyday goods with stagnating wages and the nation could start to enter a cost-of-living crisis. This is typically understood to be a time when many individuals struggle to balance their income with their expenses.

What are the benefits of inflation?

The optimum rate of inflation is around 2 percent per year. This might seem surprising; surely rising prices and a decrease in the value of money is never a good thing?

In actual fact, some inflation is necessary to stimulate the economy. A little inflation encourages consumers to buy sooner. If prices are decreasing, consumers are incentivized to hold out for a better deal before making a purchase. Plus, inflation is beneficial to consumers in debt. It erodes the value of a loan or mortgage, freeing up more dollars to spend. And finally, property owners and commodity owners will see their assets increase in value, which they can then sell at a higher rate.

Most central banks agree that an inflation rate of around 2 percent promotes spending rather than saving, which boosts the economy.

The Federal Reserve oversees US inflation rates, using various tactics to both minimize volatility and keep the inflation rate at around 2 percent.

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