Inflation. You’re likely hearing the word a lot right now, and you probably have a lot of questions.
How does inflation work? Is inflation good or bad? Why is it so high right now?
This article tackles these questions and more so you can have a better understanding of inflation and how it might impact your financial health.
If you’re trying to learn about inflation, you’ve probably seen a lot of complicated inflation definitions.
The good news is, inflation is actually pretty straightforward. It’s the increase in the price of goods over time.
Inflation is usually presented as the percentage of price growth over the last year. The most common measure of inflation is the Consumer Price Index (CPI).
The CPI measures the average change in price for products bought by real consumers.
It includes a range of products and services, like:
Let’s look at an example of inflation to get a better idea of how it works.
Say you bought a new pair of shoes a year ago. They cost $50. The inflation rate is 2%.
The same pair of shoes now cost $51, which is 2% more than you paid previously.
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Inflation happens for lots of different reasons, but most fall into two categories: demand-pull and cost-push.
Demand-pull inflation is the most common type of inflation. It happens because of basic supply and demand.
Consumers demand more of a product. The companies producing the product can’t keep up with the increased demand.
This results in a limited supply of the product, but consumers are willing to pay more to get it.
The companies then raise the price to benefit from consumer demand.
Like demand-pull inflation, cost-push inflation has to do with supply and demand.
However, cost-push inflation comes from the production side of the product instead of the consumer side.
Cost-push inflation happens when there’s an increase in the cost to produce goods.
As the cost to produce a product goes up, manufacturers increase the price. Retailers pass these costs on to consumers like you by raising the price of the product.
Crude oil is a common reason for cost-push inflation.
As the crude oil price increases, manufacturers who use it to make products increase their prices as well.
Gasoline prices, for example, are affected by the cost of crude oil. When you’re paying more at the pump, it usually means oil prices are up.
Spoiler alert: America isn’t the only country facing higher inflation.
The majority of the world is dealing with higher prices for everything from food to used cars.
How did that happen? Most of the current inflation comes from both demand-pull and cost-push sources related to the COVID-19 pandemic.
Most people spent the majority of 2020 on Zoom calls and watching Netflix.
People weren’t going out to eat, shop or meet friends for a night out. As a result, the demand for many goods and services dropped.
With falling case rates, access to vaccines and reopening plans, however, consumers are starting to go back to their regular lives.
A lot of people are ready to spend money on the things they’ve missed—from dining out to business clothes for the office.
In addition, higher wages and government pandemic relief, like stimulus checks, are putting more money in Americans’ pockets.
This has helped stimulate the economy. Unemployment is down and consumers are moving money through the economy.
However, having more money in your pocket often increases spending, which contributes to increased demand.
Moreover, retailers are having a hard time keeping up with increased demand. They’re increasing prices to make up for it, and consumers are paying more for everyday goods.
Supply chain issues are increasing the cost of manufacturing while also limiting the supply of goods.
Transportation outlets saw a sudden increase in demand and the infrastructure in place couldn’t handle it at once.
You might remember the backup of container ships outside of Southern California seaports.
There simply wasn’t enough room to bring in all of the containers in a timely fashion. The goods in the containers couldn’t get to retailers or consumers and were subsequently costing the manufacturers money to keep them on the ships.
This, along with labor shortages, has made it more expensive to manufacture and transport goods across the country.
The result: consumers are undoubtedly seeing a rise in production costs at the store.
The effects of inflation aren’t going anywhere anytime soon.
You can expect to pay higher prices for most consumer goods until next year (or later).
That doesn’t mean you can’t save money, though!
Try some of these ideas to help you cut your spending and save money during inflation:
Possible Finance Tip: You should also consider your options in case of an emergency.
It’s best to have 3-6 months of living expenses in an emergency fund, even if the interest rate isn’t keeping up with inflation.
Short-term loans can help bridge the gap if your savings can’t cover your expenses, but the best course is to focus on building an emergency cushion to get you through the hard times.
You usually hear about inflation as a negative thing because everyday costs are going up.
However, inflation isn’t always a bad thing. Most economists think low inflation reflects a healthy, growing U.S. economy.
Whether or not inflation is good or bad usually depends on how fast it’s growing.
The Federal Reserve, the central bank of the U.S., considers an annual inflation rate under 2% to be the inflation target.
Rates around 2% are thought to produce a productive economy with stable growth. Consumers can afford to purchase goods, which keeps demand steady.
This demand then encourages companies to keep enough supply of goods on the market. To do this, companies have to have enough workers. They may need to hire new employees, which lowers the unemployment rate.
Inflation turns “bad” when it starts to grow beyond the 2% range. High inflation causes prices to start outpacing paychecks.
The cost of living goes up and consumers have to pay more for everyday goods. Prices that are too high can mean serious financial consequences for everyday Americans.
Can inflation go below 0%? Yes. A negative inflation rate is called deflation. That’s when the prices of consumer goods are falling. Deflation happens when there’s a drop in demand or growth in the supply of a product.
Just like inflation, deflation can be good and bad for an economy. Short-term deflation helps lower costs for goods like apparel and gasoline.
This gives consumers more purchasing power—meaning your dollar goes further.
Lingering deflation, however, can stall economic growth. Consumers might stop buying as they wait for prices to drop more, which drives down demand.
When demand is low, companies don’t need to produce as many products and the unemployment rate can go up.
The current inflation rate is affecting everyone’s pockets.
Unfortunately, prices probably won’t drop anytime soon.
That means it’s an important time to review your budget (or set one!) and look for other ways to save.