Perhaps no other word in the English language strikes more fear in consumers than "inflation." If that is true, it likely could also be said that a majority of those same people do not adequately understand the economic principle behind inflation.
Their confusion is understandable in some respects. Economists can spend their entire lives studying inflation, and still be in disagreement with others about its specific causes and effects.
Definition of Inflation
To the general consumer, however, inflation can be easily defined. Let’s start with a standard definition which states that it is a rise in the average price level of goods and services or a decrease in the purchasing power of the standard unit of currency.
While that definition is a bit confusing in its own right, it can be simplified. Basically stated, goods and services will cost the consumer more when inflation rises.
Example of Inflation and Gauging It
Let’s look at the cost of a one pound loaf of white bread over a twenty-five year period. In January of 1988, the United States Department of Labor, Bureau of Statistics, indicates that a loaf of white bread cost approximately 59¢. In January of 2013, that same loaf of bread cost $1.42. Thus, in the twenty-five year period, the bread increased 83¢ or rose by 140%. (Use this site’s Inflation Calculator to find how buying power of the US dollar has changed over the year.)
One cannot look at a single item, however, to determine inflation. Thus the Bureau of Statistics gathers pricing data on thousands of items monthly from many locations throughout the United States. In doing so, it can get a more accurate sampling of the cost of those items throughout the country while tempering significant swings in pricing in individual items or areas of the country.
This sampling is known as the Consumer Price Index (CPI), also sometimes called the cost-of-living index. By using the CPI, the government can gauge more accurately the cost of goods and services to consumers throughout the nation and paint a more accurate picture of the effects of inflation.
For comparison, lets go back to the 25-year period used previously. You will recall that the cost bread during the period from 1988 to 2013 rose by 140%. However, based on the hundreds of items sampled in the CPI, cumulative inflation rose by only 96.9%. This is a perfect example of why so many different items need to be sampled in order to make a more accurate estimate of the effects of inflation.
Causes of Inflation
What causes inflation though? Most economists feel there are three main factors which lead to it. These three are usually called demand-pull, cost-push, and money supply expansion.
In the demand-pull scenario, consumer demand for goods and services is greater than the available supply. Thus, the pricing of those items is raised to prevent inventories from being depleted.
Cost-push inflation happens on the supply side. Sellers raise their pricing in order to cover their increased production costs such as labor and components of the items they produce.
Money supply is the third major factor to be considered. It is also a method of the government to help control inflation. As more money is in circulation, consumers will likely use it to purchase additional items they would not have normally bought.
Keeping these factors in mind, it becomes easier to understand both the positive and negative effects of inflation and why its control is important for a growing economy.