What Is Inflation, and How Does It Affect Your Finances?

Photo Courtesy: Aslan Alphan/iStock; Elena Perova/iStock

In late 2021, inflation hit a 39-year high. The Consumer Price Index (CPI) — a measurement of the average change in prices we pay for goods over time — rose by 7%, marking its largest 12-month increase since June 1982.

While you likely heard about the record-breaking climb in the news, it might not be clear right away what it means for you personally. If you’re wondering what inflation is and how it affects your finances, here’s what you need to know.

What Is Inflation, and What Causes It?

Generally, inflation is a term that can describe a variety of economic conditions. In this context, though, inflation refers to the increase of the cost of goods and services over time, usually in a broad sense — like in a country’s economy. Inflation usually references the tendency for goods and services to rise in cost over time, but it can also represent a decline. It can mark the decline of purchasing power — the amount or number of goods or services an amount of money can buy — over a period of time. Essentially, when inflation goes up, one dollar can’t buy as much as it did before.

It’s natural to think that inflation is caused by rising prices and, in a way, that’s true. However, it’s a bit simplistic. Prices don’t rise without a reason, and what spurs the increases is usually at the heart of inflation. Rising costs for manufacturers or suppliers could play a role. If the price of raw materials, manufacturing, labor, taxes or other factors that influence how much the business can spend rise, the company usually increases consumer prices in response. That leads to inflation, because the goods or services that company offers cost more as a result.

Inflation can also happen for other reasons. For example, if demand for a good or service far outpaces supply — meaning more people want the good or service than what’s available on the market — prices usually go up in response. When customers are willing to pay more to get their hands on something that isn’t widely available, it’s normal to see the cost rise. If that scenario plays out in enough product or service categories, it can potentially lead to inflation, too.

How Is Inflation Measured and Calculated?

Measuring inflation typically involves examining price changes in the CPI. The CPI contains collections of data about what different goods cost and how people spend money on them. It’s divided into eight major categories that include:

  • Housing
  • Apparel
  • Food and Beverage
  • Medical Care
  • Transportation
  • Education and Communication
  • Recreation
  • Other Goods and Services

Within those groups are specific products or services. For example, “raw boneless, skinless chicken breast” could be an item tracked in the Food and Beverage category, while “unleaded gasoline” might be something monitored in the Transportation group.

Exactly what’s in each category may change over time. The Bureau of Labor Statistics, which maintains the CPI, aims to choose a representative set of products and services to demonstrate costs and spending habits accurately. Because people’s purchasing habits and priorities might shift over time, the BLS updates the lists as needed.

By monitoring how the cost of those items changes over time, it’s possible to estimate how the price of consumer goods and services is broadly changing within the national marketplace. That makes the CPI a solid economic indicator for tracking inflation and deflation.

The CPI helps analysts see how the purchasing power of the dollar is shifting. When the overall price level of the CPI goes up, purchasing power typically declines — and that indicates inflation. When the price level goes down, purchasing power usually rises, marking a period of deflation.

What Are the Effects of Inflation?

On a broader scale, inflation causes a country’s currency to lose its buying power. This means that the cost of living — the amount of money people need to afford basic expenses like housing and food — typically goes up. When the cost of living goes up, people have to allocate more of their income toward necessities. In time, this process can slow a country’s overall economic growth.

The reason economic growth stalls is relatively simple: Consumers aren’t buying as much stuff. This limits the flow of money through an economy. When shopping slows down, companies’ profits drop. As a result, they may then need to lower wages or lay off employees, removing more functional money from the economy. If that leads to even fewer people buying goods and services, it creates a cycle that can dramatically slow the economy in the area where it’s happening. If this happens on a larger scale, it can affect an entire country.

How and Why Governments Respond to Inflation

The main reason that governments respond to inflation is that the flow of money within the country benefits the national economy. Along with limiting how much people buy, inflation might encourage the public to save more of their cash instead of spending it. That locks money away, preventing it from circulating. When money isn’t moving well, it impacts business and consumers alike. And, it means economic growth, like job growth, isn’t happening.

Usually, the goal of any government intervention is to create a balance that makes sure the purchasing power of the currency, wages and prices pushes supply and demand for goods and services to a healthy point. When that happens, cash circulates through communities and can create economic growth.

One way governments influence inflation is by encouraging the central bank — in the U.S., that’s the Federal Reserve — to reduce interest rates. Along with lowering how much a household might have to spend to repay a debt, it makes borrowing more attractive to people. As a result, if you borrow some cash, you might be more willing to spend it because the interest rate is lower and you won’t worry as much about repaying the loan.

Stimulus checks can also influence inflation by giving people more money to circulate in their local economies. But, the end result depends on other economic factors, how people use the money and how businesses respond to shifts in demand. Stimulus checks may raise or lower inflation.

How Inflation Impacts Everyday People’s Financial Health

Mainly, inflation impacts our financial health by reducing the purchasing power of a dollar. Even if prices are rising, that doesn’t mean wages are increasing in turn. As a result, your household might see expenses go up, even though your income is staying the same. And, that may mean you can’t afford as much as you did before.

When that happens, you might need to make some tough spending choices. Usually, cutting back on optional expenses — like entertainment or dining out — is what people first opt for. However, if inflation continues, you might have to choose between necessities.

While middle- or high-income households might simply need to switch away from name-brands to generics or make similar smaller sacrifices, low-income households can face bigger challenges due to unchecked inflation. For example, older adults on fixed incomes might have to choose between buying food and medications.

In the end, rising prices impact everyone. Your money won’t go quite as far. Unless your wages increase at the same pace as inflation, you might need to respond by adjusting your spending to offset its impact.