Inflation in Economics: Types, Causes & Indexes
What Is Inflation?
Inflation is an economic phenomenon wherein a currency loses its purchasing value over time due to the rising prices of goods and services. That means consumers’ buying power also decreases.
Inflation is represented by a percentage, which shows the rate of change in price levels of a diversified set of commodities during a specific period.
Various types of inflation differ based on what the cause is. Knowing these can help you better understand inflation and how it affects your everyday life.
Understanding Inflation in the Economy
The Bureau of Labor Statistics (BLS) reported a year-on-year increase of 9.1% in inflation in June 2022, the highest recorded increase since 1981.
The prices of consumer goods are used to determine inflation. Instead of individual products, a basket of goods representing consumer spending is evaluated. For instance, the recent rise in inflation was broad-based but was driven mainly by certain indexes like food, shelter and gasoline.
An increase in prices solely doesn’t define inflation. A sustained upward movement must be observed in overall price levels, resulting in the loss of value of money.
Various facets of the economy are affected by inflation — from the spending power of consumers to the national debt interest. That said, inflation isn’t inherently bad. A low inflation increase can be a sign of a growing economy. However, a problem may arise when inflation rate growth leads to a significant decrease in purchasing power.
The Consumer Price Index (CPI) shows how prices change across commodities typically consumed in the U.S. in a certain period. Since it reflects changes to the cost of living in the country, it’s widely used to measure inflation.
In itself, inflation can’t be considered a bad thing. However, excessive inflation or hyperinflation can contribute to recession. That’s because of a possible drop in consumer spending, ultimately affecting economic activity.
A recession, in turn, may also affect the CPI. Consumers tend to change their shopping habits. For instance, CPI dropped during the 2008 recession. This also signifies a decrease in spending.
The Different Types and Causes of Inflation
Different shifts in the economy influence various types of inflation. The most common types are demand-pull and cost-push. Demand-pull refers to the increase in commodity demand, pushing producers to increase prices. On the other hand, cost-push is the increase in prices due to higher costs.
The root cause of inflation can be traced back to the money supply. Controlling the supply of money allows monetary authorities to manipulate its value. Thus, in some instances, inflation can be intentional.
The law of supply and demand explains how sellers and consumers interact. It helps understand the factors affecting the costs of goods and the availability of resources.
Money is also subject to the law of supply and demand. For instance, a sudden increase in money supply can reduce its value, meaning more money is required to buy the same amount and type of goods or services. This leads to inflation.
Generally, increasing the money supply is done to stimulate the economy. For instance, a country’s monetary authority can print out more money to increase the total amount in circulation. They can also devalue the currency. Another option is to loan new money as reserve account credits via banks. That said, all of these methods can cause a currency to lose its purchasing power.
The Federal Reserve monitors market conditions and changes the money supply to maintain balance in the country's economic conditions. The money supply is measured using M2, which includes cash, checking deposits, and non-cash (liquid) assets that can be converted into cash like savings accounts, certificates of deposits and liquid foreign currencies. M2 is used to forecast specific issues. Inflation happens if the money supply increases faster than the economy's growth.
There are various reasons why an increase in the money supply may be necessary. An example is the COVID-19 pandemic that hit different sectors. In response, the CARES Act was enacted in 2020. Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, trillions of dollars were provided to hard-hit sectors, workers, families and small businesses.
Sometimes, monetary authorities may deem it necessary to devalue a currency. Devaluation is a tool to cause inflation intentionally.
Deliberate devaluation of money is typically done to create artificial demand for products, especially goods the country produces. There are three main reasons for this — to boost the country’s exports, address trade deficits and lower the cost of the country’s debt.
Many countries have done currency devaluation to address various issues. Argentina, for example, has been practicing a uniform devaluation in the past years to stabilize foreign reserves.
Another example of uniform devaluation is Egypt. The country’s central bank devalued the Egyptian pound in March 2022 as foreign investors pulled billions of dollars out of the country’s treasury market amid the Russia-Ukraine war and the effects of the pandemic. The move made the country's exports competitive and attracted investors.
While the devaluation of a currency is often done to address specific issues, it can also lead to other problems.
In 2019, the world witnessed a currency war between the U.S. and China. The two economies tried to dominate trade by imposing greater tariffs on each other’s goods.
China devalued the yuan to manage the symptoms of a slowing economy. It aimed to protect trade by making its exports cheaper and imports more expensive. The country’s exports experienced a massive hit after the U.S. imposed higher tariffs.
Given that these two are the largest economies, the effects of the trade war were also seen in other currencies. A surge in foreign exchange activity was seen, with currencies highly exposed to China seeing depreciation.
Supply and demand are important factors affecting the prices of goods and services. They help drive the economy. Any irregularity in supply or demand can have a negative impact.
A possible result is demand-pull inflation, which is also called price inflation. This occurs when the demand for certain products and/or services outpaces the aggregate supply. Because of this, sellers tend to increase prices. Consumers have to spend more money to purchase the same amount or similar type of goods or services.
In 2022, car prices in the U.S. are rising for new and used vehicles. This is a real-world example of demand-pull inflation.
There are various factors increasing car prices. For instance, global production has significantly been reduced.
The Ukraine crisis and the related sanctions have heavily impacted trade. The cost of metals used to produce cars and gas prices have also soared. Additionally, the COVID-19 pandemic has affected semiconductor production, with the industry suffering from a chip shortage. All of these made it hard to meet global demand.
The rising prices of new cars have also affected the cost of used vehicles. Many consumers are holding off on buying new cars. Thus, limiting available used cars in the market. With the loosening of restrictions, demand for cars has also increased. However, manufacturers and sellers find it hard to keep up.
Another type of inflation is cost-push, which is also known as wage-push. This inflation happens when the increase in price levels is caused by either an increase in the cost of production or a decrease in supply levels. In this scenario, demand stays the same.
There are different factors affecting the supply side of the economy. But five situations can lead to cost-push inflation. These are the monopoly of an industry, wage inflation, natural disasters disrupting supply, government regulations or taxation and a shift in exchange rates.
The economic impact of cost-push inflation can be felt on a personal level. With rising costs, businesses tend to increase prices on their products and services. Thus, consumers have to spend more.
The pandemic caused a slump in crude oil prices in 2020 as demand for oil declined due to lockdowns and travel restrictions. Prices per barrel went as low as $20.46 (Brent crude oil), $12.41 (OPEC basket) and $14.22 (WTI crude oil) at the end of April 2020. But the reopening of international markets caused a drastic change in demand, making it hard for the supply side to keep up. Thus, leading to higher oil prices.
At the end of April 2021, prices per barrel were at $65.65 (Brent crude oil), $63.22 (OPEC basket) and $61.91 (WTI crude oil). And by the end of June 2022, prices per barrel were $114.65 (Brent crude oil), $115.97 (OPEC basket) and $110.65 (WTI crude oil).
Rising oil prices have a significant impact on the supply. Oil companies are not simply oil companies, they’re also considered energy companies. Byproducts of crude oil after refining are also used in multiple industries. Thus, with crude oil prices going up, various industries like electricity, transportation, manufacturing and logistics are affected.
Generally, supply and demand are behind higher oil prices. The lockdowns and restrictions due to the pandemic led to economic disruptions, which caused less energy demand. Demand climbed when restrictions were relaxed. Supply, however, didn’t.
Tensions due to the Russia-Ukraine war affected the global supply of oil. There was also lower production from Saudi Arabia, a major oil producer. Furthermore, U.S. oil producers have also been reluctant to expand production.
How Is Inflation Measured
Inflation is defined by the general increase in price levels over time and the currency’s spending power decline. That means the inflation rate relies heavily on the prices of goods and services.
There are multiple ways to measure inflation. The most common is the CPI. But many also use the Producer Price Index (PPI). The CPI and PPI show price changes across a representative basket of goods.
Consumer Price Index (CPI)
The CPI is a measurement used to track the movement of the aggregate price level of a basket of goods over a certain period. The basket of goods comprises goods and services commonly purchased or used. There are more than 200 categories, which can be grouped into eight types.
- Food and beverage
- Medical care
- Education and communication
- Other goods and services
In determining the CPI, the BLS collects detailed expenditure data from individuals and families from two population groups — urban consumers and urban wage earners/clerical workers.
CPI is used as an indicator to determine if inflation is occurring. That’s because an overall rise in price levels over time could result in the declining value of a currency. Consumers will have to spend more on the same products or services.
Calculating Inflation with CPI
Calculating the inflation rate using CPI requires you to have two CPI data. These are the new CPI and previous CPI. Subtract the previous CPI from the new CPI. Divide that value by the previous CPI. Multiply it by 100 to get a percentage. The final answer is the inflation rate.
For example, if the new CPI is 291.5 and the previous CPI is 268.8, the equation would look like this:
Using this formula, the result would be 0.085. Multiply this value by 100 to get 8.5%, meaning the inflation rate during the given period would be 8.5%.
Producer Price Index (PPI)
Another tool used to measure inflation is the PPI. It refers to the average change in how much domestic producers get for the goods and services they produce. It shows how price level changes from the seller’s perspective.
Generally, there are three main classification structures of PPI:
- Industry classification
- Commodity classification
- Commodity-based Final Demand-Intermediate Demand System
PPI has a wide coverage. The BLS releases thousands of PPIs for individuals and groups of products every month. There are over 25,000 establishments that provide about 100,000 price quotations.
PPI shows input costs. This gives a perspective on increasing price levels. For instance, sellers increase prices to maintain operating margins if PPI increases along with the CPI. However, if the increase in PPI is much slower than CPI, then the reason why retailers are increasing their prices may not be inflation.
Producer prices for goods and services showed a continuous decline throughout the first quarter of 2020, attributed mainly to the pandemic. The year’s biggest drop was recorded in April 2020 when the PPI fell by 1.5%, which is also the lowest since 2011. But prices have been on an aggressive uptrend since the COVID Crash bottom. PPI levels for total less foods, energy and trade services have started rolling over in November 2021, with a 7% year-over-year jump. If producer price levels for foods, energy and trade services follow suit, a slowdown in inflation may be seen.
Inflation in US History
Various factors could cause a recession. In some cases, it may be due to excessive inflation. That’s because this can cause a decline in consumer spending. Monetary authorities may also decide to tighten monetary policy to address high inflation, which could cause a drop in aggregate demand and lower economic growth.
Examples of recessions due to inflation are the Great Inflation of 1965 to 1982 and the high inflation currently experienced in the U.S. and globally.
The Great Inflation (1965–1982)
The U.S. experienced a long period of inflation in the past, lasting almost two decades. The Great Inflation of 1965 to 1982 led to four recessions. Inflation during this period is attributed to the excessive money supply.
At the end of World War II, the U.S. Congress focused on specific policies it hoped could help stabilize the economy. One of these is expanding a monetary policy for an economic boost that could trigger full employment. This is due to the Phillips curve, which states a trade-off between unemployment and inflation.
Inflation continued to rise throughout the 1970s, which led the Federal Reserve to take more drastic measures to promote price stability and control the growth of money supply and reserve. While the attempt at disinflation contributed to the weakening of the economy and two recessions in the early 1980s, it succeeded in slowing inflation by the mid-1980s.
Commodity prices, from gas to groceries, have risen during the past few months. According to the BLS, CPI jumped 9.1% in June. This is the highest inflation rate increase since 1981.
*The 2022 average is taken from January–June 2022.
Multiple things that provoked high inflation across the globe. The COVID-19 pandemic is one of them. For instance, the U.S. implemented its stimulus package to help those highly affected by the pandemic. This has caused an increase in the country’s money supply.
A disruption in the supply chain also made it hard to meet consumer demand after restrictions were relaxed. Other factors that led to the current global inflation are the food crisis, the oil price hike and the war in Ukraine.
To address the current global inflation, the Federal Reserve announced an interest rate hike by three-quarters of a percentage point.
Knowing the definition of inflation can help you see its impact on the economy and your everyday life. Below are some commonly asked questions to deepen your understanding of the concept.
Inflation is a phenomenon that affects everyone. MoneyGeek asked industry experts to answer a few important questions regarding inflation to provide further insight.
- What ways can individuals protect their savings from inflation?
- Are there instances where inflation can be good for the average consumer?
- Why do economists prefer slight inflation over deflation where prices of goods/services are reduced?
- What can the average consumer do to shield themselves, or at the very least, mitigate the financial impact of a recession on their lives?
- Considering recessions are happening every few years, what does that say about the modern US economy?
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