If you’re noticing your money doesn’t stretch quite as far as it used to, it may not be your imagination. Chances are, you’re experiencing the effects of Inflation, an economic phenomenon in which prices rise over time. It’s a natural part of the world’s economic cycles, but it can distort relative prices, wages and rates of return.
Inflation can be caused by a number of factors, but it often comes down to an imbalance between two economic forces: supply and demand. Supply describes how much of a good or service is made and sold, while demand refers to the amount of people that want to buy it at a particular price. When demand exceeds supply, prices tend to rise. This is known as demand-pull inflation, and it can be a positive sign for the economy, especially when it’s driven by healthy economic growth and low unemployment rates.
A high rate of inflation can hurt savers, eroding the purchasing power of their savings; but it can benefit borrowers, as higher inflation makes it easier to pay back loans. Inflation also affects the value of a nation’s currency, making exporters more competitive when their goods are priced in foreign currencies.
Inflation is measured by tracking changes in the prices of a “basket” of goods and services purchased by consumers. The Bureau of Labor Statistics’ Consumer Price Index (CPI) is one such measure, although other indices exist, including the Personal Consumption Expenditures Index (PCE). It’s important to remember that not all prices change at the same rate. Some change rapidly while others—such as wages established in contracts—take longer to adjust.