You’ve probably filled up your tank with gas or purchased groceries recently, and found yourself shocked at how much prices have risen over the past year. This is because of inflation—which you’ve likely heard a lot about in the news recently. The U.S. is currently experiencing the highest inflation levels since 1990, with a 6.2% spike in prices for consumer goods.
It’s important to understand inflation and its role in your finances. So let’s take a look at what inflation is, how it affects you, and what you need to know in order to be smart with your money.
What is inflation?
Inflation is the rate at which the price of goods and services increase, and as a result, the value of money, or purchasing power, decreases. As money loses its value, you can’t afford to buy as many goods and services with it. This loss in purchasing power negatively impacts the cost of living for the general public and leads to less economic growth.
While the prices of individual goods can change over time, inflation happens on a much larger scale. Instead of the prices of a few goods increasing, inflation occurs when the prices of many goods and services increase at the same time. This includes things like food, gas, electricity, transportation, health care, entertainment, and labor prices all increasing at the same time.
Prices of goods and services are tracked through price indexes. The most common price indexes that you may have heard about are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). These indexes provide insight and measurement for inflation.
Typically, a small, stable increase in prices is natural and expected—in fact, the Federal Reserve tries to maintain an inflation level around 2% each year. However, the reason that inflation is in the news right now is because the current inflation rate is substantially higher than 2%.
What causes inflation?
Inflation can be caused by a variety of different factors including supply-chain disruptions, the amount of goods in the market, the availability of raw materials, unemployment rates, or changes in wages across the country.
So why is inflation increasing so much right now? The COVID-19 pandemic caused a shutdown of the economy, followed by a rise in spending when the economy reopened.
Consumers are spending like they did before the pandemic—they’re going back to restaurants, travel destinations, and entertainment venues while continuing to stock up on supplies for their home in case of a future emergency. This sudden spike in spending drove up the demand for goods.
While all of this spending and returning to normal is great, there are some downsides. In fact, one crucial factor that we’re currently experiencing is the supply chain back-up. Supplies are more limited and there’s a labor shortage, meaning that fewer workers are available to meet the high demand. When demand exceeds supply, the prices of goods increase and, in turn, reduce the value of the dollar.
What are the types of inflation?
There are generally three main types of inflation that can be caused by different factors.
Demand-Pull Inflation: This occurs when there’s an increase in spending and the supply can’t meet the increased demand in the market.
Cost-Push Inflation: This occurs when high production prices or high costs associated with raw materials result in higher prices.
Built-in Inflation: This occurs when people expect inflation rates to continue to rise in the future. As people anticipate prices to rise, workers expect an increase in wages as well. The increased wages result in the higher cost of goods and services.
How does inflation affect interest rates?
The Federal Reserve will increase interest rates during times of inflation in an effort to even out the amount of spending happening in the economy. The idea here is that when interest rates rise, many people will cut back on spending and tighten up their budgets. This creates a lower demand for goods and services in the market. Interest rates can continue to rise until inflation slows down.
How does inflation affect my finances?
The most direct impact inflation has on your finances is the rising costs of the many things that you buy regularly. You can see this at the grocery store where the cost of food has increased just in the past year. Car rentals, used cars, air travel, and furniture are also seeing particularly high price increases.
Home prices and rentals have increased significantly in the past year, which leads to people not being able to afford a house and having to put more of their income towards rent. This will generally only affect those who are renting or looking to purchase a home while homeowners are less likely to see a larger difference in their finances.
Despite the downsides of inflation, there are some potentially positive ways that high inflation can affect your finances. In this economy, the unemployment rates are down which means there are more job opportunities available. It also means that negotiating a higher wage with your employer can be easier due to the increase in costs.
Inflation can and likely will affect your finances in some form over the next year. It’s important to stay informed about inflation and what it means for you.