Inflation

Definition

Inflation is a sustained, economy-wide rise in the general price level, measured as a percentage rate over a defined period (usually a year). It is not a rise in one price but in the average of all prices — a fall in the purchasing power of money itself. If prices rise 5% in a year, a dollar that bought one unit of goods last year buys only 0.95 units today.

Economists distinguish inflation from price changes in individual markets. Wheat prices can rise because of drought while the general price level stays flat. Inflation is a monetary phenomenon at its root — too much money chasing too few goods — though supply shocks, wage spirals, and expectations can all feed or suppress the rate in the short run.

Why it matters

Key takeaways

Inflation is measured by price indexes — CPI (consumer price index) tracks a basket of household goods; PCE (personal consumption expenditures) is the Fed's preferred measure; PPI tracks producer prices.
Demand-pull inflation: too much spending chasing too few goods — typically associated with rapid money supply growth, fiscal stimulus, or strong credit expansion.
Cost-push inflation: supply-side shocks (oil embargoes, supply chain disruptions) raise production costs, which are passed to consumers even without excess demand.
Inflation redistributes wealth: debtors benefit (they repay in cheaper dollars); creditors and savers lose. Fixed-income recipients are hit hardest.
Expected inflation gets built into wages and contracts, making it self-fulfilling. Breaking high-inflation expectations requires credible tightening — often at the cost of a recession.
The Fisher effect: nominal interest rates rise roughly one-for-one with expected inflation, leaving real interest rates (what lenders actually earn) roughly unchanged.

Causes and the inflation cycle

Read it as: Inflation can start from excess demand (too much money chasing goods) or supply disruption (rising input costs). Once prices begin rising, workers demand higher wages to keep up, and those higher wages feed back into prices — the wage-price spiral. Central banks break this cycle by raising interest rates to cool spending, at the cost of slower growth and higher unemployment.

How inflation is measured

The Consumer Price Index (CPI)

The CPI tracks the cost of a fixed basket of goods and services purchased by a typical urban household: food, housing, transportation, medical care, and recreation. The basket is updated periodically to reflect changing consumption patterns. Year-over-year CPI growth is the most commonly cited inflation measure in public discourse.

Core inflation

“Core” inflation strips out food and energy prices — the most volatile components — to reveal the underlying trend. Central banks focus on core measures because temporary food or fuel price spikes do not necessarily signal a persistent inflation problem. The Fed’s preferred metric is the PCE price index (personal consumption expenditures), which uses chain-weighted averaging rather than a fixed basket.

Inflation’s redistributive effects

Debtors and creditors

Inflation reduces the real value of debt. A mortgage borrower who owes $200,000 fixed in nominal terms benefits when inflation erodes the purchasing power of that liability. The lender — the bank — receives repayments worth less in real terms than anticipated. This is why high inflation can trigger financial system stress: lenders systematically underestimate borrower risk when they fail to anticipate rising prices.

Fixed income and savings

Savers holding cash or low-yield assets lose purchasing power to inflation without recourse. Retirees on fixed pensions, bondholders with non-indexed coupons, and workers in non-unionized jobs with slow wage growth are particularly vulnerable. Cost-of-living adjustments (COLAs) and inflation-indexed bonds (TIPS) are mechanisms for protecting real value against this erosion.