When the inflation rate rises, you’ll likely feel it in your wallet, whether it’s higher grocery bills or higher utility payments. But inflation isn’t just something that you feel—it can have a profound impact on the economy. Understanding how it works and how it differs can help you make smart financial choices.
Generally speaking, inflation is caused when there’s too much money chasing too few goods or services. Various factors can contribute to this, including government policy (like deficit spending or central bank interventions), supply chain issues, and global economic factors like a trade war or spiking oil prices.
Because the prices of different goods and services can vary widely, statisticians measure inflation by determining the current value of a basket of goods and services used by households and comparing it to the previous one. This is known as a price index. Statisticians then divide the change in the index by the number of months in a year to get the annual inflation rate.
To ensure that inflation is measured consistently, the items in the basket are weighted so that the cost of something like eggs has more sway on the overall index than motor fuel does. This is why you’ll often hear people refer to core inflation, which focuses on the underlying trends in inflation by excluding energy and food prices that can fluctuate wildly.
Inflation is a concern because it can make money saved in savings and investments less valuable over time. However, it’s important to understand that inflation isn’t always bad—it can be a sign of a healthy economy and provide an opportunity for businesses to increase their profits. If inflation gets too high, however, it can lead to overheating that may require the Federal Reserve to slow the economy and risk a recession to bring inflation back down to its target of 2 percent.