The inflation rate affects many facets of our economy, including people’s purchasing power and economic growth. It also raises or lowers interest rates on debt. Understanding and properly managing inflation can help you plan for the future.
Inflation is a process that occurs when a central bank creates more money than the public demands, and this excess cash inevitably enters the economy and causes prices to rise. It’s important to note that relative price changes—no matter how annoying they might be for consumers and producers—transmit vital information that supports sound economic choices and encourages people to work hard and produce more, which is a positive economic outcome. Inflation, by contrast, distorts these vital relative-price signals and impedes productive activity.
A common measure of inflation is the consumer price index, which combines the price of all items in a basket of goods and services that are purchased by households, weighs the prices of each item by their relative importance to household consumption, and calculates an overall inflation rate for the entire economy. A price index is used because individual prices change at different speeds, and a general index helps to eliminate the effects of these differences.
During periods of inflation, commodity prices often move one step ahead of final product prices because companies must increase the prices of their inputs to cover rising costs. This is known as cost-push inflation. People with fixed interest payments or mortgages can benefit from inflation, because they can make their repayments using inflated dollars that will have more purchasing power in the future. Deflation, on the other hand, can make it more difficult to service debt because the value of loans will decline along with prices.