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What is Inflation? The Simple Explanation

You may have heard of inflation before, on the news or radio, and seen headlines like “Stock Market Dips on Inflation Fears ”. It's important to understand what inflation is when you’re making large-scale financial decisions, as inflation plays a key role in the state of our assets.

Inflation is an essential part of not only finance, but also economics, which explores money on a much larger scale. Inflation, or rather mitigating its effects, is also the basis for many common financial behaviors, like minimizing cash in favor of assets and investing rather than saving. I’ve mentioned inflation a few times before, but in this article, I’ll be explaining it in-depth and touch on a few of its effects.

Inflation is a decline in purchasing power over time. This means that one dollar will be able to buy fewer goods/services as time passes. What you could have purchased for $10 in 1990 now costs $20. Similarly, inflation is why you could have bought an entire meal for 25 cents back in 1960, but will only get a gumball for the same amount of money today.

Inflation is measured by the Consumer Price Index. The Consumer Price Index, or CPI, measures the price of a collection of common goods and services that the average person uses/buys often, and shows how the price has changed over time.

This collection of goods and services is called a “basket”, and serves as a benchmark, meaning it's standardized and consistent. The basket of goods includes things like gas and food. The CPI shows how much the basket of goods has changed over time.

An increase in price over time indicates inflation because the same items got more expensive over time despite there being no change in the goods themselves; a loaf of bread in 2000 is pretty much the same as a loaf of bread today.

In short, inflation causes one dollar to weaken over time, which is why saving only cash for long periods of time can be harmful. Here’s an example of inflation.

Let's say you saved $10,000 in 1990, in cash. That $10,000 didn’t generate any returns, because it was in cash, so it didn’t grow(cash needs to be invested for it to produce profit). Furthermore, due to inflation, that money’s purchasing power had decreased over time. You could have bought a brand new Toyota Camry with $10,000 in 1990, but won’t even come close to buying a brand new Camry in 2021 (a new Camry starts at around $25,000).

Now, you might be asking, “Why is inflation a thing?”. There are three types of inflation, each with different causes. I’ll touch on each of them right now, and explain them in detail in a separate article.

The first is demand-pull inflation, which occurs because people have access to more money, either in cash, or using credit. Because people have more money, they want to buy more items. Companies see people buying more, and want to take advantage of this demand, so they increase the prices of goods.

The second is cost-push inflation. This occurs when means of production, like wages or resources, increase in price. Because it costs more to produce items, companies need to raise prices to continue making a profit. This leads to an overall increase in prices.

The third kind of inflation is built-in inflation. Personally, I find this variation to be the funniest and most ironic. Built-in inflation occurs because people expect current rates of inflation to continue, so if the price of goods and services rises, they expect them to continue rising and demand higher wages because they need more money to purchase the same items. Because workers demand higher wages, companies raise prices to compensate for more expenses, which, in turn, leads to a positive feedback loop.

Inflation is a central part of both economics and finance and should be a key factor you consider when you make decisions regarding money. I’ll dedicate articles in the coming weeks to discussing inflation in greater detail, so be on the lookout! Thanks for reading, and I’ll catch you in the next one!

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