What Does Inflation Really Mean?

By: First Union


What Does Inflation Really Mean?

When the spending power of a dollar seems to go down about a rather sharp rise in prices this is essentially when inflation occurs. There is an across the board rise in prices for most things and therefore how much you can buy with a dollar decreases. For instance, looking at the price of a concert ticket back in 1990, we see that on average they were approximately 40.00. In 2019, the average price was more than doubled at 95.00. However, it is important to keep in mind that inflation pertains to a broader increase in prices versus just one specific price. As a result, such an increase impacts the entire economy of a country. In this article, we look closer at what exactly inflation entails.

Inflation Basics

Primarily measured in the US by the Consumer Price Index (CPI/), inflation also involves measurements by the Producer Price Index as well as the Personal Consumption Expenditure Price Index. These indexes show us the purchasing power of the consumer in tandem with what producers are receiving for their goods and services. And while yes, prices going up while the dollar value decreases can seem an unsatisfactory turn of events, most experts agree that having some inflation is important to any economy, as a manageable amount of inflation does spur people to invest their money and thus gets it circulating out in the economy.

However, that said, if inflation gets out of control and prices rise significantly all at once, this could lead to major problems. Some countries in which this has occurred saw their economies all but crumble.

Understanding Deflation

The opposite of inflation, deflation, represents when there is a price decline across a broad portion of the economy. While this could seem a good thing, experts warn that deflation could spell even bigger trouble than inflation. This is largely because in several ways deflation has the potential to bring a halt to any meaningful growth within the economy. Growth coming to a standstill could mean decreased job wages as well as an economic shutdown if left unchecked for too long.

Understanding Hyperinflation

Hyperinflation is what happens when inflation goes unchecked for a longer period. In the case of hyperinflation, prices are rising, and additionally, the value of the dollar is consistently decreasing. Generally speaking, during a time of hyperinflation, prices tend to rise by fifty percent or more at a monthly rate. Usually, hyperinflation is not seen unless the country is going through some form of crisis, such as during wartime for example.

Understanding Stagflation

Stagflation is when there are high rates of inflation and at the same time, the number of those who are unemployed is rising somewhat rapidly. When this happens people are going to be watching what they spend and so consumer spending by and large during stagflation tends to slow way down. Often this slow down in spending does affect prices, as producers will drop their prices because the demand is no longer there. But when there is stagflation, prices will stay high and so it becomes all the more difficult for people to get the goods they need at prices they can afford.

The Causes of Inflation

Almost always, the root cause of inflation begins with theories of supply and demand. For instance, demand-pull inflation signifies that the demand for products/services is on the rise but supply stays the same. This, in turn, causes prices for the most part to rising; in other words, the demand is pulling up prices.

There is also cost-push inflation; in this scenario, goods and services are limited and yet the demand is the same, thereby pushing those prices up. The reasons why a company may not be able to keep up with demand may vary—from a natural disaster to international regulations.

Measuring Inflation

In the US, inflation is measured by the Consumer Price Index, the Producer Price Index, and the Personal Consumption Expenditures Price Index. It is difficult for one index to paint a truly comprehensive picture of where the country's economy stands. Economists, therefore, rely on multiple indexes to gauge the inflation rate.

The primary index, the Consumer Price Index, is calculated every month by the Bureau of Labor Statistics. With this index, experts can look at changes in the prices of goods and services. The CPI focuses on eight categories of goods and services, including food, clothing/apparel, transportation, housing, education, recreation, medical and miscellaneous.

Most economists do look at the CPI as the benchmark for understanding inflation during a given period. Additionally, the CPI is utilized for calculating the cost of living increases as they pertain to Social Security for example.

Beating Inflation

What inflation means is that the value of the dollar is decreasing in terms of purchasing power domestically. There are some investments however that enable you to beat inflation.

The stock market for some has proven to be one way of beating inflation. Over time, stock market indexes tend to rise, even though some companies will fall in value or perhaps go out of business. When looking at long term returns in the stock market, the average, according to the S&P 500, is slightly above 10%. Again, this is over the long term; for shorter-term periods, there can be low or possibly even negative returns.

This is why if investing in stocks, it's crucial to have a diversified portfolio as well as investments in broader market index funds as opposed to investing in just an individual stock for a single company.

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