What is inflation? Why the cost of goods rise over time and what it means for the value of your money

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Inflation, an increase in the costs of goods and services, means that your money has effectively gone down in value.

  • Inflation is the increase in the prices of goods and services in an economy over time.
  • It could also be thought of as a decrease in the value of your money and purchasing power.
  • While a low, steady inflation rate of 2% indicates a healthy economy, high or rapidly changing inflation can become dangerous.
  • Visit Insider’s Investing Reference library for more stories.

Does it feel like a dollar buys less than it used to? You’re not imagining things. “It’s inflation,” people sigh.

You probably have a rough idea of what inflation means. The cost of things is going up.

But what is inflation really, what causes it, and how does it affect your finances? Here’s everything you need to know about this everyday economic term.

What is inflation?

Inflation is an increase in the prices of goods and services in an economy over a period of time.

That means you lose buying power – the same dollar (or whatever currency you use) buys less, and is thus worth less. In other words: When high inflation happens, your money doesn’t go as far as it used to.

Remember that modern money really has no intrinsic value – it’s just paper and ink, or, increasingly, digits on a computer screen. Its value is measured in what or how much it can buy.

While it’s easier to understand inflation by calculating goods and services, it’s typically a broad measure that can be applied across sectors or industries, impacting the entire economy. In fact, one of the primary jobs of the Federal Reserve is to control inflation to an optimum level to encourage spending and investing instead of saving, thereby encouraging economic growth.

How is inflation measured?

Inflation is measured by the inflation rate, which is the percent change in prices from one year to another. The inflation rate can be measured a few different ways:

  • The US Bureau of Labor Statistics measures the inflation rate using the Consumer Price Index (CPI). The CPI measures the total cost of goods and services consumers have purchased over a certain period using a representative basket of goods, based on household surveys. Increases in the cost of that basket indicate inflation, and using a basket accounts for how prices for different goods change at different rates by illustrating more general price changes.
  • In contrast with the CPI, the Producer Price Index (PPI) measures inflation from the producer’s perspective. The PPI is a measure of the average prices producer’s receive for goods and services produced domestically. It’s calculated by dividing the current prices sellers receive for a representative basket of goods by their prices in a specific base year, then multiplying the result by 100.
  • The Bureau of Economic Analysis measures the inflation rate using a third common index, the Personal Consumption Expenditures (PCE). The PCE measures price changes for household goods and services based on GDP data from producers. It’s less specific than the CPI because it bases price estimates on those used in the CPI, but includes estimates from other sources, too. As with both other indices, an increase in the index from one year to another indicates inflation.

The PPI is useful in its ability to forecast consumer spending and demand, but the CPI is the most common measure and tends to have a significant influence on inflation-sensitive price forecasts.

The PCE is less well-known than the CPI, using different calculations to measure consumer spending. It’s based on data from the GDP report and businesses and is generally less volatile than the CPI, because its formula accounts for potential price swings in less stable industries.

Real versus nominal prices

To make meaningful historical cost comparisons – to compare apples to apples, so to speak – economists adjust prices for inflation.

When you hear a price from the past talked about in “real” dollars, that means the price has been adjusted for inflation. When you hear prices from the past talked about in “nominal” dollars, that means it hasn’t been adjusted.

Is inflation good or bad?

Inflation is certainly a problem when it comes to ready cash that isn’t invested or earning anything. Over time, it’ll erode the value of your cash and bank account. It’s also the enemy of anything that pays a fixed rate of interest or return.

But individuals with assets that can appreciate in price, like a home or stocks, may benefit from inflation and sell those assets at a higher price.

In general, economists like inflation to occur at a low, steady rate. It indicates a healthy economy: that goods and services are being produced at a growing rate, and that consumers are buying them in increasing amounts, too. In the US, the Federal Reserve targets an average 2% inflation rate over time.

When inflation starts mounting higher than that or changes quickly, it can become a real problem. It’s a problem because it interferes with how the economy works as currency loses its value quickly and the cost of goods skyrockets. Wages can’t keep up, so people stop buying. Production then stops or slows, and an economy can tumble into recession.

What causes inflation?

There’s a massive economic literature on the causes of inflation and it’s fairly complex. Basically, though, it comes down to supply and demand. Keynesian economists emphasize that it’s demand pressures that are most responsible for inflation in the short term.

  • Demand-pull inflation happens when prices rise from an increase in demand throughout an economy.
  • Cost-push inflation happens when prices rise because of higher production costs or a drop in supply (such as from a natural disaster).

Other analysts cite another cause of inflation: An increase in the money supply – how much cash, or readily available money, there is in circulation. Whenever there’s a plentiful amount of something, that thing tends to be less valuable – cheaper. Indeed, many economists of the monetary school believe this is one of the most important factors in long-term inflation: Too much money sloshing around the supply devalues the currency, and it costs more to buy things.

Types of extreme inflation

Hyperinflation refers to a period of extremely high inflation rates, sometimes as much as price rises over 50% per month for several months. Hyperinflation is usually caused by government deficits and the over-printing of money. For example, hyperinflation occurred during the US Civil War when both the Union and the Confederate states printed money to finance their war efforts.

In a modern case, Venezuela is experiencing hyperinflation, reaching an inflation rate over 800,000% in October 2020.

Stagflation is a rare event in which rising costs and prices are happening at the same time as a stagnant economy – one suffering from high unemployment and weak production. The US experienced stagflation in 1973-4, the result of a rapid increase in oil prices in the midst of low GDP.

How inflation is controlled

Governments can control inflation through their monetary policy. They have three primary levers.

  • Interest rates: Increasing interest rates makes it more expensive to borrow money. So people spend less, reducing demand. As demand drops, so do prices.
  • Bank reserve requirements: Increasing reserve requirements means banks must hold more money in reserve. That gives them less to lend, reducing spending and leading (hopefully) to deflation, a drop in prices.
  • Supply of money: Reducing the money supply reduces inflation. There are several ways governments do this; one example is increasing interest paid on bonds, so more people buy them, giving more money to the government and taking it out of circulation.

How to beat inflation with investments

Investing for inflation means ensuring that your rate of return outpaces the inflation rate. Certain types of assets may beat inflation better than others.

  • Stocks: There are no guarantees with the stock market, but overall and over time, share prices appreciate at a rate that typically exceeds the inflation rate. Most index funds also post returns better than inflation.
  • Inflation-indexed bonds: Most US Treasuries pay the same fixed amount of interest – whose value erodes if inflation is rampant. However, with one type of bond, called Treasury Inflation-Protected Security (TIPS), interest payments rise with inflation (and fall with deflation).
  • Physical assets and commodities: Alternative investments – often, tangible assets like gold, commodities, fine art, or collectibles – do well in inflationary environments. So does real property: Zach Ashburn, president of Reach Strategic Wealth, notes, “returns on investments in real estate have kept up with, or surpassed, rates of inflation for many periods in the past.” That’s because these physical assets, unlike paper ones, have intrinsic value, and are sold and priced in markets outside the conventional financial ones.

More generally, Asher Rogovy, chief investment officer at Magnifina, suggests that it’s best to avoid nominal assets in favor of real assets when inflation’s on the upswing. Real assets, like stocks and real estate, have prices that fluctuate or vary freely. Nominal assets, like CDs and traditional bonds, are priced based on the fixed interest they pay and will lose value in inflationary times.

The financial takeaway

Inflation means costs and prices are rising. When they do, it means that paper money buys less. Low, steady inflation is good for the economy but bad for your savings. Ashburn says, “While having cash available is important for financial security, cash will see its value slowly eaten away by inflation over time.”

To beat inflation, don’t leave your cash under your mattress – or in any place where it’s stagnant. It has to keep earning.

Instead, aim to structure your portfolio so that it provides a rate of return – one that’s hopefully better than, or at least keeps pace with, that of inflation, which is almost always happening. If you do, it means that your investment gains really are making you richer – in real terms.

What are commodities? Tangible, everyday goods you can invest in, to hedge against inflation or sinking stock pricesWhat is real GDP? Understanding the tool economists and governments use to manage the economyWhy the Federal Reserve uses contractionary monetary policy to curb the inflation that accompanies an overheating economyAmericans are the most worried about inflation they’ve been in 7 years

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Experts lay out how the chaos caused by pandemic-era panic buying could revolutionize our global supply chain

Stockpiling toilet paper
In the US, one of the earliest stories of the pandemic was the toilet paper shortage.

A year-long struggle with the COVID-19 pandemic has brought more headlines than we as a society – as well as the people writing those headlines – can really handle. There’s been speculation, sadness, chaos, fear, isolation, data, and graphs. So many graphs.

But one of the earliest headlines of the pandemic wasn’t about any of that. It was about supply, and the supply of one product in particular: toilet paper.

When Insider mentioned the great toilet paper crisis of 2020 in a virtual roundtable with Hannah Kain, founder and CEO of California-headquartered supply chain management supplier ALOM Technologies, she laughed.

“Yes, we can talk about the toilet paper,” she said. “I never thought I would be interviewed so much about toilet paper.”

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A shopper at a Target store in Brooklyn reaches for disinfectant wipes in March 2020.

When much of the US shifted to quarantine overnight last March, the world’s supply chain was forced into the spotlight. Suddenly, we were ordering more online: our groceries, our home office setups, our bread ingredients, our puzzles. When we did face this new, mysterious virus to go into a store, we were met with empty shelves and freshly printed signs telling us we couldn’t buy more than two jugs of milk. Sales of toilet paper in the US shot up 845%, demand for Clorox products spiked by 500%, and treadmill sales more than doubled.

As we depended on our supply chain more, we criticized it more. After all, how hard could it be to just make some more toilet paper?

As consumers, we focused on the supply side of the equation. But Kain said for the professionals, supply problems haven’t been the story for much of the pandemic – demand shift has.

“Demand shifted so dramatically, sometimes 50% or 100% compared to forecast,” Kain said. “The supply really got constrained, right? If the demand had not shifted, the supply side would have been difficult, but it would still have been flowing really, really well.

“Many [journalists] say, ‘But why don’t they just make more?’ I’m like, ‘Well, guess what, you need equipment to make more toilet tissue, and where do you get the equipment from?’ A lot of times, from China. But even if you use a local equipment maker, they need spare parts from all over the world and it just takes time to deploy it.”

Toilet paper production
The US saw demand spikes as the pandemic took hold, and toilet paper sales shot up 845%.

Kain said demand changed in two important ways: which products people bought and, as people shifted even more of their purchasing online, which channels they bought them through.

Mei Yee Pang, the Singapore-based head of DHL Asia Pacific Innovation, saw similar patterns, illustrating a common theme of the pandemic: how intertwined supply chains are, for better and for worse.

“Supply chains today are so global, you see pretty much the same phenomena everywhere we go,” Pang told Insider. “We too had our toilet paper issues. There was, at some point in time, a global shortage of glassware because everybody started making jams at home and needed glass jars.

“So we do see very interesting demand shapes, and a lot of them, looking back, are something that we can expect. That’s where big data potentially in the future can come in more, better forecasting some of these effects that we normally wouldn’t have expected.”

costco cart toilet paper kirkland
The production of toilet paper came into the spotlight during the shortages, with many asking why companies couldn’t just make more. Experts told Insider it wasn’t that easy.

Changing demand isn’t the only issue the pandemic highlighted. More online ordering didn’t just mean more convenience for the buyer – it meant more waste, too.

“Every time I receive a parcel, I feel bad about it because I’m contributing to waste,” Pang said. “I think this is something that needs to change. We can’t be sending individual shipments using partially utilized vehicles to send stuff around to individual homes.

“It’s not easy, but I think as we go more and more from a less than 20% e-commerce channel to now, some companies are having that switch around to e-commerce as a major channel, we are going to see a lot of waste coming into play and it’s not sustainable.”

Cargo planes
As many places shifted to quarantine, consumers’ online ordering habits expanded.

Kain thinks the switch to e-commerce is here to stay, but said there’s “no easy solution” to making the change more sustainable from a packaging perspective.

“If we go to things like consumer electronics, everything was packaged for the retail shelves,” Kain said. “Maybe now you have a shippable box, and you don’t have a box inside a box.

“We are a little bit in a tough spot right now because recycling and return packaging is of course a big issue because of the risk of infection. I think this is something that we’ve got to develop over time, but I do think that the big carriers are going to come out with support in this area.”

Mailed packages on front porch
A stack of delivered packages and boxes sit outside a front door.

Pang, whose employer DHL is one of those big carriers with more than 350,000 employees worldwide, said analytics will help.

“In our organization, we start looking at how we can help our customers look at packaging and use data information to optimize the way we pack, the way we pelletize,” Pang said. “Every small bit counts to really reducing our footprint, and at the same time, lowers cost. So what’s not to like about this sort of solution?”

Peter Evans, CEO of the UK-based sustainable supply chain technology company Orderly, told Insider his company’s main product is something called a “scorecard.” Its goals include reducing waste of both products and packaging.

“It rates everyone who manages supply chain operations, from someone in a warehouse to the CEO, on a scale of zero to five,” Evans said. “Zero being ‘You’re wrecking the planet and you’re wrecking your business,’ five being ‘You’re really making some decent change here.’ We use AI against all this data we pull in to give each person two recommendations each week on what they can do to provide the biggest, most sustainable impact to their supply chain.

“For us, it’s changing people’s mindsets on an individual level, showing them what can be done in the world as well – what can create the biggest benefit.”

ups employee packages delivery
A UPS employee delivers packages.

Kain said that’s important, both in terms of sustainability and social responsibility, as more people think about their relationships with companies.

“Corporate social responsibility has become way more important for decision makers,” Kain said. “It’s driven by consumers. We want companies to be in sync with our values. We don’t want them to be out of sync.

“For instance, early in the pandemic, there was a survey done in the US showing 87% of consumers did not want to buy product from companies that did not keep their workers safe. We’ve never seen sentiments like this before, and it’s very healthy and good. It’s forcing the corporations to think differently about their supply chain in a very healthy manner. In any crisis, there’s a silver lining, and I think that’s it.”

amazon package logo warehouse
A worker loads a truck with packages at an Amazon packaging center in Germany.

Another silver lining might be that when or if this kind of global crisis happens again, the supply chain will be a bit more prepared for what’s coming – thanks, in part, to how big of a spotlight its struggles received when the pandemic hit.

“I think there’s a newfound respect for the sector, from the boardroom to the individual consumers at home,” Pang said. “There’s a newfound priority placed on the sector to put in more technology, to put in more innovation, to put in more R&D into making it more agile and more prepared for situations like this, so I’m quite optimistic about what we can see from the sector in the next few years.”

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