The economic term ‘inflation’ describes the sustained increase in prices of goods and services over a period of time. Any market economy experiences inflation. To measure inflation, CPI is used, which is a basket of goods and services that are commonly purchased by households. In simple terms, the concept goes like this: when inflation increases, the purchasing power of money decreases and vise versa. In practice, this means that you can buy fewer items with the same amount of money than before. It is therefore important to understand inflation rates and how these affect you.
What is inflation?
In short, inflation refers to the sustained increase in the general price level of goods and services in an economy over a period of time. This is measured as an annual percentage increase, which directly affects consumers’ purchasing power. The cause of increase in inflation is related to money: when there is too much money chasing too few goods, then the prices increase. So, when inflation rises, each unit of currency buys fewer goods and services than before. This can all be caused by several factors, related to anything from increased government spending and higher taxes, to natural disasters disrupting supply chains.
Analyzing the relationship between interest rates and inflation rates
The relationship between interest rates and inflation rates is a complex one, so here is a linear and simple depiction of the relationship: When inflation increases, central banks raise interest rates to control the inflation rate. This is usually done by making it more expensive to borrow money, to reduce the spending power and keep prices from increasing. This also means that when inflation falls, central banks reduce the interest rates to stimulate economic growth by making loans cheaper and thereby increasing spending power.
How does inflation affect you?
Everyone is affected by inflation, since it is an economic phenomena happening in any market economy. It is a general increase in prices over time, leading to goods and services being more costly than they were before. Purchasing power decreases as inflation rates increase, so you can buy less for the same amount of money. If you have a fixed income or you live paycheck to paycheck, inflation will be especially hard on you. If you have invested, inflation rates also affect these investments, since they reduce the value of cash in savings accounts and other investments – if these investments are not able to keep up with the inflation rates.
