What is inflation?
Inflation is a sustained rise in the general price level, not just a few products getting pricier. As prices rise, a dollar buys less, so money loses purchasing power. It's usually measured as the year-over-year change in the consumer price index (CPI), with core inflation, which strips out volatile food and energy, used to gauge the underlying trend (Mankiw, 2021). The Federal Reserve and many other central banks target about 2%.
What causes inflation?
| Type | How it works | Examples |
|---|---|---|
| Demand-pull | Total demand outruns what the economy can produce | An overheating economy, big fiscal spending |
| Cost-push | Higher production costs squeeze supply | Oil or commodity spikes, supply chain snarls |
| Monetary | The money supply grows faster than output | Excessive money creation |
Milton Friedman famously argued that "inflation is always and everywhere a monetary phenomenon" (Friedman, 1970). Inflation expectations matter too: if people expect higher prices, they build them into wages and prices, which helps make it happen.
Who wins and who loses?
The Fisher equation (Fisher, 1930) says the real interest rate ≈ the nominal rate − inflation. When inflation runs higher than expected, the real burden of debt shrinks, which helps borrowers and hurts savers, people on fixed incomes and anyone holding cash. Other costs include "menu costs" of changing prices, tax distortions and harder long-term planning.
Policy responses and related ideas
When inflation runs above target, central banks raise interest rates to cool demand; in downturns they cut rates or turn to quantitative easing. Phillips (1958) found an inverse link between unemployment and wage growth, which became the Phillips curve. A sustained fall in prices is deflation, and high inflation paired with a stagnant economy is stagflation.
FAQ
- Is a little inflation bad?
- Most economists see mild, predictable inflation as manageable, which is why central banks aim for around 2% rather than zero.
- Why does inflation feel higher than the official number?
- CPI tracks an average household's basket. If the things you buy most often, like groceries, jump in price, your personal inflation rate can feel much higher.
Sources reviewed: 2026-10-25
See also: Compound Interest, Base Effect
References
- Mankiw, N. G. (2021). Principles of economics (9th ed.). Cengage Learning.
- Fisher, I. (1930). The theory of interest. Macmillan.
- Friedman, M. (1970). The counter-revolution in monetary theory (IEA Occasional Paper No. 33). Institute of Economic Affairs.
- Phillips, A. W. (1958). The relation between unemployment and the rate of change of money wage rates in the United Kingdom, 1861–1957. Economica, 25(100), 283–299.