Inflation is the increase in prices that reduces the purchasing power of money over time. McKinsey defines it as “the rise in the general price level of goods and services that people buy”. When it’s stable, inflation allows people to make more informed decisions about spending, saving, and investing. It’s important to understand how to manage inflation, because it affects everyone: workers, businesses, those on fixed incomes, borrowers and savers. The Fed targets inflation to be about 2% on average over the long term.
To measure inflation, statisticians check the prices of a broad set of items that people on average consume (the ‘basket’). They then compare the cost of this basket over one period to its cost over another to determine the rate of change in prices; for example, $10,000 bought a lot more in January 1975 than it does today. The Bureau of Labor Statistics (BLS) uses a weighting system to take into account seasonal fluctuations, like back-to-school or tax season prices, and year-over-year changes in the cost of the basket.
The primary causes of inflation are demand-pull and cost-push. Demand-pull inflation happens when aggregate consumer demand outpaces supply, causing prices to go up over time as the economy grows and consumption rises. Cost-push inflation occurs when production costs rise, such as from higher raw material or wage costs or from disruptions in the supply chain. Producers pass these additional costs on to consumers through increased prices for finished products.
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