Pop quiz: Suppose over the next 10 years, the prices of the things you buy double. If your income also doubles, will you be able to buy (A) less than you can buy today, (B) the same as you can buy today, or (C) more than you can buy today?
Answer: B – the same.
This question was asked in the S&P Global Financial Literacy Survey to probe consumers’ understanding of inflation, a key component of financial literacy. If you weren’t sure about the answer, don’t stress—we’ll cover all the important details of inflation and illustrate how this concept impacts your everyday life.
What is inflation?
Inflation is a sustained increase in the general level of prices for goods and services. It’s typically expressed as the rate at which prices are increasing over a certain period of time. As the rate of inflation rises, every dollar you have buys a smaller amount of goods and services. In other words, inflation eats away at your purchasing power.
For example, let’s say a loaf of white bread costs $1.00 today. If the annual inflation rate is 2%, the same bread will cost you $1.02 next year. The dollar you’re using this year won’t cover the full cost of the bread next year, so in this sense, next year’s dollar has less value—you have less purchasing power.
On the other hand, when prices in an economy are generally falling, it’s called “deflation.”
If you’re curious about the current inflation rate in the US, you can check out the Consumer Price Index (CPI), which measures the price change of certain items over time. There are other measures of inflation, but CPI is one of the most widely monitored. As of the latest reading (March 2018), the CPI shows that overall prices in the US have increased 2.4% in the past 12 months, with food prices increasing 1.3% and energy prices rising 7.0%.
What causes inflation?
Experts usually focus on two types of inflation: one related to demand, and a second related to costs.
“Demand-pull” inflation happens when demand for goods and services rises and production can’t keep up. There’s too much money chasing too few goods, so prices rise in response.
“Cost-push” inflation happens when it becomes more costly to produce goods and services. For example, if the cost of oil rises, it becomes more expensive to produce and transport goods. These higher production costs lead to a decrease in supply and an increase in prices.
Keep in mind that what happens in any economy—whether it’s the US economy as a whole or the economy of a particular state or region—is much more complex. It’s actually pretty difficult to explain price changes.
What are the effects of inflation on everyday consumers?
Inflation impacts American consumers both in terms of their income and expenses:
- Inflation affects the cost of everyday expenses, including food, gas, clothing, utilities, medical care and cars.
- Inflation can also impact the cost of housing. If you rent your home, your landlord may increase your rent each year according to inflation. For example, if your rent is $100 per month this year, and inflation is 2%, your landlord may be able to raise your rates 2% next year to $102 per month.
- Ideally, your wages or salary will be adjusted according to inflation, sometimes known as a “cost of living” adjustment. This way, if your rent and grocery bills increase according to the inflation rate, your paycheck also increases, so you won’t be in worse shape financially. If, however, your rent and grocery bills increase according to inflation, but your wages stay the same, your money won’t go as far as it did before and your budget will be tighter.
Inflation also impacts savers. Let’s say you have an emergency fund set aside to cover unexpected expenses and your goal is to keep six months’ worth of expenses in the account. Today, that figure equals $3,000. If the annual inflation rate is 2%, next year your account would need to increase to $3,060 to cover the same six months’ worth of expenses. Many savings accounts pay interest, but often the interest rate is not enough to counteract the inflation rate, so savers need to be savvy about setting aside enough money to compensate for inflation and reduced purchasing power.
If you’re striving to build better money habits, RISE is here to help. Check out our free, interactive tools for setting savings goals and managing debt, and stay tuned to our blog for more tips on improving your financial knowledge. An online loan from RISE can help you take control of your credit card debt and improve your financial wellness—apply for a loan today.