Mar 17th, 2008
Working Backwards: What is Inflation?
Inflation is a rise in prices of goods and services over a period of time. Due to inflation, purchasing power of a set unit of money declines. If the current rate of inflation is 3 percent, what a dollar can buy today will require $1.03 to buy next year at this time.
Inflation is measured in many ways. The Federal Open Market Committee (also known as “the Fed”) looks at the Consumer Price Index (CPI) as a gauge of inflation, both the “headline” CPI which attempts to measure total inflation, and the “core” CPI which eliminates the volatile energy and food areas. This is important because the Federal Open Market Committee sets policies which directly and indirectly affect interest rates.
As you can see, inflation influences interest rates (and vice versa). When inflation appears to be rising, the Fed tends to raise interest rates; when inflation appears to be at bay, the Fed either will keep interest rates as they are or lower them. As interest rates rise, people and businesses are less likely to spend or borrow money and more likely to save money; as interest rates fall, the opposite happens. When people and businesses spend more, the economy tends to expand; when they spend less, the economy tends to contract.
Inflation is also influenced by supply and demand. If goods are scarce and in high demand, their price tends to increase; if goods are in abundant supply or in low demand, their price tends to decrease.
Understanding inflation can help consumers and investors understand fiscal policy and what their effects are on the economy, which may help them make better decisions about what to do with their money. If inflation is high, it is likely that interest rates will be raised higher, which would behoove the financially savvy to pay down their debt and pour money into savings; if inflation is low, it’s likely interest rates will become lower, which might indicate a time to refinance debt and try to lock in higher interest rates (perhaps in certificates of deposit). If inflation is high, it becomes even more important to seek out frugal ways to make your dollars stretch farther; when inflation is lower, this is not as much an issue. In any case, trying to understand what inflation is and its effects on your dollars can help you deal with your financial situation.
[...] Working Backwards: What is Inflation? Inflation is a rise in prices of goods and services over a period of time. Due to inflation, purchasing power of a set unit of money declines. If the current rate of inflation is 3 percent, what a dollar can buy today will require $1.03 to buy next year at this time. Inflation is measured in many ways. The Federal Open Market Committee (also known as “the Fed”) looks at the Consumer Price Index (CPI) as a gauge of inflation, both the “headline” CPI which attempts to measure total inflation, a [...]