8/4/25, 11:35 AM Inflation: What It Is and How to Control Inflation Rates

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Inflation: What It Is and How to Control Inflation Rates

What you need to know about the purchasing power of money and how it changes

By JASON FERNANDO Updated February 25, 2025

Reviewed by MICHAEL J BOYLE

Fact checked by PETE RATHBURN

Part of the Series

Inflation

What Is Inflation?
Inflation is a gradual loss of purchasing power that is reflected in a broad rise in
prices for goods and services over time. The inflation rate is calculated as the
average price increase of a basket of selected goods and services over one year.
High inflation means that prices are increasing quickly, while low inflation
means that prices are growing more slowly. Inflation can be contrasted with
deflation, which occurs when prices decline and purchasing power increases.

KEY TAKEAWAYS
Inflation measures how quickly the prices of goods and services are
rising.
Inflation is classified into three types: demand-pull inflation, cost-push
inflation, and built-in inflation.
The most commonly used inflation indexes are the Consumer Price
Index and the Wholesale Price Index.
Inflation can be viewed positively or negatively depending on the
individual viewpoint and rate of change.

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Those with tangible assets may like to see some inflation as it raises
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the value of their assets.

What Is Inflation?

Understanding Inflation
An increase in the money supply is the root of inflation, though this can play out
through different mechanisms in the economy. A country’s money supply can
be increased by the monetary authorities by:

Printing and giving away more money to citizens

Legally devaluing (reducing the value of) the legal tender currency
Loaning new money into existence as reserve account credits through the
banking system by purchasing government bonds from banks on the
secondary market

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Other causes of inflation include supply bottlenecks and shortages of key

goods, which can push prices to rise.

When inflation occurs, money loses its purchasing power. This can occur across
any sector or throughout an entire economy. The expectation of inflation itself
can further sustain the devaluation of money. Workers may demand higher
wages and businesses may charge higher prices, in anticipation of sustained
inflation. This, in turn, reinforces the factors that push prices up.

How Does Inflation Work?

Credit: Melissa Ling © Investopedia, 2019

Types of Inflation
Inflation can be classified into three types: demand-pull inflation, cost-push
inflation, and built-in inflation.

Demand-Pull Effect
Demand-pull inflation occurs when an increase in the supply of money and
credit stimulates the overall demand for goods and services to increase more
rapidly than the economy’s production capacity. This increases demand and
leads to price rises.

When people have more money, it leads to positive consumer sentiment. This,
in turn, leads to higher spending, which pulls prices higher. It creates a demand-
supply gap with higher demand and less flexible supply, which results in higher
prices.

Cost-Push Effect
Cost-push inflation is a result of the increase in prices working through the
production process inputs. When additions to the supply of money and credit

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are channeled into a commodity or other asset markets, costs for all kinds of
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intermediate goods rise. This is especially evident when there’s a negative
economic shock to the supply of key commodities.

These developments lead to higher costs for the finished product or service and
work their way into rising consumer prices. For instance, when the money
supply is expanded, it creates a speculative boom in oil prices. This means that
the cost of energy can rise and contribute to rising consumer prices, which is
reflected in various measures of inflation.

Built-In Inflation
Built-in inflation is related to adaptive expectations or the idea that people
expect current inflation rates to continue in the future. As the price of goods
and services rises, people may expect a continuous rise in the future at a similar
rate.

As such, workers may demand more costs or wages to maintain their standard
of living. Their increased wages result in a higher cost of goods and services,
and this wage-price spiral continues as one factor induces the other and vice
versa.

How Inflation Impacts Prices

While it is easy to measure the price changes of individual products over time,
human needs extend beyond just one or two products. Individuals need a big
and diversified set of products as well as a host of services to live a comfortable
life. They include commodities like food grains, metal, fuel, utilities like
electricity and transportation, and services like healthcare, entertainment, and
labor.

Inflation aims to measure the overall impact of price changes for a diversified
set of products and services. It allows for a single value representation of the
increase in the price level of goods and services in an economy over a specified
time.

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Prices rise, which means that one unit of money buys fewer goods and services.
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This loss of purchasing power impacts the cost of living for the common public
which ultimately leads to a deceleration in economic growth. The consensus
view among economists is that sustained inflation occurs when a nation’s
money supply growth outpaces economic growth.

3%
The increase in the Consumer Price Index for All Urban Consumers
(CPI-U) over the 12 months ending January 2025 on an unadjusted
basis. Prices increased by 0.5% on a seasonally adjusted basis in
January 2025 from the previous month. [1]

To combat this, the monetary authority (in most cases, the central bank) takes
the necessary steps to manage the money supply and credit to keep inflation
within permissible limits and keep the economy running smoothly.

Theoretically, monetarism is a popular theory that explains the relationship

between inflation and the money supply of an economy. For example, following
the Spanish conquest of the Aztec and Inca empires, massive amounts of gold
and silver flowed into the Spanish and other European economies. Since the
money supply rapidly increased, the value of money fell, contributing to rapidly
rising prices. [2]

Inflation is measured in a variety of ways depending on the types of goods and

services. It is the opposite of deflation, which indicates a general decline in
prices when the inflation rate falls below 0%. Keep in mind that deflation
shouldn’t be confused with disinflation, which is a related term referring to a
slowing down in the (positive) rate of inflation.

Inflation Example
Credit: Julie Bang / Investopedia

How to Protect Your Finances During Inflation

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There are a range of measures that individuals can take to protect their finances
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against inflation. For instance, one may choose to invest in asset classes that
outperform the market during inflationary times. This might include
commodities like grain, beef, oil, electricity, and natural gas.

Commodity prices typically stay one step ahead of product prices, and price
increases for commodities are often seen as an indicator of inflation to come.
Commodities, which can also be volatile, are easily affected by natural
disasters, geopolitics, or conflict.

Real estate income may also help buffer against inflation, as landlords can
increase their rent to keep pace with the rise of prices overall.

The U.S. government also offers Treasury Inflation-Protected Securities (TIPS), a

type of security indexed to inflation to protect against declines in purchasing
power.

Types of Price Indexes

Depending upon the selected set of goods and services used, multiple types of
baskets of goods are calculated and tracked as price indexes. The most
commonly used price indexes are the Consumer Price Index (CPI) and the
Wholesale Price Index (WPI).

Consumer Price Index (CPI)

The CPI is a measure that examines the weighted average of prices of a basket
of goods and services that are of primary consumer needs. They include
transportation, food, and medical care.

CPI is calculated by taking price changes for each item in the predetermined
basket of goods and averaging them based on their relative weight in the whole
basket. The prices in consideration are the retail prices of each item, as
available for purchase by the individual citizens. CPI can impact the value of
one currency against those of other nations.

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Changes in the CPI are used to assess price changes associated with the cost of
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living, making it one of the most frequently used statistics for identifying
periods of inflation or deflation. In the United States, the Bureau of Labor
Statistics (BLS) reports the CPI each month and has calculated it as far back as
1913. [3]

IMPORTANT

The CPI-U, which was introduced in 1978, represents the buying habits of
approximately 88% of the noninstitutional population of the United States.
[4] [5]

Wholesale Price Index (WPI)

The WPI is another popular measure of inflation. It measures and tracks the
changes in the price of goods in the stages before the retail level.

While WPI items vary from one country to another, they mostly include items at
the producer or wholesale level. For example, it includes cotton prices for raw
cotton, cotton yarn, cotton gray goods, and cotton clothing. [6]

Although many countries and organizations use the WPI, many other countries,
including the U.S., use a similar variant called the Producer Price Index (PPI). [7]

Producer Price Index (PPI)

The PPI is a family of indexes that measures the average change in selling prices
received by domestic producers of intermediate goods and services over time.
The PPI measures price changes from the perspective of the seller and differs
from the CPI, which measures price changes from the perspective of the buyer.
[8]

In all variants, the rise in the price of one component (say oil) may cancel out
the price decline in another (say wheat) to a certain extent. Overall, each index

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represents the average weighted price change for the given constituents which
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may apply at the overall economy, sector, or commodity level.

The Formula for Measuring Inflation

The above-mentioned variants of price indexes can be used to calculate the
value of inflation between two particular months (or years). While a lot of ready-
made inflation calculators are already available on various financial portals and
websites, it is always better to be aware of the underlying methodology to
ensure accuracy with a clear understanding of the calculations. Mathematically,

Percent Inflation Rate = (Final CPI Index Value ÷ Initial CPI Value) ×
100

Say you wish to know how the purchasing power of $10,000 changed between
January 1975 and January 2024. One can find price index data on various
portals in a tabular form. From that table, pick up the corresponding CPI figures
for the given two months. For September 1975, it was 52.1 (initial CPI value),
and for January 2024, it was 308.417 (final CPI value). [9] [10]

Plugging in the formula yields:

Percent Inflation Rate = (308.417 ÷ 52.1) × 100 = (5.9197) × 100 =

591.97%

Since you wish to know how much $10,000 from January 1975 would be worth
in January 2024, multiply the inflation rate by the amount to get the changed
dollar value:

Change in Dollar Value = 5.9197 × $10,000 = $59,197

This means that $10,000 in January 1975 will be worth $59,197 today.
Essentially, if you purchased a basket of goods and services (as included in the
CPI definition) worth $10,000 in 1975, the same basket would cost you $59,197
in January 2024.

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Advantages and Disadvantages of Inflation

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Inflation can be construed as either a good or a bad thing, depending upon
which side one takes, and how rapidly the change occurs.

Advantages
Individuals with tangible assets (like property or stocked commodities) priced
in their home currency may like to see some inflation as that raises the price of
their assets, which they can sell at a higher rate.

Inflation often leads to speculation by businesses in risky projects and by

individuals who invest in company stocks because they expect better returns
than inflation.

An optimum level of inflation is often promoted to encourage spending to a

certain extent instead of saving. If the purchasing power of money falls over
time, there may be a greater incentive to spend now instead of saving and
spending later. It may increase spending, which may boost economic activities
in a country. A balanced approach is thought to keep the inflation value in an
optimum and desirable range.

Disadvantages
Buyers of such assets may not be happy with inflation, as they will be required
to shell out more money. People who hold assets valued in their home
currency, such as cash or bonds, may not like inflation, as it erodes the real
value of their holdings.

As such, investors looking to protect their portfolios from inflation should

consider inflation-hedged asset classes, such as gold, commodities, and real
estate investment trusts (REITs). Inflation-indexed bonds are another popular
option for investors to profit from inflation.

High and variable rates of inflation can impose major costs on an economy.
Businesses, workers, and consumers must all account for the effects of
generally rising prices in their buying, selling, and planning decisions.

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This introduces an additional source of uncertainty into the economy, because

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they may guess wrong about the rate of future inflation. Time and resources
expended on researching, estimating, and adjusting economic behavior are
expected to rise to the general level of prices. That’s opposed to real economic
fundamentals, which inevitably represent a cost to the economy as a whole.

Even a low, stable, and easily predictable rate of inflation, which some consider
otherwise optimal, may lead to serious problems in the economy. That’s
because of how, where, and when the new money enters the economy.

Whenever new money and credit enter the economy, it is always in the hands of
specific individuals or business firms. The process of price level adjustments to
the new money supply proceeds as they then spend the new money and it
circulates from hand to hand and account to account through the economy.

Inflation does drive up some prices first and drives up other prices later. This
sequential change in purchasing power and prices (known as the Cantillon
effect) means that the process of inflation not only increases the general price
level over time but also distorts relative prices, wages, and rates of return along
the way. [11]

Economists, in general, understand that distortions of relative prices away from

their economic equilibrium are not good for the economy, and Austrian
economists even believe this process to be a major driver of cycles of recession
in the economy. [12]

Pros Cons

Leads to higher resale Buyers have to pay more

value of assets for products and services

Optimum levels of inflation Imposes higher prices on

encourage spending the economy

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Drives some prices up first

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and others later

How Inflation Can Be Controlled

A country’s financial regulator shoulders the important responsibility of
keeping inflation in check. It is done by implementing measures through
monetary policy, which refers to the actions of a central bank or other
committees that determine the size and rate of growth of the money supply.

In the U.S., the Fed’s monetary policy goals include moderate long-term interest
rates, price stability, and maximum employment. Each of these goals is
intended to promote a stable financial environment. The Federal Reserve
clearly communicates long-term inflation goals in order to keep a steady long-
term rate of inflation, which is thought to be beneficial to the economy.

Price stability or a relatively constant level of inflation allows businesses to plan

for the future since they know what to expect. The Fed believes that this will
promote maximum employment, which is determined by non-monetary factors
that fluctuate over time and are therefore subject to change.

For this reason, the Fed doesn’t set a specific goal for maximum employment,
and it is largely determined by employers’ assessments. Maximum employment
does not mean zero unemployment, as at any given time there is a certain level
of volatility as people vacate and start new jobs. [13] [14]

Hyperinflation is often described as a period of inflation of 50% or

more per month. [15]

Monetary authorities also take exceptional measures in extreme conditions of

the economy. For instance, following the 2008 financial crisis, the U.S. Fed kept
the interest rates near zero and pursued a bond-buying program called
quantitative easing (QE). [16]
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Some critics of the program alleged it would cause a spike in inflation in the
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U.S. dollar, but inflation peaked in 2007 and declined steadily over the next
eight years. There are many complex reasons why QE didn’t lead to inflation or
hyperinflation, though the simplest explanation is that the recession itself was a
very prominent deflationary environment, and quantitative easing supported
its effects. [17] [18]

Consequently, U.S. policymakers have attempted to keep inflation steady at

around 2% per year. The European Central Bank (ECB) has also pursued
aggressive quantitative easing to counter deflation in the eurozone, and some
places have experienced negative interest rates. That’s due to fears that
deflation could take hold in the eurozone and lead to economic stagnation. [19]
[20]

Moreover, countries that experience higher rates of growth can absorb higher
rates of inflation. India’s target is around 4% (with an upper tolerance of 6% and
a lower tolerance of 2%), while Brazil aims for 3.25% (with an upper tolerance of
4.75% and a lower tolerance of 1.75%). [21] [22]

Meaning of Inflation, Deflation, and Disinflation

While a high inflation rate means that prices are increasing, a low inflation rate
does not mean that prices are falling. Counterintuitively, when the inflation rate
falls, prices are still increasing, but at a slower rate than before. When the
inflation rate falls (but remains positive), this is known as disinflation.

Conversely, if the inflation rate becomes negative, that means that prices are
falling. This is known as deflation, which can have negative effects on an
economy. Because buying power increases over time, consumers have less
incentive to spend money in the short term, resulting in falling economic
activity.

Hedging Against Inflation

Stocks are considered to be the best hedge against inflation, as the rise in stock
prices is inclusive of the effects of inflation. Since additions to the money
supply in virtually all modern economies occur as bank credit injections

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through the financial system, much of the immediate effect on prices happens
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in financial assets that are priced in their home currency, such as stocks.

Special financial instruments exist that one can use to safeguard investments
against inflation. They include Treasury Inflation-Protected Securities (TIPS), a
low-risk treasury security that is indexed to inflation where the principal
amount invested is increased by the percentage of inflation. [23]

One can also opt for a TIPS mutual fund or TIPS-based exchange-traded fund
(ETF). To get access to stocks, ETFs, and other funds that can help avoid the
dangers of inflation, you’ll likely need a brokerage account. Choosing a
stockbroker can be a tedious process due to the variety among them.

Gold is also considered to be a hedge against inflation, although this doesn’t

always appear to be the case looking backward.

Examples of Inflation
Since all world currencies are fiat money, the money supply could increase
rapidly for political reasons, resulting in rapid price level increases. The most

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famous example is the hyperinflation that struck the German Weimar Republic
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in the early 1920s.

The nations that were victorious in World War I demanded reparations from
Germany, which could not be paid in German paper currency, as this was of
suspect value due to government borrowing. Germany attempted to print paper
notes, buy foreign currency with them, and use that to pay their debts.

This policy led to the rapid devaluation of the German mark along with the
hyperinflation that accompanied the development. German consumers
responded to the cycle by trying to spend their money as fast as possible,
understanding that it would be worth less and less the longer they waited. More
money flooded the economy, and its value plummeted to the point where
people would paper their walls with practically worthless bills. Similar
situations occurred in Peru in 1990 and in Zimbabwe between 2007 and 2008.
[24] [25] [26]

What Causes Inflation?

There are three main causes of inflation: demand-pull inflation, cost-push
inflation, and built-in inflation.

Demand-pull inflation refers to situations where there are not enough

products or services being produced to keep up with demand, causing their
prices to increase.
Cost-push inflation, on the other hand, occurs when the cost of producing
products and services rises, forcing businesses to raise their prices.
Built-in inflation (which is sometimes referred to as a wage-price spiral)
occurs when workers demand higher wages to keep up with rising living
costs. This, in turn, causes businesses to raise their prices in order to offset
their rising wage costs, leading to a self-reinforcing loop of wage and price
increases.

Is Inflation Good or Bad?

Too much inflation is generally considered bad for an economy, while too little
inflation is also considered harmful. Many economists advocate for a middle

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ground of low to moderate inflation, of around 2% per year.

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Generally speaking, higher inflation harms savers because it erodes the

purchasing power of the money they have saved; however, it can benefit
borrowers because the inflation-adjusted value of their outstanding debts
shrinks over time.
What Are the Effects of Inflation?
Inflation can affect the economy in several ways. For example, if inflation
causes a nation’s currency to decline, this can benefit exporters by making their
goods more affordable when priced in the currency of foreign nations.

On the other hand, this could harm importers by making foreign-made goods
more expensive. Higher inflation can also encourage spending, as consumers
will aim to purchase goods quickly before their prices rise further. Savers, on
the other hand, could see the real value of their savings erode, limiting their
ability to spend or invest in the future.

Why Was Inflation So High in 2024?

Inflation has remained elevated since 2022 when inflation rates around the
world rose to their highest levels since the early 1980s. While there is no single
reason for this rapid rise in global prices, a series of events worked together to
boost inflation to such high levels. [27] [28]

The COVID-19 pandemic led to lockdowns and other restrictions that greatly
disrupted global supply chains, from factory closures to bottlenecks at
maritime ports. Governments also issued stimulus checks and increased
unemployment benefits to counter the financial impact on individuals and
small businesses. When vaccines became widespread and the economy
bounced back, demand (fueled in part by stimulus money and low interest
rates) quickly outpaced supply, which struggled to get back to pre-COVID levels.

Russia’s unprovoked invasion of Ukraine in early 2022 led to economic

sanctions and trade restrictions on Russia, limiting the world’s supply of oil and
gas since Russia is a large producer of fossil fuels. Food prices also rose as
Ukraine’s large grain harvests could not be exported. As fuel and food prices

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rose, it led to similar increases down the value chains. The Fed raised interest
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rates to combat the high inflation, which significantly came down in 2023,
though it remains above pre-pandemic levels. [29] [9]
The Bottom Line
Inflation is a rise in prices, which results in the decline of purchasing power over
time. Inflation is natural and the U.S. government targets an annual inflation
rate of 2%; however, inflation can be dangerous when it increases too much,
too fast.

Inflation makes items more expensive, especially if wages do not rise by the
same levels of inflation. Additionally, inflation erodes the value of some assets,
especially cash. Governments and central banks seek to control inflation
through monetary policy.
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ARTICLE SOURCES

Part of the Series

Inflation

Inflation: What It Is and How to Control Inflation Rates

CURRENT ARTICLE

Understanding Inflation
1 9 Common Effects of Inflation
NEXT UP

2 How to Profit From Inflation

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3 When Is Inflation Good for the Economy? TRADE

4 How Does Current Cost of Living Compare to 20 Years Ago?

5 Why Are P/E Ratios Higher When Inflation Is Low?

6 What Causes Inflation and Who Profits From It?

Types of Inflation

What Does Inflation Impact?

Understanding Hyperinflation

Understanding CPI

Related Terms (A-I)

Related Terms (J-Z)

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