essay about effects of inflation

Essay on Inflation: Types, Causes and Effects

Essay on Inflation!

Essay on the Meaning of Inflation:

Inflation and unemployment are the two most talked-about words in the contemporary society. These two are the big problems that plague all the economies. Almost everyone is sure that he knows what inflation exactly is, but it remains a source of great deal of confusion because it is difficult to define it unambiguously.

Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget may be financed by additional money creation. But the situation of monetary expansion or budget deficit may not cause price level to rise. Hence the difficulty of defining ‘inflation’ .

Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the price of only one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in the general level or average of prices’ . In other words, inflation is a state of rising price level, but not rise in the price level. It is not high prices but rising prices that constitute inflation.

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It is an increase in the overall price level. A small rise in prices or a sudden rise in prices is not inflation since these may reflect the short term workings of the market. It is to be pointed out here that inflation is a state of disequilibrium when there occurs a sustained rise in price level.

It is inflation if the prices of most goods go up. However, it is difficult to detect whether there is an upward trend in prices and whether this trend is sustained. That is why inflation is difficult to define in an unambiguous sense.

Let’s measure inflation rate. Suppose, in December 2007, the consumer price index was 193.6 and, in December 2008 it was 223.8. Thus the inflation rate during the last one year was 223.8 – 193.6/193.6 × 100 = 15.6%.

As inflation is a state of rising prices, deflation may be defined as a state of falling prices but not fall in prices. Deflation is, thus, the opposite of inflation, i.e., rise in the value or purchasing power of money. Disinflation is a slowing down of the rate of inflation.

Essay on the Types of Inflation :

As the nature of inflation is not uniform in an economy for all the time, it is wise to distinguish between different types of inflation. Such analysis is useful to study the distributional and other effects of inflation as well as to recommend anti-inflationary policies.

Inflation may be caused by a variety of factors. Its intensity or pace may be different at different times. It may also be classified in accordance with the reactions of the government toward inflation.

Thus, one may observe different types of inflation in the contemporary society:

(a) According to Causes:

i. Currency Inflation:

This type of inflation is caused by the printing of currency notes.

ii. Credit Inflation:

Being profit-making institutions, commercial banks sanction more loans and advances to the public than what the economy needs. Such credit expansion leads to a rise in price level.

iii. Deficit-Induced Inflation:

The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the government may ask the central bank to print additional money. Since pumping of additional money is required to meet the budget deficit, any price rise may be called deficit-induced inflation.

iv. Demand-Pull Inflation:

An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull inflation (henceforth DPI). But why does aggregate demand rise? Classical economists attribute this rise in aggregate demand to money supply.

If the supply of money in an economy exceeds the available goods and services, DPI appears. It has been described by Coulborn as a situation of “too much money chasing too few goods” .

Note that, in this region, price level begins to rise. Ultimately, the economy reaches full employment situation, i.e., Range 3, where output does not rise but price level is pulled upward. This is demand-pull inflation. The essence of this type of inflation is “too much spending chasing too few goods.”

v. Cost-Push Inflation:

Inflation in an economy may arise from the overall increase in the cost of production. This type of inflation is known as cost-push inflation (henceforth CPI). Cost of production may rise due to increase in the price of raw materials, wages, etc. Often trade unions are blamed for wage rise since wage rate is not market-determined. Higher wage means higher cost of production.

Prices of commodities are thereby increased. A wage-price spiral comes into operation. But, at the same time, firms are to be blamed also for the price rise since they simply raise prices to expand their profit margins. Thus we have two important variants of CPI: wage-push inflation and profit-push inflation. Anyway, CPI stems from the leftward shift of the aggregate supply curve.

The price level thus determined is OP 1 . As aggregate demand curve shifts to AD 2 , price level rises to OP 2 . Thus, an increase in aggregate demand at the full employment stage leads to an increase in price level only, rather than the level of output. However, how much price level will rise following an increase in aggregate demand depends on the slope of the AS curve.

Causes of Demand-Pull Inflation :

DPI originates in the monetary sector. Monetarists’ argument that “only money matters” is based on the assumption that at or near full employment, excessive money supply will increase aggregate demand and will thus cause inflation.

An increase in nominal money supply shifts aggregate demand curve rightward. This enables people to hold excess cash balances. Spending of excess cash balances by them causes price level to rise. Price level will continue to rise until aggregate demand equals aggregate supply.

Keynesians argue that inflation originates in the non-monetary sector or the real sector. Aggregate demand may rise if there is an increase in consumption expenditure following a tax cut. There may be an autonomous increase in business investment or government expenditure. Governmental expenditure is inflationary if the needed money is procured by the government by printing additional money.

In brief, an increase in aggregate demand i.e., increase in (C + I + G + X – M) causes price level to rise. However, aggregate demand may rise following an increase in money supply generated by the printing of additional money (classical argument) which drives prices upward. Thus, money plays a vital role. That is why Milton Friedman believes that inflation is always and everywhere a monetary phenomenon.

There are other reasons that may push aggregate demand and, hence, price level upwards. For instance, growth of population stimulates aggregate demand. Higher export earnings increase the purchasing power of the exporting countries.

Additional purchasing power means additional aggregate demand. Purchasing power and, hence, aggregate demand, may also go up if government repays public debt. Again, there is a tendency on the part of the holders of black money to spend on conspicuous consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused by a variety of factors.

Cost-Push Inflation Theory :

In addition to aggregate demand, aggregate supply also generates inflationary process. As inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is usually associated with the non-monetary factors. CPI arises due to the increase in cost of production. Cost of production may rise due to a rise in the cost of raw materials or increase in wages.

Such increases in costs are passed on to consumers by firms by raising the prices of the products. Rising wages lead to rising costs. Rising costs lead to rising prices. And rising prices, again, prompt trade unions to demand higher wages. Thus, an inflationary wage-price spiral starts.

This causes aggregate supply curve to shift leftward. This can be demonstrated graphically (Fig. 11.4) where AS 1 is the initial aggregate supply curve. Below the full employment stage this AS curve is positive sloping and at full employment stage it becomes perfectly inelastic. Intersection point (E 1 ) of AD 1 and AS 1 curves determines the price level.

Now, there is a leftward shift of aggregate supply curve to AS 2 . With no change in aggregate demand, this causes price level to rise to OP 2 and output to fall to OY 2 .

With the reduction in output, employment in the economy declines or unemployment rises. Further shift in the AS curve to AS 2 results in higher price level (OP 3 ) and a lower volume of aggregate output (OY 3 ). Thus, CPI may arise even below the full employment (Y f ) stage.

Causes of CPI :

It is the cost factors that pull the prices upward. One of the important causes of price rise is the rise in price of raw materials. For instance, by an administrative order the government may hike the price of petrol or diesel or freight rate. Firms buy these inputs now at a higher price. This leads to an upward pressure on cost of production.

Not only this, CPI is often imported from outside the economy. Increase in the price of petrol by OPEC compels the government to increase the price of petrol and diesel. These two important raw materials are needed by every sector, especially the transport sector. As a result, transport costs go up resulting in higher general price level.

Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions demand higher money wages as a compensation against inflationary price rise. If increase in money wages exceeds labour productivity, aggregate supply will shift upward and leftward. Firms often exercise power by pushing up prices independently of consumer demand to expand their profit margins.

Fiscal policy changes, such as an increase in tax rates leads to an upward pressure in cost of production. For instance, an overall increase in excise tax of mass consumption goods is definitely inflationary. That is why government is then accused of causing inflation.

Finally, production setbacks may result in decreases in output. Natural disaster, exhaustion of natural resources, work stoppages, electric power cuts, etc., may cause aggregate output to decline.

In the midst of this output reduction, artificial scarcity of any goods by traders and hoarders just simply ignite the situation.

Inefficiency, corruption, mismanagement of the economy may also be the other reasons. Thus, inflation is caused by the interplay of various factors. A particular factor cannot be held responsible for inflationary price rise.

Essay on the Effects of Inflation :

People’s desires are inconsistent. When they act as buyers they want prices of goods and services to remain stable but as sellers they expect the prices of goods and services should go up. Such a happy outcome may arise for some individuals; “but, when this happens, others will be getting the worst of both worlds.” Since inflation reduces purchasing power it is bad.

The old people are in the habit of recalling the days when the price of say, meat per kilogram cost just 10 rupees. Today it is Rs. 250 per kilogram. This is true for all other commodities. When they enjoyed a better living standard. Imagine today, how worse we are! But meanwhile, wages and salaries of people have risen to a great height, compared to the ‘good old days’. This goes unusually untold.

When price level goes up, there is both a gainer and a loser. To evaluate the consequence of inflation, one must identify the nature of inflation which may be anticipated and unanticipated. If inflation is anticipated, people can adjust with the new situation and costs of inflation to the society will be smaller.

In reality, people cannot predict accurately future events or people often make mistakes in predicting the course of inflation. In other words, inflation may be unanticipated when people fail to adjust completely. This creates various problems.

One can study the effects of unanticipated inflation under two broad headings:

(i) Effect on distribution of income and wealth

(ii) Effect on economic growth.

(a) Effects of Inflation on Income and Wealth Distribution :

During inflation, usually people experience rise in incomes. But some people gain during inflation at the expense of others. Some individuals gain because their money incomes rise more rapidly than the prices and some lose because prices rise more rapidly than their incomes during inflation. Thus, it redistributes income and wealth.

Though no conclusive evidence can be cited, it can be asserted that following categories of people are affected by inflation differently:

i. Creditors and Debtors:

Borrowers gain and lenders lose during inflation because debts are fixed in rupee terms. When debts are repaid their real value declines by the price level increase and, hence, creditors lose. An individual may be interested in buying a house by taking a loan of Rs. 7 lakh from an institution for 7 years.

The borrower now welcomes inflation since he will have to pay less in real terms than when it was borrowed. Lender, in the process, loses since the rate of interest payable remains unaltered as per agreement. Because of inflation, the borrower is given ‘dear’ rupees, but pays back ‘cheap’ rupees.

However, if in an inflation-ridden economy creditors chronically loose, it is wise not to advance loans or to shut down business. Never does it happen. Rather, the loan- giving institution makes adequate safeguard against the erosion of real value.

ii. Bond and Debenture-Holders:

In an economy, there are some people who live on interest income—they suffer most.

Bondholders earn fixed interest income:

These people suffer a reduction in real income when prices rise. In other words, the value of one’s savings decline if the interest rate falls short of inflation rate. Similarly, beneficiaries from life insurance programmes are also hit badly by inflation since real value of savings deteriorate.

iii. Investors:

People who put their money in shares during inflation are expected to gain since the possibility of earning business profit brightens. Higher profit induces owners of firms to distribute profit among investors or shareholders.

iv. Salaried People and Wage-Earners:

Anyone earning a fixed income is damaged by inflation. Sometimes, unionized worker succeeds in raising wage rates of white-collar workers as a compensation against price rise. But wage rate changes with a long time lag. In other words, wage rate increases always lag behind price increases.

Naturally, inflation results in a reduction in real purchasing power of fixed income earners. On the other hand, people earning flexible incomes may gain during inflation. The nominal incomes of such people outstrip the general price rise. As a result, real incomes of this income group increase.

v. Profit-Earners, Speculators and Black Marketeers:

It is argued that profit-earners gain from inflation. Profit tends to rise during inflation. Seeing inflation, businessmen raise the prices of their products. This results in a bigger profit. Profit margin, however, may not be high when the rate of inflation climbs to a high level.

However, speculators dealing in business in essential commodities usually stand to gain by inflation. Black marketeers are also benefited by inflation.

Thus, there occurs a redistribution of income and wealth. It is said that rich becomes richer and poor becomes poorer during inflation. However, no such hard and fast generalizations can be made. It is clear that someone wins and someone loses from inflation.

These effects of inflation may persist if inflation is unanticipated. However, the redistributive burdens of inflation on income and wealth are most likely to be minimal if inflation is anticipated by the people.

With anticipated inflation, people can build up their strategies to cope with inflation. If the annual rate of inflation in an economy is anticipated correctly people will try to protect them against losses resulting from inflation.

Workers will demand 10 p.c. wage increase if inflation is expected to rise by 10 p.c. Similarly, a percentage of inflation premium will be demanded by creditors from debtors. Business firms will also fix prices of their products in accordance with the anticipated price rise. Now if the entire society “learns to live with inflation” , the redistributive effect of inflation will be minimal.

However, it is difficult to anticipate properly every episode of inflation. Further, even if it is anticipated it cannot be perfect. In addition, adjustment with the new expected inflationary conditions may not be possible for all categories of people. Thus, adverse redistributive effects are likely to occur.

Finally, anticipated inflation may also be costly to the society. If people’s expectation regarding future price rise become stronger they will hold less liquid money. Mere holding of cash balances during inflation is unwise since its real value declines. That is why people use their money balances in buying real estate, gold, jewellery, etc.

Such investment is referred to as unproductive investment. Thus, during inflation of anticipated variety, there occurs a diversion of resources from priority to non-priority or unproductive sectors.

b. Effect on Production and Economic Growth :

Inflation may or may not result in higher output. Below the full employment stage, inflation has a favourable effect on production. In general, profit is a rising function of the price level. An inflationary situation gives an incentive to businessmen to raise prices of their products so as to earn higher doses of profit.

Rising price and rising profit encourage firms to make larger investments. As a result, the multiplier effect of investment will come into operation resulting in higher national output. However, such a favourable effect of inflation will be temporary if wages and production costs rise very rapidly.

Further, inflationary situation may be associated with the fall in output, particularly if inflation is of the cost-push variety. Thus, there is no strict relationship between prices and output. An increase in aggregate demand will increase both prices and output, but a supply shock will raise prices and lower output.

Inflation may also lower down further production levels. It is commonly assumed that if inflationary tendencies nurtured by experienced inflation persist in future, people will now save less and consume more. Rising saving propensities will result in lower further outputs.

One may also argue that inflation creates an air of uncertainty in the minds of business community, particularly when the rate of inflation fluctuates. In the midst of rising inflationary trend, firms cannot accurately estimate their costs and revenues. Under the circumstance, business firms may be deterred in investing. This will adversely affect the growth performance of the economy.

However, slight dose of inflation is necessary for economic growth. Mild inflation has an encouraging effect on national output. But it is difficult to make the price rise of a creeping variety. High rate of inflation acts as a disincentive to long run economic growth. The way the hyperinflation affects economic growth is summed up here.

We know that hyperinflation discourages savings. A fall in savings means a lower rate of capital formation. A low rate of capital formation hinders economic growth. Further, during excessive price rise, there occurs an increase in unproductive investment in real estate, gold, jewellery, etc.

Above all, speculative businesses flourish during inflation resulting in artificial scarcities and, hence, further rise in prices. Again, following hyperinflation, export earnings decline resulting in a wide imbalance in the balance of payments account.

Often, galloping inflation results in a ‘flight’ of capital to foreign countries since people lose confidence and faith over the monetary arrangements of the country, thereby resulting in a scarcity of resources. Finally, real value of tax revenue also declines under the impact of hyperinflation. Government then experiences a shortfall in investible resources.

Thus, economists and policy makers are unanimous regarding the dangers of high price rise. But the consequence of hyperinflation is disastrous. In the past, some of the world economies (e.g., Germany after the First World War (1914-1918), Latin American countries in the 1980s) had been greatly ravaged by hyperinflation.

The German Inflation of 1920s was also Catastrophic:

During 1922, the German price level went up 5,470 per cent, in 1923, the situation worsened; the German price level rose 1,300,000,000 times. By October of 1923, the postage of the lightest letter sent from Germany to the United States was 200,000 marks.

Butter cost 1.5 million marks per pound, meat 2 million marks, a loaf of bread 200,000 marks, and an egg 60,000 marks Prices increased so rapidly that waiters changed the prices on the menu several times during the course of a lunch!! Sometimes, customers had to pay double the price listed on the menu when they observed it first!!!

During October 2008, Zimbabwe, under the President-ship of Robert G. Mugabe, experienced 231,000,000 p.c. (2.31 million p.c.) as against 1.2 million p.c. price rise in September 2008—a record after 1923. It is an unbelievable rate. In May 2008, the cost of price of a toilet paper itself and not the costs of the roll of the toilet paper came to 417 Zimbabwean dollars.

Anyway, people are harassed ultimately by the high rate of inflation. That is why it is said that ‘inflation is our public enemy number one’. Rising inflation rate is a sign of failure on the part of the government.

Related Articles:

• Essay on the Causes of Inflation (473 Words)
• Cost-Push Inflation and Demand-Pull or Mixed Inflation
• Demand Pull Inflation and Cost Push Inflation | Money
• Essay on Inflation: Meaning, Measurement and Causes

What is inflation?

Inflation has been top of mind for many over the past few years. But how long will it persist? In June 2022, inflation in the United States jumped to 9.1 percent, reaching the highest level since February 1982. The inflation rate has since slowed in the United States , as well as in Europe , Japan , and the United Kingdom , particularly in the final months of 2023. But even though global inflation is higher than it was before the COVID-19 pandemic, when it hovered around 2 percent, it’s receding to historical levels . In fact, by late 2022, investors were predicting that long-term inflation would settle around a modest 2.5 percent. That’s a far cry from fears that long-term inflation would mimic trends of the 1970s and early 1980s—when inflation exceeded 10 percent.

Get to know and directly engage with senior McKinsey experts on inflation.

Ondrej Burkacky is a senior partner in McKinsey’s Munich office, Axel Karlsson is a senior partner in the Stockholm office, Fernando Perez is a senior partner in the Miami office, Emily Reasor is a senior partner in the Denver office, and Daniel Swan is a senior partner in the Stamford, Connecticut, office.

Inflation refers to a broad rise in the prices of goods and services across the economy over time, eroding purchasing power for both consumers and businesses. Economic theory and practice, observed for many years and across many countries, shows that long-lasting periods of inflation are caused in large part by what’s known as an easy monetary policy . In other words, when a country’s central bank sets the interest rate too low or increases money growth too rapidly, inflation goes up. As a result, your dollar (or whatever currency you use) will not go as far  today as it did yesterday. For example: in 1970, the average cup of coffee in the United States cost 25 cents; by 2019, it had climbed to $1.59. So for $5, you would have been able to buy about three cups of coffee in 2019, versus 20 cups in 1970. That’s inflation, and it isn’t limited to price spikes for any single item or service; it refers to increases in prices across a sector, such as retail or automotive—and, ultimately, a country’s economy.

How does inflation affect your daily life? You’ve probably seen high rates of inflation reflected in your bills—from groceries to utilities to even higher mortgage payments. Executives and corporate leaders have had to reckon with the effects of inflation too, figuring out how to protect margins while paying more for raw materials.

But inflation isn’t all bad. In a healthy economy, annual inflation is typically in the range of two percentage points, which is what economists consider a sign of pricing stability. When inflation is in this range, it can have positive effects: it can stimulate spending and thus spur demand and productivity when the economy is slowing down and needs a boost. But when inflation begins to surpass wage growth, it can be a warning sign of a struggling economy.

Introducing McKinsey Explainers : Direct answers to complex questions

Inflation may be declining in many markets, but there’s still uncertainty ahead: without a significant surge in productivity, Western economies may be headed for a period of sustained inflation or major economic reset , as Japan has experienced in the first decades of the 21st century.

What does seem to be changing are leaders’ attitudes. According to the 2023 year-end McKinsey Global Survey on economic conditions , respondents reported less fear about inflation as a risk to global and domestic economic growth . But this sentiment varies significantly by region: European respondents were most concerned about the effects of inflation, whereas respondents in North America offered brighter views.

What causes inflation?

Monetary policy is a critical driver of inflation over the long term. The current high rate of inflation is a result of increased money supply , high raw materials costs , labor mismatches , and supply disruptions —exacerbated by geopolitical conflict .

In general, there are two primary types, or causes, of short-term inflation:

• Demand-pull inflation occurs when the demand for goods and services in the economy exceeds the economy’s ability to produce them. For example, when demand for new cars recovered more quickly than anticipated from its sharp dip at the beginning of the COVID-19 pandemic, an intervening shortage  in the supply of semiconductors  made it hard for the automotive industry to keep up with this renewed demand. The subsequent shortage of new vehicles resulted in a spike in prices for new and used cars.
• Cost-push inflation occurs when the rising price of input goods and services increases the price of final goods and services. For example, commodity prices spiked sharply  during the pandemic as a result of radical shifts in demand, buying patterns, cost to serve, and perceived value across sectors and value chains. To offset inflation and minimize impact on financial performance, industrial companies were forced to increase prices for end consumers.

Learn more about McKinsey’s Growth, Marketing & Sales  Practice.

What are some periods in history with high inflation?

Economists frequently compare the current inflationary period with the post–World War II era , when price controls, supply problems, and extraordinary demand in the United States fueled double-digit inflation gains—peaking at 20 percent in 1947—before subsiding at the end of the decade. Consumption patterns today have been similarly distorted, and supply chains have been disrupted  by the pandemic.

The period from the mid-1960s through the early 1980s in the United States, sometimes called the “Great Inflation,” saw some of the country’s highest rates of inflation, with a peak of 14.8 percent in 1980. To combat this inflation, the Federal Reserve raised interest rates to nearly 20 percent. Some economists attribute this episode partially to monetary policy mistakes rather than to other causes, such as high oil prices. The Great Inflation signaled the need for public trust  in the Federal Reserve’s ability to lessen inflationary pressures.

Inflation isn’t solely a modern-day phenomenon, of course. One very early example of inflation comes from Roman times, from around 200 to 300 CE. Roman leaders were struggling to fund an army big enough to deal with attackers from multiple fronts. To help, they watered down  the silver in their coinage, causing the value of money to slowly fall—and inflation to pick up. This led merchants to raise their prices, causing widespread panic. In response, the emperor Diocletian issued what’s now known as the Edict on Maximum Prices, a series of price and wage controls designed to stop the rise of prices and wages (one helpful control was a maximum price for a male lion). But because the edict didn’t address the root cause of inflation—the impure silver coin—it didn’t fix the problem.

How is inflation measured?

Statistical agencies measure inflation first by determining the current value of a “basket” of various goods and services consumed by households, referred to as a price index. To calculate the rate of inflation over time, statisticians compare the value of the index over one period with that of another. Comparing one month with another gives a monthly rate of inflation, and comparing from year to year gives an annual rate of inflation.

In the United States, the Bureau of Labor Statistics publishes its Consumer Price Index (CPI), which measures the cost of items that urban consumers buy out of pocket. The CPI is broken down by region and is reported for the country as a whole. The Personal Consumption Expenditures (PCE) price index —published by the US Bureau of Economic Analysis—takes into account a broader range of consumer spending, including on healthcare. It is also weighted by data acquired through business surveys.

How does inflation affect consumers and companies differently?

Inflation affects consumers most directly, but businesses can also feel the impact:

• Consumers lose purchasing power when the prices of items they buy, such as food, utilities, and gasoline, increase. This can lead to household belt-tightening and growing pessimism about the economy .
• Companies lose purchasing power and risk seeing their margins decline , when prices increase for inputs used in production. These can include raw materials like coal and crude oil , intermediate products such as flour and steel, and finished machinery. In response, companies typically raise the prices of their products or services to offset inflation, meaning consumers absorb these price increases. The challenge for many companies is to strike the right balance between raising prices to cover input cost increases while simultaneously ensuring that they don’t raise prices so much that they suppress demand.

How can organizations respond to high inflation?

During periods of high inflation, companies typically pay more for materials , which decreases their margins. One way for companies to offset losses and maintain margins is by raising prices for consumers. However, if price increases are not executed thoughtfully, companies can damage customer relationships and depress sales —ultimately eroding the profits they were trying to protect.

When done successfully, recovering the cost of inflation for a given product can strengthen relationships and overall margins. There are five steps companies can take to ADAPT  (adjust, develop, accelerate, plan, and track) to inflation:

• Adjust discounting and promotions and maximize nonprice levers. This can include lengthening production schedules or adding surcharges and delivery fees for rush or low-volume orders.
• Develop the art and science of price change. Instead of making across-the-board price changes, tailor pricing actions to account for inflation exposure, customer willingness to pay, and product attributes.
• Accelerate decision making tenfold. Establish an “inflation council” that includes dedicated cross-functional, inflation-focused decision makers who can act quickly and nimbly on customer feedback.
• Plan options beyond pricing to reduce costs. Use “value engineering” to reimagine a portfolio and provide cost-reducing alternatives to price increases.
• Track execution relentlessly. Create a central supporting team to address revenue leakage and to manage performance rigorously. Traditional performance metrics can be less reliable when inflation is high .

Beyond pricing, a variety of commercial and technical levers can help companies deal with price increases in an inflationary market , but other sectors may require a more tailored response to pricing.

Learn more about our Financial Services , Industrials & Electronics , Operations , Strategy & Corporate Finance , and  Growth, Marketing & Sales Practices.

How can CEOs help protect their organizations against uncertainty during periods of high inflation?

In today’s uncertain environment, in which organizations have a much wider range of stakeholders, leaders must think about performance beyond short-term profitability. CEOs should lead with the complete business cycle and their complete slate of stakeholders in mind.

CEOs need an inflation management playbook , just as central bankers do. Here are some important areas to keep in mind while scripting it:

• Design. Leaders should motivate their organizations to raise the profile of design  to a C-suite topic. Design choices for products and services are critical for responding to price volatility, scarcity of components, and higher production and servicing costs.
• Supply chain. The most difficult task for CEOs may be convincing investors to accept supply chain resiliency as the new table stakes. Given geopolitical and economic realities, supply chain resiliency has become a crucial goal for supply chain leaders, alongside cost optimization.
• Procurement. CEOs who empower their procurement  organizations can raise the bar on value-creating contributions. Procurement leaders have told us time and again that the current market environment is the toughest they’ve experienced in decades. CEOs are beginning to recognize that purchasing leaders can be strategic partners by expanding their focus beyond cost cutting to value creation.
• Feedback. A CEO can take a lead role in playing back the feedback the organization is hearing. In today’s tight labor market, CEOs should guide their companies to take a new approach to talent, focusing on compensation, cultural factors, and psychological safety .
• Pricing. Forging new pricing relationships with customers will test CEOs in their role as the “ultimate integrator.” Repricing during inflationary times is typically unpleasant for companies and customers alike. With setting new prices, CEOs have the opportunity to forge deeper relationships with customers, by turning to promotions, personalization , and refreshed communications around value.
• Agility. CEOs can strive to achieve a focus based more on strategic action and less on firefighting. Managing the implications of inflation calls for a cross-functional, disciplined, and agile response.

A practical example: How is inflation affecting the US healthcare industry?

Consumer prices for healthcare have rarely risen faster than the rate of inflation—but that’s what’s happening today. The impact of inflation on the broader economy has caused healthcare costs to rise faster than the rate of inflation. Experts also expect continued labor shortages in healthcare—gaps of up to 450,000 registered nurses and 80,000 doctors —even as demand for services continues to rise. This drives up consumer prices and means that higher inflation could persist. McKinsey analysis as of 2022 predicted that the annual US health expenditure is likely to be $370 billion higher by 2027 because of inflation.

This climate of risk could spur healthcare leaders to address productivity, using tech levers to boost productivity while also reducing costs. In order to weather the storm, leaders will need to quickly set high aspirations, align their organizations around them, and execute with speed .

What is deflation?

If inflation is one extreme of the pricing spectrum, deflation is the other. Deflation occurs when the overall level of prices in an economy declines and the purchasing power of currency increases. It can be driven by growth in productivity and the abundance of goods and services, by a decrease in demand, or by a decline in the supply of money and credit.

Generally, moderate deflation positively affects consumers’ pocketbooks, as they can purchase more with less money. However, deflation can be a sign of a weakening economy, leading to recessions and depressions. While inflation reduces purchasing power, it also reduces the value of debt. During a period of deflation, on the other hand, debt becomes more expensive. And for consumers, investments such as stocks, corporate bonds, and real estate become riskier.

A recent period of deflation in the United States was the Great Recession, between 2007 and 2008. In December 2008, more than half of executives surveyed by McKinsey  expected deflation in their countries, and 44 percent expected to decrease the size of their workforces.

When taken to their extremes, both inflation and deflation can have significant negative effects on consumers, businesses, and investors.

For more in-depth exploration of these topics, see McKinsey’s Operations Insights  collection. Learn more about Operations consulting , and check out operations-related job opportunities  if you’re interested in working at McKinsey.

Articles referenced:

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• “ Economic conditions outlook during turbulent times, December 2023 ,” December 20, 2023
• “ Forward Thinking on why we ignore inflation—from ancient times to the present—at our peril with Stephen King ,” November 1, 2023
• “ Procurement 2023: Ten CPO actions to defy the toughest challenges ,” March 6, 2023, Roman Belotserkovskiy , Carolina Mazuera, Marta Mussacaleca , Marc Sommerer, and Jan Vandaele
• “ Why you can’t tread water when inflation is persistently high ,” February 2, 2023, Marc Goedhart and Rosen Kotsev
• “ Markets versus textbooks: Calculating today’s cost of equity ,” January 24, 2023, Vartika Gupta, David Kohn, Tim Koller , and Werner Rehm  
• “ Inflation-weary Americans are increasingly pessimistic about the economy ,” December 13, 2022, Gonzalo Charro, Andre Dua , Kweilin Ellingrud , Ryan Luby, and Sarah Pemberton
• “ Inflation fighter and value creator: Procurement’s best-kept secret ,” October 31, 2022, Roman Belotserkovskiy , Ezra Greenberg , Daphne Luchtenberg, and Marta Mussacaleca
• “ Prime Numbers: Rethink performance metrics when inflation is high ,” October 28, 2022, Vartika Gupta, David Kohn, Tim Koller , and Werner Rehm
• “ The gathering storm: The threat to employee healthcare benefits ,” October 20, 2022, Aditya Gupta , Akshay Kapur , Monisha Machado-Pereira , and Shubham Singhal
• “ Utility procurement: Ready to meet new market challenges ,” October 7, 2022, Roman Belotserkovskiy , Abhay Prasanna, and Anton Stetsenko
• “ The gathering storm: The transformative impact of inflation on the healthcare sector ,” September 19, 2022, Addie Fleron, Aneesh Krishna , and Shubham Singhal
• “ Pricing during inflation: Active management can preserve sustainable value ,” August 19, 2022, Niels Adler and Nicolas Magnette
• “ Navigating inflation: A new playbook for CEOs ,” April 14, 2022, Asutosh Padhi , Sven Smit , Ezra Greenberg , and Roman Belotserkovskiy
• “ How business operations can respond to price increases: A CEO guide ,” March 11, 2022, Andreas Behrendt ,  Axel Karlsson , Tarek Kasah, and  Daniel Swan
• “ Five ways to ADAPT pricing to inflation ,” February 25, 2022,  Alex Abdelnour , Eric Bykowsky, Jesse Nading,  Emily Reasor , and Ankit Sood
• “ How COVID-19 is reshaping supply chains ,” November 23, 2021,  Knut Alicke ,  Ed Barriball , and Vera Trautwein
• “ Navigating the labor mismatch in US logistics and supply chains ,” December 10, 2021,  Dilip Bhattacharjee , Felipe Bustamante, Andrew Curley, and  Fernando Perez
• “ Coping with the auto-semiconductor shortage: Strategies for success ,” May 27, 2021,  Ondrej Burkacky , Stephanie Lingemann, and Klaus Pototzky

This article was updated in April 2024; it was originally published in August 2022.

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Annual Report 2023 | Federal Reserve Bank of St. Louis

Annual Report 2023

Federal Reserve Bank of St. Louis

Prices, Wages and Workers: The Recent U.S. Inflation Experience

By Fernando M. Martin and David C. Wheelock

Inflation was the economic story of 2023 and the two preceding years. After more than a decade of relatively stable prices, U.S. inflation began to rise in 2021 on the heels of the COVID-19 pandemic, then peaked in mid-2022 before declining.

The main essay of the Federal Reserve Bank of St. Louis’ 2023 annual report focuses on various aspects of inflation. This overview defines inflation and examines different views about its causes. It reviews the rise and fall of inflation after the COVID-19 pandemic shock in 2020 and describes how the Federal Reserve used the tools at its disposal to bring down inflation. The balance of the essay highlights the research of three St. Louis Fed economists whose work helps to explain or forecast inflation and its broader effects on the economy.

What Is Inflation, and How Is It Measured?

Consumers naturally focus on the prices of goods and services they buy and might associate inflation with increases in the prices of one or more of those items. However, to economists, inflation refers to a sustained increase in prices generally—not necessarily to all prices but to a wide range of prices throughout the economy. Economists use price indexes to measure changes in the aggregate price level and thus the rate of inflation.

Price indexes, such as the consumer price index (CPI), are composite measures of prices paid for goods and services throughout the economy. The CPI is a weighted average of prices of items in a basket of goods and services commonly purchased by urban American households, with the weights on individual prices reflecting the expenditure shares of each item. The rate of change in CPI over time is one measure of the inflation rate .

The CPI inflation rate is the most well-known measure of U.S. inflation. Certain government payments, such as Social Security benefits, are adjusted annually for changes in the CPI so that inflation does not erode the purchasing power of benefit recipients. Similarly, the interest and principal on certain marketable securities issued by the U.S. Treasury are adjusted annually to account for CPI inflation.

Other inflation measures, such as changes in the price index for personal consumption expenditures (PCE), are also popular. The Federal Reserve focuses on PCE inflation when setting monetary policy. Although both indexes are useful, the PCE price index includes a wider variety of expenditures than the CPI and is thought to better capture changing consumer spending patterns, and therefore might better reflect the true inflation rate . In recent years, the PCE inflation rate typically has been slightly lower than the CPI inflation rate, though their trends have been similar. A key difference between these two price indexes is that the CPI includes only out-of-pocket expenditures, whereas the PCE price index includes consumption expenditures regardless of how they are paid. (The difference matters for items such as health care.) In addition, housing costs have a significantly larger weight in the CPI than in the PCE price index.

Price Stability and the Federal Reserve’s Inflation Target

Consumers may find inflation frustrating at best, and possibly detrimental to their standards of living. Inflation, especially high or highly variable inflation, also interferes with the efficient functioning of the economy. Inflation can obscure the price signals that consumers and firms rely on when making their buying, saving and investment decisions. In turn, this can lead households and firms to make economic decisions that they would not have made if the price level was stable, such as using resources in an effort to protect themselves from inflation, which can slow the growth of the economy and living standards.

Recognizing the important role that monetary policy plays in determining the inflation rate over the medium to longer run, Congress made price stability one of the Federal Reserve’s main policy goals, along with maximum sustainable employment and moderate long-term interest rates. The Fed’s monetary policymaking committee, the Federal Open Market Committee (FOMC), has deemed that 2% inflation, as measured by the annual change in the PCE price index, is consistent with the price stability goal. Why 2%? It is a widely accepted international standard based on experience indicating that the economy performs well when the inflation rate remains close to 2%. Further, 2% inflation provides some room for the Fed to lower interest rates during periods when employment falls short of the maximum sustainable level. The FOMC’s statement on longer-run goals and monetary policy strategy (PDF) explains how the committee will respond to employment shortfalls and deviations from the 2% inflation target, and that it will take a balanced approach at times when its employment and price stability goals conflict.

What Causes Inflation?

“a monetary phenomenon”.

Economist Milton Friedman famously argued that “inflation is always and everywhere a monetary phenomenon.” See Milton Friedman’s “ The Counter-Revolution in Monetary Theory ,” Institute of Economic Affairs, 1970. In Friedman’s “monetarist” view, inflation is caused by excessive growth of the money supply, which generates more demand for goods and services than the economy can supply, and consequently prices are bid higher. In countries with low average inflation, however, such as the U.S., the relationship between growth of common money stock aggregates (such as currency and bank deposits) and inflation is not as tight as the theory would predict. However, expansions of the money supply in exigent circumstances, such as major wars, have been associated with a rise in inflation. See Kevin L. Kliesen and David C. Wheelock’s “ The COVID-19 Pandemic and Inflation: Lessons from Major U.S. Wars ,” Federal Reserve Bank of St. Louis Review , 2023.

Supply Shocks

Various non-monetary explanations for inflation also have been suggested. In the 1970s, for example, it was popular, even among central bankers, to blame inflation on rising energy and other costs and supply shortages. Although supply shocks and bottlenecks are unlikely to cause a persistent rise in the price level, transitory adjustment in the price level can continue for several months or quarters and thus raise the inflation rate for some time.

Unemployment: The Phillips Curve

Another popular explanation is associated with a perceived negative trade-off between inflation and unemployment known as the Phillips curve. Based on this theory, one might expect higher inflation as the economy strengthens and lower inflation as the economy weakens. This is the lens through which many central banks explain fluctuations of inflation around their targets. However, the data have offered weak support for a systematic relationship between inflation and real variables, including unemployment. From the mid-1990s through 2019, the Phillips curve was “flat”—that is, inflation was relatively stable, regardless of fluctuations in the unemployment rate. In contrast, since 2022, the Phillips curve has been “vertical,” with a low and stable unemployment rate, despite significant movements in the inflation rate.

Inflation Expectations

Although the monetarist view of a tight link between money supply growth and inflation is no longer widely held, many economists still accept that central bank policies have an important influence on inflation. A leading explanation maintains that central banks can control inflation over the medium to long term through policies and actions that anchor the public’s inflation expectations to the central bank’s inflation target. In this view, inflation is more likely to be low and stable if the public believes that the central bank is firmly committed to that outcome.

Fiscal Policy

A more recent theory of inflation is the fiscal theory of the price level, which links the overall price level and inflation to the level of government debt and expected future fiscal surpluses. This theory predicts higher prices as debt rises and higher inflation as the growth rate of debt increases. Predictions of the fiscal theory rely on a stable demand for government liabilities and, like the monetarist theory, have proved challenging to support empirically.

The high-inflation episode following the onset of the COVID-19 pandemic featured many of the elements mentioned above. On one hand, there was a significant increase in government debt, a substantial amount of which was purchased by the Federal Reserve. On the other hand, there were significant supply-side disruptions. Throughout the episode, short-term inflation expectations trailed actual inflation, while medium- and long-term expectations remained anchored near the Fed’s 2% target.

COVID-19 Pandemic Inflation

At the onset of the COVID-19 pandemic, the Federal Reserve adopted an accommodative policy stance to support the economy and smooth functioning of financial markets. Notably, the Federal Reserve cut its target range for the federal funds rate to near zero, opened multiple temporary liquidity facilities, and initiated purchases of mortgage-backed securities and U.S. Treasury debt on a large scale. During the early months of the pandemic, the overall price level declined as consumption demand fell, and 2020 ended with a low inflation rate.

Inflation then started to pick up during 2021. At first, inflation was widely expected to be short-lived and involved a relatively narrow group of goods and services. As the year went on, high inflation proved persistent and more generalized, leading the FOMC to tighten monetary policy with the purpose of returning inflation to its 2% target. For more on these topics, see Fernando M. Martin’s Oct. 19, 2021, On the Economy blog post “ How Widespread Are Price Increases in the U.S.? ” and his Oct. 17, 2022, On the Economy blog post “ Inflation Is Still High and Widespread .” The FOMC moved first to taper, or reduce the pace of, asset purchases in November 2021, which contributed to a rise in long-term interest rates. Then, in March 2022, it lifted the federal funds rate from zero and began a series of increases in its funds rate target range. Annual PCE inflation peaked in June 2022 at 7.1% and then fell throughout 2023, though it remained above the Fed’s 2% target at the end of 2023. The figure below shows the evolution of inflation and interest rates during this episode.

Annual Inflation Peaked in Mid-2022 as Interest Rates Rose

SOURCES: Bureau of Economic Analysis and FRED ® .

NOTES: Inflation is measured as the 12-month change in the PCE price index. The federal funds rate and the 10-year Treasury yield correspond to their monthly averages.

The table below breaks down inflation into four major categories and two aggregates. The major components are food, energy, core goods and core services. “Core” explains that the particular category excludes food and energy. These components account for roughly 8%, 4%, 22% and 66%, respectively, of total consumption expenditures. The two measures of aggregate inflation are those closely monitored by the Federal Reserve: PCE and PCE excluding energy and food prices (known as core PCE). The table shows inflation rates over several periods: 2016-19 (which was prior to the COVID-19 pandemic), 2020, 2021, 2022 and 2023.

Above, the table shows that inflation varied significantly across broad categories. Before the pandemic, food prices were stable and core goods prices were falling, but prices of energy and core services were rising above 2% at annual rates. Together, these numbers implied an overall, or headline, inflation rate of 1.7% annually during 2016-19, which was slightly below the Federal Reserve’s target.

All of the categories contributed to high headline inflation in 2021 and 2022, revealing the widespread nature of the phenomenon. In 2023, inflation in food, energy and core goods slowed significantly, falling below 2% at annual rates. In contrast, inflation in core services—the largest consumption category—fell but remained well above 2%, thereby preventing headline inflation from returning back to target in 2023.

Although consumption spending declined sharply and across the board during the early months of the pandemic, starting in mid-2020, consumption of goods spiked while consumption of services remained low relative to pre-pandemic levels—because of households’ response to lockdown measures implemented at the time. Consumption on an inflation-adjusted basis returned to its pre-pandemic trend in March 2021, the same month that both headline and core PCE inflation rose above 2%, and it has remained above trend ever since.

Link between Excess Savings and Excess Inflation

The federal government’s response to the pandemic, which included payments to certain individuals and organizations, resulted in a substantial increase in the federal deficit and households’ disposable income. The fiscal assistance explains, in part, why consumption remained persistently elevated through 2023, despite continued above-target inflation and high interest rates. To illustrate the relationship between the rise of disposable income through fiscal policy and high inflation, the figure below shows measures of excesses from the norm in personal savings and inflation. For more in-depth analysis, see Fernando M. Martin’s Oct. 19, 2023, On the Economy blog post “ Is Inflation on the Way Out or Here to Stay? ”

• Personal savings are defined as disposable personal income minus personal outlays. The Bureau of Economic Analysis defines personal outlays as the sum of personal consumption expenditures, personal interest payments and personal current transfer payments. Excess personal savings are then computed by subtracting the 2016-19 trend in savings. Accumulated excess personal savings reflect the sum of excess personal savings since January 2016.
• Excess inflation is defined as the annual growth rate of the PCE price index excluding energy minus 2%. This measure removes the effect of fluctuations in energy prices, which depend largely on global factors, on inflation but still acknowledges the fact that food prices react to local factors, including government policy, in tandem with other goods and services.

Excess Personal Savings and Excess Inflation Have Steadily Declined

SOURCES: Bureau of Economic Analysis and authors’ calculations.

NOTES: Personal savings are defined as disposable personal income minus personal outlays. Excess personal savings are computed by subtracting the 2016-19 trend in savings. Accumulated excess personal savings are the sum of excess personal savings since January 2016. Excess inflation is defined as the annual growth rate of the PCE price index excluding energy minus 2%.

Excess savings averaged zero until the beginning of COVID-19. Then, because of lower consumption and three rounds of government assistance, there was a significant and persistent increase in personal savings. After peaking at $2.16 trillion in August 2021, accumulated excess personal savings steadily declined. As of December 2023, this excess totaled roughly $300 billion, or about one-fifth of monthly consumption. Even with the dampening effects of higher interest rates, households on average still had the economic means to continue spending above trend and make up for privations related to the pandemic.

Excess inflation followed a similar pattern as accumulated excess savings but with a lag. This co-movement underscores the connection between fiscal policy during the pandemic and resulting inflation. While accumulated excess savings and excess inflation both declined since reaching their peaks, inflation declined a bit faster, likely because of tight monetary policy.

Summary and What’s to Come in the 2023 Annual Report

By the end of 2023, substantial progress had been made toward restoring price stability. However, in his press conference following the December 2023 FOMC meeting , Federal Reserve Chair Jerome Powell commented that “no one is declaring victory” and doing so would be premature. Further, he said, “Restoring price stability is essential to achieve a sustained period of strong labor market conditions that benefit all.”

Economists at the Federal Reserve Bank of St. Louis are actively engaged in research to help us better forecast and understand how inflation arises and how it impacts the labor market and broader economy. The remainder of this annual report essay provides three examples of our economists’ work that relate to inflation. The authors examine these key questions:

• How has inflation impacted workers’ wages?
• How has the rate at which employed workers move from one job to another affected inflation?
• How far into the future can data that are available now be used to improve the accuracy of inflation forecasts?

Impact of Inflation on Workers’ Wages

By Victoria Gregory

In the aftermath of the COVID-19 pandemic, the U.S. sustained some of the highest inflation rates since the 1980s. During the same period, a historically tight labor market led to substantial gains in workers’ wages. For workers, the extent to which their wage growth exceeds inflation—their “real” wage growth rate—says a lot about whether their standard of living is improving from one year to the next. Both components vary from person to person. One individual’s wages may grow in a certain year because of switching to a higher-paying job or getting a raise. Someone else’s employment situation may go in the opposite direction or remain unchanged. People also experience inflation differently because they consume different baskets of goods and services.

To get a complete picture of how all members of the population fared over a certain period, it is important to look beyond the aggregate inflation and wage growth numbers and take into consideration the entire distribution of real wage growth. Recent research has improved the methodology for measuring real wage growth by using existing monthly data. For a less technical summary, see Victoria Gregory and Elisabeth Harding’s Feb. 23, 2023, On the Economy blog post “ Nominal Wage Growth at the Individual Level in 2022 ” and their March 27, 2023, blog post “ Real Wage Growth at the Individual Level in 2022 .” In addition, that particular research analyzed the distribution of real wage growth to see whose wages kept up with inflation and whose wages didn’t during the high-inflation episode in 2021-22. Here, I extend the analysis to 2022-23 as well as 2018-19—before the onset of the COVID-19 pandemic—to establish a pre-pandemic benchmark and study how close we are to returning to that level using the latest available data.

How to Measure Real Wage Growth for Individuals

Measuring real wage growth at the individual level is challenging because there are no datasets that contain a panel of both wages and consumption for a comprehensive set of items. To overcome this, I drew on consumption data from the Consumer Expenditure Surveys (CEX) and wage growth data from the Current Population Survey (CPS) , both from the Bureau of Labor Statistics. The CEX provides information about household expenditures on different categories of goods and services. The CPS contains wage data for individuals measured one year apart, provided that they are employed during the months they are surveyed about wages.

I assigned consumption data to individuals in the CPS using the consumption patterns of individuals in the CEX with similar demographic attributes, including age, education, income and household size. This process resulted in a dataset that combines observed wages with estimated consumption of different item categories. From this, I obtained a measure of each CPS respondent’s annual nominal wage growth and personal inflation rate, which is a weighted average of the inflation rates of the items in the basket of goods and services that the individual purchases. The difference between the two of these is that person’s real wage growth. Real wage gains mean that nominal wage growth exceeded inflation in a given year, while real wage declines mean that inflation exceeded nominal wage growth.

Comparing the Distribution of Real Wage Growth in Recent Periods

The figure below compares the distribution of real wage growth from: 2018 to 2019, which is representative of “normal” years with respect to aggregate wage growth and inflation; 2021 to 2022, the years coinciding with the highest recent wage growth and inflation rates; and 2022 to 2023, which contains the most recent data available and coincides with a cooling of both wage growth and inflation. I organized wage growth into different intervals and, for each year, calculated the percentage of observations in each category.

Real Wage Growth Distribution Shifted to the Negative Range in 2022

SOURCES: Author’s calculations using Consumer Expenditure Surveys, the Current Population Survey and consumer price index data from the Bureau of Labor Statistics.

Before the pandemic, between 2018 and 2019, about 45% of workers experienced a decline in their real wages, much lower than the 54% between 2021 and 2022. Real wage increases were most common in the years before COVID-19. In addition, real wage declines of 5% or larger were least common over this period.

During the peak inflation period of 2021 and 2022, the distribution shifted toward the negative part of its range. Although nominal wage growth tended to be high, the high levels of inflation wiped out these gains for many workers: The median worker saw a 1.5% real wage decline, meaning that half of workers experienced a decline of at least 1.5%. Medium to large real wage cuts also became more common. Since there are always some individuals who have exactly zero nominal wage growth, between 2021 and 2022 those individuals automatically got a much larger real wage cut than normal, typically about 7% to 9%, depending on their inflation rates. As a result, the share of workers with real wage declines between 5% and 15% saw the biggest shift relative to the 2018-19 distribution.

In the following year, the distribution shifted back toward its pre-pandemic range. That is, the proportion of real wage growth in all intervals edged back to levels seen before the pandemic. The median worker had a slight real wage gain, of 0.9%, while about 49% of workers received real wage cuts. However, relative to the period between 2018 and 2019, there were many more individuals with medium-sized wage cuts and not as many with small increases.

After an unusual episode between 2021 and 2022, the real wage growth distribution has started to look more like it did pre-pandemic. However, different groups will likely continue to have distinct experiences in terms of real wage growth. For example, in all three periods considered above, young workers, low earners and people who had switched jobs experienced the highest gains in real wages.

For individuals, their real wages hinge on both the price levels of goods and services they consume and the evolution of their own employment situations. Monetary policy impacts both components. As the Federal Reserve continues to work to achieve price stability, it will be important to consider both components of real wage growth in the coming years to fully understand how the current tightening cycle has impacted the entire population.

• Job Switching and Inflation Dynamics

By Serdar Birinci

The Federal Reserve has a dual mandate from Congress of fostering price stability and maximum employment. To determine its policy actions, the Fed monitors inflation and other economic indicators, such as the unemployment rate. The unemployment rate is a relevant measure because it reflects the quantity of employment in the economy—specifically the fraction of the labor force that is jobless.

However, it also is important to understand how well-matched employed individuals are with their existing jobs and employers given their sets of skills. In this regard, there is growing interest in understanding how the quality of employment affects inflation and other macroeconomic outcomes over the business cycle. One such measurement of quality is the rate at which employed workers move from one job to another without an observed unemployment spell in between, known as the employer-to-employer (EE) transition rate or the job switching rate. By examining this indicator, economists can improve their understanding of the relationship between labor market conditions and inflation and, by extension, offer policymakers another possible data point to consider.

Breaking Down Employer-to-Employer Transitions

Why is the job switching rate an important indicator to follow? It can tell us a lot about wage and productivity growth:

• Because individuals typically change jobs to make higher salaries, a higher EE transition rate is generally associated with higher wage growth.
• Individuals also tend to leave an employer when the new job is a better match for their skills, which allows these workers to be more productive. This movement facilitates a reallocation of workers across jobs, which could contribute to overall productivity growth.

The relative strength of wage and productivity growth over the business cycle affects inflation, and therefore fluctuations in the EE transition rate are relevant for inflation dynamics.

Motivated by these ideas, Fatih Karahan, Yusuf Mercan, Kurt See and I recently co‑authored a paper that investigated how job switching fluctuations affect inflation dynamics. Our analysis was spurred by empirical observations of unemployment and EE transition rates, as well as their impact on employer costs over time. The figure below plots the cyclical components of the unemployment rate and job switching rate. It shows that the correlation between the two series is typically negative. In other words, periods of tightening labor markets, characterized by declining unemployment rates, are typically periods when the EE transition rate rises.

Cyclical Components of Unemployment and Job Switching Rates

SOURCES: Current Population Survey and author’s calculations.

NOTES: The monthly data are from September 1995 to September 2023. Both series are detrended using the Hodrick-Prescott filter with a smoothing parameter of 10 5 . The 12-month centered moving average is used for visual clarity.

However, during the labor market recovery from the Great Recession, in particular during 2016-19, the job switching rate remained flat, despite an approximate 25% decline in the unemployment rate from its trend. This is in contrast to the period from the COVID-19 recession, when the unemployment rate declined by almost the same amount, while the EE transition rate increased by more than 6% from its trend.

Employer-to-Employer Transition Rates and Employer Costs

How did EE transition rates over the past two recovery episodes affect employer costs? To answer this question, my co-authors and I analyzed the time series of unit labor cost (ULC), as shown in the figure below. ULC measures the total compensation paid to a worker for each unit of output produced, adjusted for worker composition and productivity changes over time. This measure is often used by policymakers and researchers to understand labor cost pressures in the economy.

During 2016-19, the average ULC growth was about 2%. However, for almost the same decline in the unemployment rate during the recovery from the COVID-19 recession (from the third quarter of 2021 to the third quarter of 2023), ULC growth reached as high as 6%. Therefore, the different behavior of ULC growth during the two recovery episodes cannot be accounted for by unemployment dynamics alone, but rather can more likely be attributed to differences in EE transition dynamics.

Unit Labor Cost Growth versus Unemployment Rate

SOURCES: Bureau of Labor Statistics and author’s calculations.

NOTES: This figure plots the four-quarter growth rate of the quarterly ULC index (left axis) between the third quarter of 1995 and the third quarter of 2023, as well as the monthly unemployment rate (right axis) between September 1995 and September 2023. For each quarter, we calculate the four-quarter growth rate and for visual clarity use a four-quarter moving average.

Importantly, the 2016-19 episode was characterized as a “missing inflation” episode: Despite a historically low unemployment rate (when one would expect to see wage pressure), annual inflation—as measured by the personal consumption expenditures price index—was about or below 2%.

It appears that a muted EE transition rate, as shown in the first figure, played a role in softening inflationary pressure during this period. In fact, my co-authors and I estimated that muted worker mobility allowed annualized inflation to be about 0.25 percentage points less than it would have been if job switching had increased with the falling unemployment rate during that period.

On the other hand, the 2021-22 recovery period saw something quite different because of a sharp rise in the EE transition rate, as shown in the first figure. In that period, the U.S. economy experienced an elevated number of workers quitting their jobs—a phenomenon some called the “great resignation”—and higher inflation. We estimated that an elevated EE transition rate raised annualized inflation by 0.60 percentage points during that period.

Our findings reveal that, in addition to paying attention to unemployment dynamics, policymakers might want to take into account the rate at which employed workers change jobs. This is because job switching rates in the economy affect employer costs, productivity and, eventually, inflation dynamics.

• Inflation Forecasting across Time Horizons

By Michael McCracken

Given its impact on daily life, people put a lot of effort into forecasting inflation. Forward-looking households consider both current and expected future prices in making decisions about when to purchase goods and services. Firms do the same with investment decisions and their own price-setting behavior.

Central to these interactions are the policymaking decisions of the Federal Reserve, which has its dual mandate from Congress to conduct monetary policy to promote maximum sustainable employment and stable prices. The latter part of this mandate is interpreted by the Fed as achieving a rate of inflation that averages 2% over time. Not surprisingly, the Fed invests a great deal of time and energy into forecasting inflation to guide its decisions on monetary policy as it works to promote a healthy economy and financial stability.

How Forecasters Predict Inflation

The steady rise in inflation in 2021 surprised many economists and was initially considered to be transitory. The COVID-19 pandemic and subsequent economic shocks led to previously unseen levels of economic uncertainty that made forecasting inflation particularly difficult. Looking back, one might wonder when forecasters might have expected to be able to predict the rise in inflation.

In the forecasting literature, this time frame is known as the “content horizon.” This concept asks how long into the future can currently available information be used to improve the accuracy of forecasts beyond just using the historical average.

Consider the following baseball analogy: On average, the St. Louis Cardinals are a better team than the Cincinnati Reds, a team they happen to be playing. Absent any other information before the first pitch is thrown, the best forecast is that the Cardinals will defeat the Reds. But once the game starts, information is gathered on the score, injuries, fan support, etc.—all of which affects the best prediction of who will win. In this example, the content horizon is the typical number of innings before the end of the game in which the gathered information is a better predictor of a Cardinals victory than the team’s average record.

In a similar vein, we might gauge the typical number of months into the future that current macroeconomic data can be used to improve inflation forecasts relative to the historical average. As an example, Jörg Breitung and Malte Knüppel found that across a range of countries, including the United States, professional forecasters exhibited a content horizon of two to three quarters when predicting annualized quarterly real gross domestic product growth. See Jörg Breitung and Malte Knüppel’s article “ How Far Can We Forecast? Statistical Tests of the Predictive Content ,” Journal of Applied Econometrics , 2021. In the same exercise, the authors found that when forecasting year-over-year inflation, the content horizon was a bit longer but still only three to four quarters.

In a recent analysis, Trần Khánh Ngân and I revisited their results but in the context of recent U.S. inflation and the Fed’s price stability mandate. For more information, see Michael McCracken and Trần Khánh Ngân’s Feb. 29, 2024, On the Economy blog post “ Core Inflation Revisited: Forecast Accuracy across Horizons .” Specifically, we provided some simple evidence on the content horizon for U.S. inflation across time but relative to the Fed’s 2% target rather than average inflation, per se. The distinction is based on the premise that the Fed acts credibly to achieve its mandate and, over any given forecast horizon, enacts monetary policy that is intended to achieve its 2% target rate of inflation in addition to maximum sustainable employment. This exercise was not intended to illustrate how the Fed constructs inflation forecasts. Instead, it is a simple-to-follow example of the content horizon of inflation forecasts and how that horizon may be limited.

Examining the Accuracy of Inflation Forecasts across Time Horizons

Building on Breitung and Knüppel’s research, for any given month, we forecasted year-over-year inflation three, six, nine, 12, 15, 18, 21 and 24 months into the future. The targeted measure of inflation is the one preferred by the Fed: headline inflation as measured by the personal consumption expenditures (PCE) price index. As a simple-to-use representative forecast, we used year-over-year core PCE inflation—a measure of inflation that excludes food and energy prices, which economists often reference as a measure of “trend” inflation. In other words, we looked at core PCE inflation to see how accurately it predicts future headline PCE inflation. Then, we considered a constant 2% as the benchmark forecast with the idea that the Fed will enact optimal policy to achieve that level of inflation.

The table below shows the average relative accuracy of the two forecasts across all eight horizons during two different time periods: the 14 years prior to 2021 and the following three-year period. Values less than 1 indicate that core PCE is more accurate than the 2% target, while values greater than 1 indicate the reverse. For example, in the years prior to 2021, at the three-month horizon, the value of 0.75 indicates that core PCE inflation was 25% more accurate than the target. (A value between 0.95 and 1.05 indicates no meaningful difference between the two forecasts.)

In broad terms, the results in the table above align with the results found by Breitung and Knüppel. In the pre-2021 period, core PCE inflation was more accurate than the target for horizons three to nine months. At the longer horizons, the gains diminished substantially. In the more recent period, in which there was substantially higher inflation, the pattern continued but was exaggerated. For this period, core PCE was, on average, a more accurate forecast out to 12 months and, perhaps, 15 months. Interestingly, and in contrast to the earlier sample, the content horizon of core PCE not only diminishes but substantially deteriorates at the longer horizons, making the 2% target a more accurate forecast.

As noted earlier in this article, inflation’s rise in 2021 was unexpected and then considered transitory. Based on prior historical experience, it appears that the typical content horizon of headline PCE inflation is about nine months into the future. Beyond that, there doesn’t appear to be much predictive content to work with other than knowing that the Fed will enact monetary policy to achieve its 2% objective. That said, the content horizon lengthened from 2021 through 2023, favoring core PCE at horizons out to 12 months.

• A key difference between these two price indexes is that the CPI includes only out-of-pocket expenditures, whereas the PCE price index includes consumption expenditures regardless of how they are paid. (The difference matters for items such as health care.) In addition, housing costs have a significantly larger weight in the CPI than in the PCE price index.
• See Milton Friedman’s “ The Counter-Revolution in Monetary Theory ,” Institute of Economic Affairs, 1970.
• However, expansions of the money supply in exigent circumstances, such as major wars, have been associated with a rise in inflation. See Kevin L. Kliesen and David C. Wheelock’s “ The COVID-19 Pandemic and Inflation: Lessons from Major U.S. Wars ,” Federal Reserve Bank of St. Louis Review , 2023.
• From the mid-1990s through 2019, the Phillips curve was “flat”—that is, inflation was relatively stable, regardless of fluctuations in the unemployment rate. In contrast, since 2022, the Phillips curve has been “vertical,” with a low and stable unemployment rate, despite significant movements in the inflation rate.
• For more on these topics, see Fernando M. Martin’s Oct. 19, 2021, On the Economy blog post “ How Widespread Are Price Increases in the U.S.? ” and his Oct. 17, 2022, On the Economy blog post “ Inflation Is Still High and Widespread .”
• “Core” explains that the particular category excludes food and energy.
• For more in-depth analysis, see Fernando M. Martin’s Oct. 19, 2023, On the Economy blog post “ Is Inflation on the Way Out or Here to Stay? ”
• The Bureau of Economic Analysis defines personal outlays as the sum of personal consumption expenditures, personal interest payments and personal current transfer payments.
• For a less technical summary, see Victoria Gregory and Elisabeth Harding’s Feb. 23, 2023, On the Economy blog post “ Nominal Wage Growth at the Individual Level in 2022 ” and their March 27, 2023, blog post “ Real Wage Growth at the Individual Level in 2022 .”
• See Jörg Breitung and Malte Knüppel’s article “ How Far Can We Forecast? Statistical Tests of the Predictive Content ,” Journal of Applied Econometrics , 2021.
• For more information, see Michael McCracken and Trần Khánh Ngân’s Feb. 29, 2024, On the Economy blog post “ Core Inflation Revisited: Forecast Accuracy across Horizons .”
• This exercise was not intended to illustrate how the Fed constructs inflation forecasts. Instead, it is a simple-to-follow example of the content horizon of inflation forecasts and how that horizon may be limited.

Fernando M. Martin is an economist and senior economic policy advisor at the Federal Reserve Bank of St. Louis. His research interests include macroeconomics, monetary economics, banking and public finance. He joined the St. Louis Fed in 2011. Read more about his work .

David Wheelock is senior vice president and special policy advisor to the St. Louis Fed president. Also an economist, his research interests include U.S. monetary history and policy as well as the performance and regulation of commercial banks. He joined the St. Louis Fed in 1993. Read more about his work .

Victoria Gregory is an economist at the Federal Reserve Bank of St. Louis. Her research interests include labor economics and macroeconomics. She joined the St. Louis Fed in 2020. Read more about her work .

Serdar Birinci is an economist and economic policy advisor at the Federal Reserve Bank of St. Louis. His areas of research include labor economics and macroeconomics. He joined the St. Louis Fed in 2019. Read more about his work .

Michael W. McCracken is an economist and senior economic policy advisor at the Federal Reserve Bank of St. Louis. His research focuses on econometrics and macroeconomic forecasting. He joined the St. Louis Fed in 2008. Read more about his work .

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What Causes Inflation? 

• Walter Frick

Why your money is worth less than it used to be.

What causes inflation? There is no one answer, but like so much of macroeconomics it comes down to a mix of output, money, and expectations. Supply shocks can lower an economy’s potential output, driving up prices. An increase in the money supply can stoke demand, driving up prices. And the expectation of inflation can become a self-fulfilling cycle as workers and companies demand higher wages and set higher prices.

Since the financial crisis of 2008 and the Great Recession, investors and executives have grown accustomed to a world of low interest rates and low inflation. No longer. In 2021, inflation began rising sharply in many parts of the world, and in 2022 the U.S. saw its worst inflation in decades.

• Walter Frick is a contributing editor at Harvard Business Review , where he was formerly a senior editor and deputy editor of HBR.org. He is the founder of Nonrival , a newsletter where readers make crowdsourced predictions about economics and business. He has been an executive editor at Quartz as well as a Knight Visiting Fellow at Harvard’s Nieman Foundation for Journalism and an Assembly Fellow at Harvard’s Berkman Klein Center for Internet & Society. He has also written for The Atlantic , MIT Technology Review , The Boston Globe , and the BBC, among other publications.

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How bad is inflation?

Stacey Vanek Smith

Julia Ritchey

Darian Woods

Inflation is at a 40-year high, and this has impacted everything – from raises at work, to trips to the grocery store. Today, two stories from The Indicator on how rising prices have affected the economy, and what can be done about it.

We follow an UberEats driver and Instacart shopper who's seen her paycheck go up. But she's also seen rising prices for food, gas, and other basics that eat away at her income. So, has she gotten a real raise, or is it just an illusion? And we break down how the Federal Reserve is planning to fight inflation with one primary tool: interest rates.

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Facing down a surprising U.S. inflation surge

Kennedy School experts in public finance and economic policy weigh in on the causes and responses to the highest American consumer price jump in three decades.

Inflation in the United States has jumped to the highest level in 30 years, reaching 6.2% in October as measured by the Consumer Price Index. The COVID-19 pandemic has fueled consumer demand for goods and services at a time when supply lines are constrained and many industries have been affected by staff shortages. The inflation surge has generated intense political debate on the causes and the appropriate response.

We asked several economists and public finance experts at Harvard Kennedy School—all of whom have held senior federal government economics roles—to offer brief perspectives on how they view the underlying issues and the key policy choices facing the Biden administration and Congress. 

• Linda Bilmes - Inflation's impact at the state and local level
• Karen Dynan - Weighing the uncertainties
• Jeffrey Frankel - Inflation Do's and Don'ts
• Jason Furman - Supply and demand challenges
• Lawrence H. Summers - Biden team needs to signal its concern about inflation

Inflation risks also lie ahead for state and local governments

On the revenue side, income and sales tax receipts will largely keep pace with inflation, so moderate inflation is unlikely to have a major impact. However, if inflation leads to sharply higher interest rates that lead to a stock market sell-off, then states that are highly dependent on capital gains taxes (such as California and New Jersey) may suffer. Another area of vulnerability could be property taxes, especially states where increases in assessed values or in property taxes are capped, as with California’s Prop. 13. These prevent rising house prices feeding through into state revenues, and are also the major revenue source for local governments.

On the expense side, the biggest risk is rising wages, which consume the largest share of state budgets. We could see public sector unions pushing for a return of “CPI-plus” language in new labor agreements. This would automatically bake in the cost of higher inflation to local expenditures. In addition, high inflation could significantly weaken state pension plans, many of which assume that future wage increases will be only 2%.  Most of the current generation of local pension managers have little experience with inflation. They need to begin adjusting their portfolios now to prevent erosion of their asset bases.

Linda Bilmes is the Daniel Patrick Moynihan Lecturer in Public Policy and previously served as Assistant Secretary of Commerce.

What's certain is just how many uncertainties lie ahead

What is not clear is how quickly these issues will resolve. The size and persistence of demand/supply imbalances has repeatedly surprised us, in part because virus caseloads have stayed unexpectedly high. We have only a limited understanding of why so many would-be workers are staying out of the labor force, making it hard to predict how many will return and how quickly. We are not sure how much inflation expectations have risen (a critical determinant of whether higher inflation sticks) because of measurement difficulties.

This uncertainty makes it difficult for monetary policymakers to know when they need to begin raising rates to avoid letting inflation stay at undesirably high levels. Given that they may need to revise their views quickly based on incoming data, it is especially important that they communicate the high degree of uncertainty. Surprising financial markets with an abrupt unexpected change in policy could lead to a rapid decline in asset prices that causes a significant setback in the economic recovery.

Karen Dynan is a professor of the practice of economics and former chief economist of the U.S. Treasury.

Some inflation-fighting do's and don'ts

Let’s start with two don'ts.

• Don’t do what Federal Reserve Chair Arthur Burns and President Richard Nixon did in 1971, in order to help the president’s reelection: They responded to moderate 5% to 6 % inflation with a combination of rapid monetary stimulus and doomed wage-price controls. The lid was blown off the boiling pot a few years later; the inflation rate jumped above 12%.
• Don’t do what Donald Trump did on April 2, 2020 , to help out American oil producers: He persuaded Saudi Arabia that OPEC must cut oil output and raise prices.
• Continue to fight in the Senate for a fully funded social spending bill (“Build Back Better”).
• Let imports into the country more easily.  They are a safety valve for an overheated economy.  Trump put up a lot of import tariffs , which raise prices to consumers—sometimes directly, as with washing machines, and sometimes indirectly, as with steel and aluminum, which are important inputs into autos and countless other goods. With or without foreign reciprocation, U.S. trade liberalization could bring prices down quickly in many supply-constrained sectors. 
• Similarly, facilitating orderly immigration would help alleviate the shortage of workers that employers in some sectors are experiencing.
• Further vaccination would increase the supply of labor, through several possible channels.  One channel would be to keep children in school, allowing more parents to go back to work. Another channel is to alleviate worker’s fears of infection in the workplace. 

Jeffrey Frankel is the James W. Harpel Professor of Capital Formation and Growth and was a member of the Council of Economic Advisors from 1983-1984 and 1996-1999.   

Supply and demand—and the Federal Reserve’s key role

Economists like to explain everything with demand and supply, and the concepts work well here. Demand is likely to remain high, fueled by households with healthy balance sheets, continued fiscal support, and very low interest rates. No one knows how long it will take supply to recover, or even whether it will fully recover, but it could be at least a year. The combination of strong demand and weak supply will likely keep inflation uncomfortably high.

President Biden can do a little about inflation by helping with port capacity and other supply-chain measures. Even better would be dropping President Trump’s tariffs on China. But these steps would only be small. The main agency charged with controlling inflation is the Federal Reserve. They are right to continue to be focused on the millions of people without jobs but should recalibrate towards incorporating more concern for inflation into their policy stance, including setting a default of more rate increases in 2022, something it can call off if inflation and/or employment is well below what we are currently expecting.

Jason Furman is the Aetna Professor of the Practice of Economic Policy and previously was chair of the Council of Economic Advisors under President Obama.

Biden team needs to signal its determination to address inflation

 Simultaneously, the Administration should signal that a concern about inflation will inform its policies generally. Measures already taken to reduce port bottlenecks may have limited effect but are a clear positive step. Buying inexpensively should take priority over buying American. Tariff reduction is the most important supply-side policy the administration could undertake to combat inflation. Raising fossil fuel supplies, such as the recent deployment of the Strategic Petroleum Reserve, is crucial. And financial regulators need to step up and be attentive to the pockets of speculative excess that are increasingly evident in financial markets.

 Excessive inflation and a sense that it was not being controlled helped elect Richard Nixon and Ronald Reagan, and risks bringing Donald Trump back to power. While an overheating economy is a relatively good problem to have compared to a pandemic or a financial crisis, it will metastasize and threaten prosperity and public trust unless clearly acknowledged and addressed.

Lawrence H. Summers is Charles W. Eliot University Professor , Weil Director of the Mossavar-Rahmani Center for Business and Government,  and president emeritus of Harvard University. His government positions included Secretary of the Treasury in the Clinton Administration and Director of the National Economic Council under President Obama. Portions of this essay were excerpted from a Washington Post column .

Banner image by AP Photo/Noah Berger; inline image by Xinhua via Getty Images; faculty portraits by Martha Stewart

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What is Inflation: Causes and Impact on Consumers

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

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What Is Inflation?

How inflation impacts consumers, how to protect your finances during inflation, types of price indexes.

• Pros and Cons

How Inflation Can Be Controlled

• Inflation, Deflation, and Disinflation

Hedging Against Inflation

The bottom line.

Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.

Inflation is a gradual loss of purchasing power, 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, with low inflation meaning that prices are increasing 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 sometimes 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.
• Those with tangible assets, like property or stocked commodities, may like to see some inflation as that raises the value of their assets.

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 for living 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.

Prices rise, which means that one unit of money buys fewer goods and services. 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.

The increase in the Consumer Price Index For All Urban Consumers (CPI-U) over the 12 months ending March 2024 on an unadjusted basis. Prices rose 0.4% on a seasonally adjusted basis in March 2024 from the previous month.

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.

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.

Investopedia / Julie Bang

What Causes Inflation

An increase in the supply of money 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 (the most common method)
• Supply bottlenecks and shortages of key goods, causing other prices to rise.

In all of these cases, the money ends up losing its purchasing power. The mechanisms of how this drives 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.

Melissa Ling {Copyright} Investopedia, 2019

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 are channeled into a commodity or other asset markets, costs for all kinds of 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.

There are a range of measures that individuals can take to protect their finances 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. However, commodities can also be volatile, 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.

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) .

The 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 in relation to those of other nations.

Changes in the CPI are used to assess price changes associated with the cost of living , making it one of the most frequently used statistics for identifying periods of inflation or deflation. In the U.S., the Bureau of Labor Statistics (BLS) reports the CPI on a monthly basis and has calculated it as far back as 1913.

The CPI-U, which was introduced in 1978, represents the buying habits of approximately 88% of the non-institutional population of the United States.

The 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.

Although many countries and organizations use WPI, many other countries, including the U.S., use a similar variant called the producer price index (PPI) .

The 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.

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 represents the average weighted price change for the given constituents which 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) x 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).

Plugging in the formula yields:

Percent Inflation Rate = (308.417 ÷ 52.1) x 100 = (5.9197) x 100 = 591.97%

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

Change in Dollar Value = 5.9197 x $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.

Advantages and Disadvantages of Inflation

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

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.

This introduces an additional source of uncertainty into the economy, because 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 it also distorts relative prices , wages, and rates of return along the way.

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.

Leads to higher resale value of assets

Optimum levels of inflation encourage spending

Buyers have to pay more for products and services

Impose higher prices on the economy

Drives some prices up first and others later

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.

Hyperinflation is often described as a period of inflation of 50% or more per month.

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) .

Some critics of the program alleged it would cause a spike in inflation in the 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.

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.

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%).

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.

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 through the financial system, much of the immediate effect on prices happens 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) , low-risk treasury security that is indexed to inflation where the principal amount invested is increased by the percentage of inflation.

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 famous example is the hyperinflation that struck the German Weimar Republic 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.

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

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 Is Inflation So High Right Now?

In 2022, 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.

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 still 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 rose, it led to similar increases down the value chains. The Fed raised interest rates to combat the high inflation, which significantly came down in 2023, though it remains above pre-pandemic levels .

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.

U.S. Bureau of Labor Statistics. " CONSUMER PRICE INDEX ," Page 1.

Edo, Anthony and Melitz, Jacques. " The Primary Cause of European Inflation in 1500-1700: Precious Metals or Population? The English Evidence ." CEPII Working Paper , October 2019, pp. 13-14. Download PDF.

U.S. Bureau of Labor Statistics. " Consumer Price Index: Overview ."

U.S. Bureau of Labor Statistics. " Chapter 17. The Consumer Price Index (Updated 2-14-2018) ," Page 2.

U.S. Bureau of Labor Statistics. " Consumer Price Index Chronology ."

U.S. Bureau of Labor Statistics. " Producer Price Index Frequently Asked Questions (FAQs) ," Select "4. How does the Producer Price Index differ from the Consumer Price Index?"

U.S. Bureau of Labor Statistics. " Producer Price Index Frequently Asked Questions (FAQs) ," Select "3. When did the Wholesale Price Index become the Producer Price Index?"

U.S. Bureau of Labor Statistics. " Producer Price Indexes ."

U.S. Bureau of Labor Statistics. " Consumer Price Index Historical Tables for U.S. City Average ."

U.S. Bureau of Labor Statistics. " Historical CPI-U ," Page 3.

Adam Smith Institute. " The Cantillion Effect ."

Foundation for Economic Education. " The Current Economic Crisis and the Austrian Theory of the Business Cycle ."

Board of Governors of the Federal Reserve System. " Review of Monetary Policy Strategy, Tools, and Communication ."

Board of Governors of the Federal Reserve System. " What is the Lowest Level of Unemployment that the U.S. Economy Can Sustain? "

Fischer, Stanley and et al. " Modern Hyper- and High Inflations ." Journal of Economic Literature , vol. 40, no. 3, September 2002, pp. 837.

Federal Reserve History. " The Great Recession and its Aftermath ."

Federal Reserve Bank of New York. " Liberty Street Economics: Ten Years Later—Did QE Work? "

Congressional Budget Office. " How the Federal Reserve’s Quantitative Easing Affects the Federal Budget ."

Board of Governors of the Federal Reserve System. " FAQs: Why Does the Federal Reserve Aim for Inflation of 2 Percent Over the Longer Run? "

European Central Bank. " How Quantitative Easing Works ."

Reserve Bank of India. " Monetary Policy ," Select "The Monetary Policy Framework."

Central Bank of Brazil. " Inflation Targeting Track Record ."

TreasuryDirect. " Treasury Inflation-Protected Securities (TIPS) ."

University of Illinois, Urbana-Champaign. " 1920s Hyperinflation in Germany and Bank Notes ."

Rossini, Renzo (Editors Alejandro M. Werner and Alejandro Santos). " Staying the Course of Economic Success: Chapter 2. Peru’s Recent Economic History: From Stagnation, Disarray, and Mismanagement to Growth, Stability, and Quality Policies ." International Monetary Fund, September 2015.

Kramarenko, Vitaliy and et al. " Zimbabwe: Challenges and Policy Options after Hyperinflation ." International Monetary Fund , June 2010, no. 6.

The World Bank. " Inflation, Consumer Prices (Annual %) ."

Federal Reserve Bank of St. Louis, FRED. " Consumer Price Index for All Urban Consumers: All Items in U.S. City Average ."

Board of Governors of the Federal Reserve System. " Open Market Operations ."

• What is Inflation: Causes and Impact on Consumers 1 of 41
• 10 Common Effects of Inflation 2 of 41
• How to Profit From Inflation 3 of 41
• When Is Inflation Good for the Economy? 4 of 41
• History of the Cost of Living 5 of 41
• Why Are P/E Ratios Higher When Inflation Is Low? 6 of 41
• What Causes Inflation? How It's Measured and How to Protect Against It 7 of 41
• Understand the Different Types of Inflation 8 of 41
• Wage Push Inflation: Definition, Causes, and Examples 9 of 41
• Cost-Push Inflation: When It Occurs, Definition, and Causes 10 of 41
• Cost-Push Inflation vs. Demand-Pull Inflation: What's the Difference? 11 of 41
• Inflation vs. Stagflation: What's the Difference? 12 of 41
• What Is the Relationship Between Inflation and Interest Rates? 13 of 41
• Inflation's Impact on Stock Returns 14 of 41
• How Does Inflation Affect Fixed-Income Investments? 15 of 41
• How Inflation Affects Your Cost of Living 16 of 41
• How Inflation Impacts Your Savings 17 of 41
• How Inflation Impacts Your Retirement Income 18 of 41
• What Impact Does Inflation Have on a Dollar's Value Over Time? 19 of 41
• Inflation and Economic Recovery 20 of 41
• What Is Hyperinflation? Causes, Effects, Examples, and How to Prepare 21 of 41
• Why Didn't Quantitative Easing Lead to Hyperinflation? 22 of 41
• Worst Cases of Hyperinflation in History 23 of 41
• How the Great Inflation of the 1970s Happened 24 of 41
• What Is Stagflation, What Causes It, and Why Is It Bad? 25 of 41
• Understanding Purchasing Power and the Consumer Price Index 26 of 41
• Consumer Price Index (CPI): What It Is and How It's Used 27 of 41
• Why Is the Consumer Price Index Controversial? 28 of 41
• Core Inflation: What It Is and Why It's Important 29 of 41
• What Is Headline Inflation (Reported in Consumer Price Index)? 30 of 41
• What Is the GDP Price Deflator and Its Formula? 31 of 41
• Indexation Explained: Meaning and Examples 32 of 41
• Inflation Accounting: Definition, Methods, Pros & Cons 33 of 41
• Inflation-Adjusted Return: Definition, Formula, and Example 34 of 41
• What Is Inflation Targeting, and How Does It Work? 35 of 41
• Real Economic Growth Rate: Definition, Calculation, and Uses 36 of 41
• Real Gross Domestic Product (Real GDP): How to Calculate It, vs. Nominal 37 of 41
• Real Income, Inflation, and the Real Wages Formula 38 of 41
• Real Interest Rate: Definition, Formula, and Example 39 of 41
• Real Rate of Return: Definition, How It's Used, and Example 40 of 41
• Wage-Price Spiral: What It Is and How It’s Controlled 41 of 41

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Home — Essay Samples — Economics — Political Economy — Inflation

Essays on Inflation

Inflation essay topics and outline examples, essay title 1: understanding inflation: causes, effects, and economic policy responses.

Thesis Statement: This essay provides a comprehensive analysis of inflation, exploring its root causes, the economic and societal effects it generates, and the various policy measures employed by governments and central banks to manage and mitigate inflationary pressures.

• Introduction
• Defining Inflation: Concept and Measurement
• Causes of Inflation: Demand-Pull, Cost-Push, and Monetary Factors
• Effects of Inflation on Individuals, Businesses, and the Economy
• Inflationary Policies: Central Bank Actions and Government Interventions
• Case Studies: Historical Inflationary Periods and Their Consequences
• Challenges in Inflation Management: Balancing Growth and Price Stability

Essay Title 2: Inflation and Its Impact on Consumer Purchasing Power: A Closer Look at the Cost of Living

Thesis Statement: This essay focuses on the effects of inflation on consumer purchasing power, analyzing how rising prices affect the cost of living, household budgets, and the strategies individuals employ to cope with inflation-induced challenges.

• Inflation's Impact on Prices: Understanding the Cost of Living Index
• Consumer Behavior and Inflation: Adjustments in Spending Patterns
• Income Inequality and Inflation: Examining Disparities in Financial Resilience
• Financial Planning Strategies: Savings, Investments, and Inflation Hedges
• Government Interventions: Indexation, Wage Controls, and Social Programs
• The Global Perspective: Inflation in Different Economies and Regions

Essay Title 3: Hyperinflation and Economic Crises: Case Studies and Lessons from History

Thesis Statement: This essay explores hyperinflation as an extreme form of inflation, examines historical case studies of hyperinflationary crises, and draws lessons on the devastating economic and social consequences that result from unchecked inflationary pressures.

• Defining Hyperinflation: Thresholds and Characteristics
• Case Study 1: Weimar Republic (Germany) and the Hyperinflation of 1923
• Case Study 2: Zimbabwe's Hyperinflationary Collapse in the Late 2000s
• Impact on Society: Currency Devaluation, Poverty, and Social Unrest
• Responses and Recovery: Stabilizing Currencies and Rebuilding Economies
• Preventative Measures: Policies to Avoid Hyperinflationary Crises

Exploring The Implications of The Inflation Reduction Act

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Increasing Inflation Impact on Individuals Essay

Inflation refers to a general increase in the prices of basic commodities and services, usually taken to represent an average spending pattern (Mankiw, 2012). In simpler terms, inflation is the rise in the cost of living due to an exaggerated increase in commodity prices. As inflation sets in, both individuals, corporations, and the government usually feels its impacts. However, a significant increase in the level of inflation will cause numerous impacts on me as an individual.

Since inflation means a rise in prices of common and basic goods, my purchasing power will reduce since the income shall remain constant as prices rise up (Sexton, 2007). This is because the rate of inflation affects the currency’s purchasing power. As inflation rises, the value of the currency reduces proportionately or even at a higher rate pattern (Mankiw, 2012). Generally, the prevailing rate of inflation dictates the number of goods that I will be able to afford. As the cost of basic such as fuel prices, its trickle-down effects are manifold. The energy prices will increase the prices of foodstuffs such as grains since the machinery costs used in production shall have increased.

Because of a rise in the cost of living, it will lead to lower standards of living since inflation negatively influences the comfort of life. To demonstrate this impact, clearly, there shall be a shift from spending on leisure activities toward basic commodities.

Inflation influences budgeting and planning for investment. Ordinarily, inflation is a phenomenon that happens without the prior and perfect knowledge of an individual, and as such, planned budgets are affected. The confusion created by an uncertain increase in both costs and prices eventually hampers the planning process (Sexton, 2007). Similarly, the amount planned for investment will reduce hence causing a detriment in my overall investment base.

Inflation causes money to lose its value due to a rise in the price level. Since I am a regular saver, the rising inflation will affect me in the sense that I will lose confidence in the currency as a measure of value. This is because the rate of savings will be lower than the inflation resulting in a negative real interest rate on savings (Madura, 2006). For instance, if the per year inflation rate is at 6% while the nominal rate on savings is 3%, it means that the real interest rate on my savings is -3%.

The other effect of inflation will be tendencies of food shortages on the market occasioned by hoarding by sellers. Market analysis shows that an anticipated increase in inflation stimulates hoarding since sellers withhold goods with a view to selling at a higher price. Sellers will begin to cause physical scarcity of food and other products on the market since they would be anticipating better prices in the future (Sexton, 2007). As an individual, it will become difficult to access basic items, and if available, their prices will be excessively farther than what I can afford.

However, I will also be able to benefit from the government intervention plans and policy adjustments geared towards addressing inflation (Madura, 2006). The government’s policy to amend the nominal rates in order to cushion the savers will automatically be advantageous to me. As such, I will be motivated to increase my savings and investment in order to meet my future investment objectives.

Madura, J. (2006). Introduction to business . New York, NY: Cengage Learning.

Mankiw, N.G. (2012). Principles of macroeconomics (6 th .). Mason, OH: South-Western, Cengage Learning.

Sexton, R. L. (2007). Exploring Economics . New York, NY: Cengage Learning.

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• Nominal versus Real Gross Domestic Product
• Nominal and Real GDP Growth Rates
• Economic Issues: Real and Nominal Variables
• Maintenance of Stable Pricing
• Inflation Expectations: Households and Forecasters
• Macroeconomic Elements: the Reduction of Oil Prices
• Inflation Targeting in Emerging Economies
• United Arab Emirates and Norway Economies

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With Inflation This High, Nobody Knows What a Dollar Is Worth

Strong reactions to rising prices and misunderstandings about the value of money are rampant, our columnist says.

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By Jeff Sommer

Jeff Sommer writes Strategies , a weekly column on markets, finance and the economy.

Rising prices have made people grumpy. They have depressed consumer confidence , despite a growing economy and low unemployment.

But exactly how inflation is hurting, helping and confusing people is hard to understand. Everyone knows that the cost of living has increased. Yet unless you’re constantly pulling out a calculator, you’re unlikely to know whether your wages are keeping up with inflation, whether the stock market has actually hit a real peak or whether a lottery jackpot is as sweet as the marketers claim.

There’s a fancy name for the common human failure to see past the gaudy prices largely created by inflation. This widespread inability to recognize what money is really worth is known as money illusion.

Irving Fisher, a Yale economist, wrote a book about it nearly a century ago. John Maynard Keynes , the British economist, popularized the idea. Behavioral economists have studied it extensively. But their insights tend to be forgotten when prices are fairly stable, as they were in the United States until three years ago.

When inflation increases annually at 2 percent or so, who really cares about it? You can function well without thinking about the slowly eroding value of your money — although old-timers notice it because even at a 2 percent annual inflation rate, prices double every 36 years.

But now that we’ve been living with high inflation for a while, everyone is prone to money illusion, to one extent or another.

Consider that a March 2021 dollar is worth less than 85 cents today, according to the government’s Consumer Inflation Index calculator . When I keep that number in my head, the dollars in my bank account look especially unimpressive. (And I’ve been working full-time since the summer of 1977. The calculator says that every dollar I earned in my first job is worth only 19 cents in 2024 money. Yikes!)

Of course, everyone knows by now that the purchasing power of the dollar has dropped. When the price of products you see every day has gone up — a gallon of gasoline, a loaf of bread, a cup of coffee — you know prices have risen.

Even so, it’s easy to slip back into thinking a dollar is simply worth a dollar, and that it always has been.

Stocks and the Lottery

Certain aspects of inflation’s toll on the markets are extensively chronicled — yet, I think, the profound effects of inflation on stocks and bonds are still widely underestimated.

First, a few things about inflation’s costs are clear. Because the Federal Reserve has been fighting inflation, short-term rates are high. And several consecutive months of bad inflation readings have made it unlikely that the Fed will cut rates soon. In the bond market, which responds to the Fed’s signals and to traders’ judgments about inflation and economic growth, yields have surged. As a result of all this, a range of consumer credit rates steepened. These include mortgages, credit cards and personal loans.

In addition, the dawning realization this month that the Fed is in no rush to lower interest rates stalled the stock market.

I wrote about a less well-known aspect of inflation recently. The frequent exuberant references to new peaks in the S&P 500 during the recent bull rally didn’t take rising consumer prices into account. (They used what economists call nominal prices, not real ones.) On an inflation-adjusted basis, the stock market only in March approached a new peak for the first time in years. I relied on an analysis by Robert Shiller, a Yale economist, who has long used inflation-adjusted data to pierce the veil of money illusion. Because of setbacks in the past few weeks — high inflation and a faltering stock market — the market has fallen below peak levels in real terms.

Using nominal returns in an inflationary era can lead you to the erroneous conclusion that market is generating phenomenal returns.

Here’s another product of money illusion, one that state governments are exploiting relentlessly: lottery jackpots. As I wrote in March, a spate of recent huge jackpots have been artificially pumped up by questionable marketing practices, high interest rates and inflation.

When used by skilled marketers, money illusion can make unwary humans so excited that they will pour hard-earned money into chimeras, like lotteries and frothy stock markets.

Unhappy Workers

The old refrain, that the rent is too damn high, is resonating now. Steep housing costs are embedded in government indexes and account for a substantial part of recent official inflation increases.

Wages are another nagging problem. Numerous surveys show that many working people believe their wages haven’t kept up with the cost of living. Whether they actually have kept up is debatable. The official data on average wages is volatile and difficult to interpret.

Meticulous research by the economists David Autor, Annie McGrew and Arindrajit Dube shows that for lower-income people, real wages have risen, erasing nearly 40 percent of the longstanding wage gap between richer and poorer workers in the United States.

Even so, because inflation in essentials like food, housing and transportation stresses lower-income people more acutely than the rich, it’s not clear that those wage increases are well appreciated.

In fact, research by Stefanie Stantcheva, a scholar at Harvard and the Brookings Institution, building on earlier work by Professor Shiller, finds that it’s not.

People tend to blame the government for the pain of inflation, and to give themselves credit for raises they have received — even while feeling angry that those raises don’t seem to be keeping up with the cost of living.

That’s a core issue when inflation is high. “Money Illusion,” a classic 1997 paper by the economists Eldar Shafir and Peter Diamond and the psychologist Amos Tversky, found that in periods of high inflation, employers can get away with giving workers raises that amount to substantial wage cuts on an inflation-adjusted basis.

Say inflation is rising at a 4 percent annual rate, and you get a 2 percent raise. You’ve just received a real wage cut. If there’s no inflation, and your wage is cut by 1 percent, you’ve also gotten a wage cut — but you’ve lost less money than in the case of high inflation. What’s odd is that workers tend to view the bigger real wage cuts as fairer.

This makes sense, the authors say, when you factor in money illusion.

Where We Are Now

At the moment, consumer sentiment surveys are skewing lower than they have in periods that were similar in economic growth and employment. Neale Mahoney and Ryan Cummings , two economists at Stanford, think inflation, and lingering dissatisfaction with price levels, may well be the cause.

Looking back at past periods of high inflation, they have done some rough calculations that show that the negative effects of inflation on consumer sentiment erode 50 percent each year. In other words, they have a half life of about one year.

Professor Mahoney updated the research at my request. In the three years through March, prices rose 17.9 percent. According to his model — and, crucially, assuming the rate of inflation drops immediately to the Fed’s forecast of 2.5 percent annually — there would be an eight percentage point increase in consumer sentiment by November. There happens to be a national election then.

Mr. Mahoney and Mr. Cummings both served in the Biden administration. If they are right — and, if inflation really drops quickly and stays low — the improvement in the national mood could tilt the outcome of the election.

But inflation has defied economists’ prediction efforts over the past few years. I make no assumptions.

Certainly, I hope inflation will fall and it will be safe to live an ordinary life without thinking about money illusion. But it will take a long while for me to unsee the shrinking dollar.

An earlier version of this article misspelled the surname of one of the economists who conducted research on wage trends. She is Annie McGrew, not McGraw.

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Jeff Sommer writes Strategies , a weekly column on markets, finance and the economy. More about Jeff Sommer