Inflation is an increase in the average price level of goods and services over time. It happens when the total of all goods and services demanded exceeds production, or when there is a decrease in the amount of all goods and services supplied by producers.
Let's take a look at two economic scenarios. If business is booming, unemployment is low, and wages are increasing, consumers have more disposable income available to purchase goods and services. Therefore, average prices will tend to rise due to the increase in demand for all goods and services.
However, if the economy is suffering and wages remain stagnant, consumers are unable to purchase additional goods and services. As a result, producers slow down production and raise prices to cut their losses, and average prices rise due to a decrease in the supply of all goods and services.
Of course, consumers are not the only market participants that affect the economy. Businesses, government agencies, and foreign markets spend billions of dollars on U.S. goods and services, and their spending can also influence supply and demand, which, in turn, can result in inflation.
Inflation and Economic Policy Decisions
Some inflation is normal in a healthy economy; one of the United States' economic policy goals is to maintain a 0-3% annual inflation rate. However, too much inflation, or no inflation at all, is a bad sign.
Two types of federal economic policies are used to control the economy and manipulate inflation. Fiscal policy, made by Congress, uses taxation and spending to promote employment, stabilize prices, and boost economic growth; monetary policy, controlled by the Federal Reserve Bank (the Fed), manipulates the money supply and short-term interest rates to spur growth or control inflation.
Congress and the Fed look at the monthly Consumer Price Index (CPI) when making policy decisions. The CPI gauges the average change in prices paid by urban consumers for a fixed market basket of goods and services over a period of time. If the CPI rises too fast, Congress or the Fed will take measures to bring the rate of inflation down. The Fed reacts more quickly, since Congress requires political debate and the passage of legislation before fiscal decisions can be carried out.
Inflation and Personal Economics
In sound economic times, price increases are usually accompanied by wage increases that keep pace with inflation. However, during downturns in the economy when wages remain level, the cost of living increases and purchasing power diminishes. One of your greatest challenges in saving and investing will be making your investments work harder to exceed inflation. Therefore, you should always take inflation into consideration when you save, invest, and make purchase decisions.