The Reason Why You Should Know About Inflation

To understand inflation you must learn about its causes, how it can be measured, how it affects investors, savers, borrowers and how it can be controlled.

Inflation is the increase in the general price level of goods and services. In an economy, prices increase when a particular good or service gets more expensive. The Federal Reserve defines price stability as a long-run inflation rate of around 2% per year, a benchmark that guides monetary policy decisions across the United States.

Inflation can affect any market segment, although, over time, it has been primarily experienced by buying power of lower-income groups due to higher cost factors such as oil, healthcare, and fuel prices (in terms of inflation-adjusted value). High inflation rates often result in increased interest rates to combat it. Inflation is also one factor that allowed nations with solid central banks to avoid the Great Depression but historically has long been recognized as one cause among many for problems associated with high debt levels in some countries.

How is inflation measured?

Inflation is not an easy thing to measure. There are multiple ways of measuring inflation, and depending on the country and institution, different measurements may have different meanings. For example, in the United States, there is the Personal Consumption Expenditures Price Index (PCE), which the Federal Reserve uses as its primary inflation gauge. There is also the Producer Price Index (PPI), published by the Bureau of Labor Statistics, which tracks price changes from the seller’s perspective. In Germany, there is the Consumer Price Index (CPI). The United Kingdom has a different measurement called Retail Prices Index (RPI). How these indices work depends on how the index operators collect prices for goods and services in their components. Some indices are based on the so-called “market basket of goods,” collected from stores and monitored over time to determine if prices change. Other indices are based on the prices of individual goods and services. There is a third way of measuring inflation: the implicit price deflator (IPD), used by the Bureau of Economic Analysis when calculating real GDP growth.

What causes inflation?

Various factors can cause inflation but usually boils down to the amount of money in circulation. When more money is in circulation, prices go up. Economists refer to this as demand-pull inflation, where too many dollars chase too few goods. A second cause, cost-push inflation, occurs when production costs — such as oil, wages, or raw materials — rise sharply, forcing businesses to pass those costs on to consumers. The International Monetary Fund (IMF) identifies both of these as primary inflation drivers in its economic research. The inflation levels are generally measured as a percentage change from the previous period. For example, if the price level goes up 10% from last year, the inflation rate will be 10%. However, inflation doesn’t always mean prices increase. It can also mean that in specific market segments, such as commercial buildings, people pay less for the same thing. This is because buildings are getting more efficient, and there is less construction waste, increasing their efficiency.

What is an example of inflation?
The industrial revolution, starting in England in the late 18th century, led to a dramatic increase in the volume of goods and services produced and consumed at each point on a consumption path. To facilitate the production of these wide-ranging products, which included clothing, food, and housing, the capital markets in some countries developed financial tools that allowed investors to purchase production services from many small suppliers. A more modern example is the post-2020 inflationary period, during which the Federal Reserve raised the federal funds rate aggressively — from near 0% to over 5% between 2022 and 2023 — in an effort to bring inflation back toward its 2% target.

How can inflation be controlled?
When the time comes to control inflation, there are many ways to control it. The government can try to stabilize the money supply and interest rates, usually combined with wage and price controls. A central bank buying government bonds can also control inflation. If government bonds are purchased and held as assets, then interest rates will tend to be lower than if the bond is sold into the market. The difference in interest payments on the bond sold and held will cover the extra cost of inflation over time. The central bank has to be careful in what it does and when it does it, as the impact of its actions will affect the market. The Federal Open Market Committee (FOMC) meets eight times per year specifically to evaluate inflation data and set the federal funds rate accordingly.

The relation between inflation and profit margins is a crucial indicator of how stable prices are and how much room there is for wage increases. If wages go up, the price of products goes up, which means a decrease in sales. In turn, businesses will react by firing workers to cut costs. This cycle leads to unemployment, which can cause more people to stop spending money on products and services. Financial platforms like SoFi note that this wage-price spiral is one of the most difficult inflationary dynamics for central banks to unwind once it takes hold.

The interest rate is the price of money. A high-interest rate creates prosperity, and a low-interest rate causes inflation. The balance between interest rates and inflation determines prosperity or recession. When the federal funds rate rises, so do the annual percentage rates (APRs) on consumer products — credit cards, auto loans, and mortgages all become more expensive to carry. According to NerdWallet’s 2025 data, the average credit card APR in the United States reached over 20% following multiple Federal Reserve rate hikes, a direct consequence of the inflation-fighting cycle.

How does inflation affect investment returns?
When inflation is high, the nominal return on investment is lower. Inflation decreases the purchasing power of income and requires higher returns to provide a real return (i.e., maintain the purchasing power). The investor can compensate for inflation by selling at a higher price to realize a capital gain, but unless other forces are increasing the value of the asset, such as increased demand or decreased supply of similar investments, it will not increase in value as much as compensation for inflation would have. The investor can also hold an investment until the price increases enough to compensate for inflation. Still, if inflation is higher than the return, acquiring an equivalent value of money will take longer. Treasury Inflation-Protected Securities (TIPS), offered through TreasuryDirect, are one instrument specifically designed to protect investors from this erosion, as their principal adjusts automatically with CPI changes.

What does inflation mean to investors?
If inflation rises, the actual cost of investments will increase. This means that the percentage return is reduced. If inflation is higher than the nominal return, there will be an actual loss. To calculate what an investor could lose from inflation, the investor needs to establish the inflation rate (CPI) and the nominal return on investment. Tools from institutions like Chase and Experian can help investors model real versus nominal returns and understand how a debt-to-income (DTI) ratio can shift during inflationary periods when income does not keep pace with rising costs.

What does inflation mean to savers?
Inflation affects banks by reducing profits, which means that the interest earned on deposits is less than the interest rate on other loans. Savers cannot make a profit when inflation is high, but they would gain if inflation were low. A higher interest rate will be required to make high-interest savings schemes attractive, given the inflation problems. The FDIC advises consumers to compare high-yield savings account rates against the current CPI when evaluating whether their savings are keeping pace with inflation. When a saver’s FICO Score is strong, they are also better positioned to access higher-yield financial products that may partially offset inflation’s impact on their purchasing power.

What does inflation mean to borrowers?
Borrowers tend to benefit from inflation because they repay the loan using money worth less. The CPI does not take into account the time value of money. The Consumer Financial Protection Bureau (CFPB) explains that fixed-rate mortgage borrowers, in particular, can see a real benefit during inflationary periods — the nominal dollar value of their monthly payment stays the same while the real value of that payment declines over time as money loses purchasing power.

The first lesson learned from the causes of inflation is that inflation is caused by too much money in circulation. The second lesson is that you can control inflation by controlling the money supply, interest rates, and the amount of money in circulation. The third lesson is that inflation increases profits for those who pay wages, which means higher profits for businesses. The fourth lesson is that investors can make a real gain when inflation decreases. The final lesson is that savers can make a real profit when inflation increases.

Frequently Asked Questions

What is inflation in simple terms?

Inflation is the gradual increase in the price level of goods and services over time, which reduces the purchasing power of money. A dollar today buys less than a dollar did ten years ago because of inflation. The Federal Reserve targets an annual inflation rate of 2% as a healthy benchmark for the U.S. economy.

What are the main causes of inflation?

The main causes of inflation are demand-pull inflation (too much consumer demand chasing limited goods), cost-push inflation (rising production costs passed on to consumers), and built-in inflation (wage-price spirals). Excess money supply is the root driver in most cases, which is why central banks like the Federal Reserve closely monitor money circulation and set interest rate policy accordingly.

How is inflation measured in the United States?

In the United States, inflation is primarily measured using the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) Price Index. The CPI is published monthly by the Bureau of Labor Statistics and is used to calculate cost-of-living adjustments. The PCE is published by the Bureau of Economic Analysis and is the Federal Reserve’s preferred inflation measure. The Producer Price Index (PPI) also tracks inflation from the seller’s perspective.

What is a good inflation rate?

Most economists and the Federal Reserve consider 2% annual inflation to be a healthy target rate. At this level, inflation is low enough that it does not significantly erode purchasing power, but high enough to allow businesses and workers some pricing flexibility. Inflation significantly above or below this target signals economic imbalance.

How does inflation affect my savings account?

Inflation directly reduces the real value of money sitting in a savings account. If your savings account earns 1% interest but inflation is running at 4%, your real return is negative 3% — meaning your money is actually losing purchasing power each year. The FDIC recommends comparing your savings yield against the current CPI to understand whether your savings are keeping pace with rising prices.

How does inflation affect borrowers?

Borrowers generally benefit from inflation when they hold fixed-rate loans. Because they repay the debt with dollars that are worth less than when they borrowed, the real cost of their debt declines over time. For example, a homeowner with a fixed-rate 30-year mortgage at a set monthly payment effectively pays less in real terms as inflation rises — one of the few groups that can benefit from a high-inflation environment, as noted by the CFPB.

How does the Federal Reserve control inflation?

The Federal Reserve controls inflation primarily by adjusting the federal funds rate through the Federal Open Market Committee (FOMC). Raising the federal funds rate makes borrowing more expensive, which slows consumer spending and business investment, reducing demand-pull inflation. The Fed can also use open market operations — buying or selling government bonds — to influence the money supply directly. These tools take 12 to 18 months on average to fully affect inflation, according to the Federal Reserve’s own research.

What is the difference between CPI and PCE inflation measures?

The CPI measures the price change of a fixed basket of goods and services purchased by urban consumers, while the PCE adjusts its basket dynamically based on actual consumer spending patterns. As a result, the PCE tends to run about 0.3 to 0.5 percentage points lower than the CPI. The Federal Reserve prefers the PCE because it better captures how consumers substitute cheaper products when prices rise, giving a more accurate picture of real-world spending behavior.

What is hyperinflation and how does it occur?

Hyperinflation is an extreme form of inflation where prices rise uncontrollably — often defined as price increases of more than 50% per month. It typically occurs when a government prints excessive amounts of money to cover fiscal deficits, causing the currency to lose value rapidly. Historical examples include Zimbabwe in the 2000s and Germany during the Weimar Republic in the 1920s. The IMF has identified weak central banking institutions and unsustainable government spending as the primary causes.

How does inflation affect my credit card APR?

Inflation leads the Federal Reserve to raise the federal funds rate, which directly pushes up the prime rate — the baseline rate that banks use to set variable APRs on credit cards. When the federal funds rate rises, credit card APRs follow almost immediately. According to NerdWallet’s 2025 data, the average credit card APR in the U.S. exceeded 20% following recent rate hikes, meaning carrying a balance during a high-inflation period becomes significantly more expensive for consumers.