WHAT IS INFLATION?
Inflation is the rate at which prices for goods and services increase. At first, this sounds like a simple concept, but in actuality it is rather complex. Inflation affects numerous aspects of the market and many factors influence it. If prices go up, the current value of the currency is eroded. What could have been purchased a year prior for USD 1.00 might now cost USD 1.03, and if salaries had not risen in tandem with this inflation, the public would have lost purchasing power. From this vantage point, some may see inflation as a bad thing. However, the right balance of inflation and economic growth is important for a healthy economy. An economy that grows too fast can cause high rates of inflation and an economy with slow or no growth can cause low levels of inflation or even deflation (when prices decline). Inflation is one of several key factors that are considered when interest rates are set by the U.S. Federal Reserve. Interest rates determine the cost of borrowing and dictate savings, mortgage, and car loan rates, among others (see Exhibit 1).
In general, economies are expected to grow—not stay the same or slow down. A growing economy (possibly caused by low interest rates) can cause inflation, as consumers in these economies typically feel confident about the future and spend more money. Sellers anticipate this demand and raise prices, creating inflation. This is also known as "demand-pull" inflation. When supply is not keeping up with demand, prices can become even higher. If consumers expect further inflation in the future, they may make purchases sooner in order to avoid higher prices down the road, which in turn benefits economic growth.