What is inflation in simple terms?

Inflation is prices rising across the economy over time, which means each dollar buys less. At 3% inflation, $100 of groceries today costs about $103 next year.

What causes inflation?

The main drivers are strong demand outrunning supply, rising input costs like wages and energy, and expectations of future inflation becoming self-fulfilling.

Is inflation good or bad?

Mild inflation around 2% is considered healthy: it encourages spending and gives central banks policy room. High inflation hurts savers; deflation can spiral into recessions.

What Is Inflation? A Plain-English Explanation

Inflation is the reason a dollar bought more in 1990 than it does today. Here is what causes it, how it is measured, and why a little of it is considered healthy.

Inflation is a sustained rise in the general price level, which shrinks what each dollar buys. It is measured with indexes like the CPI, driven by demand, costs, and money supply, and considered healthy at around 2 percent a year. Above that, savers lose ground unless their money grows faster than prices.

The one-sentence definition

Inflation is a sustained increase in the general level of prices for goods and services. When inflation runs at 3 percent, a basket of goods that costs $100 today costs about $103 a year from now. The flip side is that each dollar buys about 3 percent less.

A single product getting more expensive is not inflation. Inflation means prices rising broadly, across the economy. Your rent, groceries, gas, and haircut all drifting upward together is inflation. One coffee shop raising prices is just that shop.

What causes it

Economists point to three main drivers. Demand-pull inflation happens when spending outruns what the economy can produce, so sellers raise prices. Cost-push inflation happens when inputs like wages, energy, or materials get more expensive and businesses pass the cost on.

The third driver is expectations. If workers and businesses expect 4 percent inflation, workers demand 4 percent raises and businesses raise prices 4 percent to cover them, and the expectation fulfills itself. Central banks fight this channel hardest, because expectations are the hardest driver to reverse.

How it is measured

The best-known measure in the United States is the Consumer Price Index (CPI), published monthly by the Bureau of Labor Statistics. It tracks the price of a fixed basket of goods and services that represents typical household spending, from rent to eggs to medical care.

The Federal Reserve watches a related index, the PCE price index, even more closely when setting interest rates. Both are reported as year-over-year percent changes, which is the number you see in headlines like 'inflation was 3.2 percent last month.'

Why a little inflation is considered healthy

The Federal Reserve targets about 2 percent annual inflation, not zero. Mild inflation encourages spending and investment today rather than hoarding cash, keeps wages able to adjust downward in real terms without nominal pay cuts, and gives central banks room to cut real interest rates in a downturn.

Zero or negative inflation, deflation, sounds pleasant but is dangerous: if prices will be lower next month, everyone delays purchases, spending collapses, debts get heavier in real terms, and the economy can spiral. Japan's experience in the 1990s and 2000s is the cautionary tale.

What inflation means for your money

Cash sitting in a checking account earning nothing loses purchasing power every year inflation is positive. At 3 percent inflation, $10,000 in cash buys what about $7,440 buys after 10 years. That is the quiet tax inflation levies on savers.

The defense is owning assets that grow faster than inflation over time: stocks, real estate, or inflation-protected bonds. Run your own numbers with the inflation calculator to see what a given rate does to your savings over your time horizon.

What Is Inflation?