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Definition
Inflation is the general rise in the prices of goods and services over time. As prices rise, each unit of money buys less, so inflation is also described as a loss of purchasing power.
How it works
Inflation is measured with price indexes, most often a consumer price index (CPI), which tracks the cost of a fixed basket of everyday goods and services. The inflation rate is the percentage change in the index, usually compared with the same month a year earlier: inflation = (index now − index a year ago) ÷ index a year ago × 100. Each country's statistics agency publishes its own figures.
Rising prices can come from strong demand, higher costs such as energy or wages, or growth in the money supply. Many central banks aim for inflation of about 2% a year and tend to raise interest rates when it runs above target, which slows borrowing and spending. Deflation is the opposite, a general fall in prices, while disinflation means prices are still rising but more slowly.
For savers and investors, inflation turns a nominal return into a smaller real return: real return = (1 + nominal return) ÷ (1 + inflation) − 1. Cash that earns less than inflation loses purchasing power even though its balance does not fall. Over long periods the effect compounds, so even a moderate rate makes a large difference. Personal inflation can also differ from the official figure, because each household buys a different mix of goods.
Example (hypothetical numbers)
Suppose inflation is 4% a year and a basket of goods costs $1,000 today.
After 1 year it costs $1,000 × 1.04 = $1,040; after 10 years it costs $1,000 × 1.04^10 = about $1,480.
$1,000 kept in cash would then buy only about $1,000 ÷ 1.04^10 = $676 worth of today's goods.
Savings earning 5% a year give a real return of (1.05 ÷ 1.04) − 1 = about 0.96% a year, not 5%.
A moderate inflation rate, compounded over years, takes a large share of the money's purchasing power.
Common mistakes
- Judging savings or returns in nominal terms without adjusting for inflation.
- Thinking that falling inflation means prices are falling.
- Assuming the official inflation rate matches every household's own cost increases.
Related calculators
This glossary is for education only and is not investment advice. Examples use hypothetical numbers.