In economic terms, inflation is the decrease in purchasing power—or value—of money. It’s generally measured as an increase in the price of goods and services.
Since inflation affects the entire economy, we need to collect data across the entire economy in order to find and measure inflation. What kind of data? Just think about it…what are all the things you spend money on? There’s housing and transportation. Food is a big category, too.
The BLS has been measuring CPI every year since 1913, so we have accurate inflation dating back to over a century ago. The historical average inflation in the United States is 3.2% per year. Granted, there have been individual years with significantly different inflation rates.
Many economists agree that inflation is easy to identify in hindsight, but is difficult to predict beforehand. However, they will admit that almost all instances of inflation share one common trait: inflation is caused by an increase in the money supply in an economy.
This makes sense, especially if we examine it through the lens of supply, demand, and value. Supply and demand dictate that if the supply of a product goes up while the demand stays stagnant, then the value (or price) of that product will decrease. Too much supply, the price goes down.
For starters, inflation reduces the average person’s spending power. Let’s say you have $12,000 in the bank. That’s great! If your family spends $4,000 per month, that means you have enough money to cover three full months of living expenses. That’s a healthy emergency fund.
Let’s fast forward 10 years. Our $12,000 grows by about 0.5% per year (based on current interest rates in high-yield savings accounts). It grows to $12,600. But our spending also increases by the rate of inflation, which we’ll say is the aforementioned 2.4% per year. We now have to spend $5,000 per month on living expenses instead of $4,000.
Our $12,600 emergency fund now only covers 2.5 months of $5,000 living expenses.We did nothing wrong. We didn’t lose money. We didn’t spend the money. In fact, the interest from our savings account actually gave us some money. And yet we lost ground to inflation. That is why many people despise inflation.