Inflation instantly brings to mind images of rising prices, shrinking paychecks and unhappy consumers, but is inflation all bad?

Inflation is defined as a "sustained increase in the general level of prices for goods and services." Many consumers fear inflation because it reduces the purchasing power of their money. The influence that inflation has on consumers in the United States and other developed nations can be seen in gasoline prices, to name one example. When the price of gasoline goes up, it costs you more money to fill up your vehicle at the gas pump. Although the amount of money allocated to fuel takes a bigger percentage of your paycheck, you get the same amount of gas. This hit to your bottom line leaves you with less money to spend on other items.

In less-developed countries, food price inflation is an ever-greater concern. When the price of basic food items increases significantly, low-income consumers experience severe hardships. In recent years, food price inflation has resulted in public demonstrations and rioting in numerous countries across the globe, including Chile, Morocco, Tunisia and Algeria.

Measuring Inflation
There are several ways to measure inflation. Headline inflation is the raw inflation figure as reported through the Consumer Price Index (CPI). The Bureau of Labor Statistics releases the CPI monthly. It calculates the cost to purchase a fixed basket of goods as a way of determining how much inflation is occurring in the broad economy as an annual percentage increase. For example, a headline inflation figure of 3% equates to a monthly rate that, if repeated for 12 months, would create 3% inflation for the year.

The headline inflation figure is not adjusted for seasonal changes in the economy or for the often-volatile elements of food and energy prices. Headline inflation is the measure that has the most meaning for consumers, as we have to eat food and fuel our cars.

Core inflation, which is the Federal Reserve's preferred yardstick, is a measure of inflation that excludes food and energy. Core inflation eliminates these items because they can have temporary price shocks that can diverge from the overall trend of inflation and give what the prognosticators at the Federal Reserve view as a false measure of inflation. Core inflation is most often calculated by taking the Consumer Price Index and excluding certain items (usually energy and food products). Other methods of calculation include the outliers method, which removes the products that have had the largest price changes. Core inflation is thought to be an indicator of underlying long-term inflation.

Several variations on inflation are also worth noting. Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in a single month.

Stagflation is the combination of high unemployment and economic stagnation with inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with OPEC raising oil prices. At the other end of the spectrum is deflation, which occurs when the general level of prices is falling. This is the opposite of inflation.

The Good Side of Inflation
Inflation has such a negative connotation that many people fail to consider the good side of inflation. Yes, inflation means that it costs more money to purchase items that were previously available at a lower price. However, it can also mean that the prices of homes, precious metals, stocks, bonds and other assets are rising. For the owners of those assets, inflation can have a wealth-building effect. Inflation can also result in rising wages. If wages rise as quickly as the cost of goods and services, then the rising wages can offset the rising prices.

Monetary Policy
The United States, Great Britain and some other nations have set targets for the desired inflation rate. A January 2012 press release issued by the Federal Reserve's Federal Open Market Committee sums up the policy in the U.S. and highlights the reasons behind it.

"The inflation rate over the longer run is primarily determined by monetary policy, and hence, the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2%, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates, and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances."

That short paragraph sum up a complex and controversial set of issues. It starts with the Federal Reserve (Fed), the central bank in the U.S. and its dual objectives of maintaining a modest level of inflation and a low rate of unemployment. In order to achieve these objectives, the Fed controls monetary policy. The term "monetary policy" refers to the actions that the Federal Reserve undertakes to influence the amount of money and credit in the U.S. economy. Changes to the amount of money and credit affect interest rates (the cost of credit) and the performance of the U.S. economy. To state this concept simply, if the cost of credit is reduced, more people and firms will borrow money and spend it, and this spending will then foster economic growth. Similarly, if interest rates increase, it costs more to borrow money. When this happens, fewer people and firms borrow money, which results in decreased spending and slower economic growth.

The Bottom Line
Putting it all together, the Fed uses its tools to control the supply of money to help stabilize the economy. When the economy is slumping, the Fed increases the supply of money to spur growth. This fuels inflation. Conversely, when inflation is threatening, the Fed reduces the risk by shrinking the supply. It all sounds simple enough until you view it in the context of the many other factors that influence the economy in the U.S. In this larger context, monetary policy, inflation and just about everything else associated with these topics become fodder for economists, politicians, academics and just about everyone else to discuss and debate.

Related Articles
  1. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  2. Investing

    The Hunger Games Economy: 5 Unanswered Questions About Panem

    The Hunger Games's fictitious nation of Panem has technology, black markets, and government. But, we know precious little about Panem's economy and the reasons for its rampant inequality.
  3. Economics

    Understanding Donald Trump's Stance on China

    Find out why China bothers Donald Trump so much, and why the 2016 Republican presidential candidate argues for a return to protectionist trade policies.
  4. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  5. Markets

    What Slow Global Growth Means for Portfolios

    While U.S. growth remains relatively resilient, global growth continues to slip.
  6. Economics

    Will a Hike in Interest Rates Affect the US Dollar?

    Learn about how rising U.S. interest rates affect the U.S. dollar and where the dollar could be heading once the rising rate cycle begins again.
  7. Markets

    Can Deflation Be Good?

    General economic theory consensus rules that deflation is bad for the economy. But the Swiss economy, which is growing despite a drop in prices for the last four years, is proving otherwise. ...
  8. Retirement

    What Was The Glass-Steagall Act?

    Established in 1933 and repealed in 1999, the Glass-Steagall Act had good intentions but mixed results.
  9. Economics

    What to Expect From Mortgage Rates in 2016

    Understand the factors that influence the direction of mortgage rates, and use this information to project what will happen with rates in 2016.
  10. Investing

    World Bank Data For Dummies

    Developing countries can't always afford to track the data crucial to setting the right economic policies and programs. That's where the World Bank steps in.
  1. What are key economic growth rates that can be used to determine the economic health ...

    Before you can determine the proper indicators for economic health, you must understand what causes an economy to grow and ... Read Full Answer >>
  2. How do you make working capital adjustments in transfer pricing?

    Transfer pricing refers to prices that a multinational company or group charges a second party operating in a different tax ... Read Full Answer >>
  3. Are Canadian Pension Plans inflation-protected?

    The Canada Pension Plan protects pension holdings against inflation and adjusts its annual rates for inflation. The Canada ... Read Full Answer >>
  4. When is the best time to invest in inflation-protected securities?

    Investment timing decisions are among the most challenging faced by investors as they have a significant impact on ultimate ... Read Full Answer >>
  5. Should I include inflation-protected securities in my 401(k)?

    One of the most significant challenges faced by 401(k) account owners is the creation of an investment plan that can withstand ... Read Full Answer >>
  6. Is Social Security inflation-protected?

    Social Security benefits are inflation-protected. Social Security was created in 1935, and taxes were collected for the first ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center