How Inflation Affects Your Cost of Living

Up until very recently, inflation had not been talked about, and for good reason. In 2019, the overall annual rate of inflation in the U.S. was running at 1.8% according to the World Bank (CPI). In 2020, the rate was 1.2%.

In the summer of 2021, however, inflation began to rear its ugly head once again, with U.S. consumer prices recording their largest annualized increases in more than 13 years. From there, inflation has continued to surge. In 2021, overall inflation was 4.7% and it reached a peak of 9.1% in June 2022. The inflation rate started to come down after that due to interest rate hikes by the Fed to combat the soaring inflation, but it still remains high.

Still, we've been through worse inflationary times. And there's always talk about inflation and cost of living increases, but what do these terms really mean? And most important, how do they affect your daily life?

Key Takeaways

  • Inflation measures the increase in the price of goods and services. Or, the decrease in the buying power of the dollar.
  • Cost of living measures the change, up or down, of the basic necessities of life, like food, housing, and healthcare.
  • Housing prices are affected by many factors but one of the biggest of them is the cost of borrowing.

The Difference Between Inflation and Cost of Living

People often use the phrases inflation and cost of living as if they were synonymous. They are not the same, although they're closely related.

  • Inflation is the big picture. As the cost of goods and services rises, the buying power of the dollar falls. The inflation rate is often measured by the change in the Consumer Price Index (CPI), a monthly measure by the Bureau of Labor Statistics (BLS) that averages the cost of a basket of goods and services from areas around the country. It reports the result as a percentage rise or drop in CPI.
  • Cost of living has a different focus. This number represents the average cost of an accepted standard of living including food, housing, transportation, taxes, and healthcare. Cost of living is frequently used to compare minimum income needs in various locations. According to the Payscale's calculator, as of Oct. 17, 2022, the cost of living in New York City is 155% higher than the national average. As a comparison, cost of living in Chapel Hill, North Carolina is 8% higher than the national average.

Cost of living is a far more difficult number to pin down, and it varies widely among different demographic groups as well as different regions. In 2022, the Social Security Administration raised benefits by 5.9% as a cost-of-living adjustment (COLA). For 2023, it has been raised by 8.7%. Whether your own cost of living goes up or down depends on how you live and where you live.

When the Going Gets Expensive

Most people feel the effects of cost-of-living increases in their daily lives. But rising prices hit the middle-class hard, and the lower-paid harder.

Higher food, gasoline, and utility costs mean less money for savings or discretionary spending. To compensate, consumers buy less, switch to cheaper substitutes, or look harder for bargains.

8.2%

The annual inflation rate for the 12 months ending September 2022 in the U.S.

Inflation Factors That Affect Cost of Living

Investopedia / Ellen Lindner

The Paycheck Factor

It’s especially difficult to keep up with the rising cost of living when your paycheck isn’t growing at a similar rate.

According to the Bureau of Labor Statistics, the median weekly earnings for full-time wage earners was $1,070 in the third quarter of 2022. That's an increase of 6.9% from a year earlier compared to the 8.3% increase in the Consumer Price Index for All Urban Consumers (CPI-U) for the same period.

How Inflation Affects the Housing Market

You would assume that higher inflation means higher prices for real estate, and that is often the case, at least at the start of a significant spike in inflation. But then things can get complicated.

To keep inflation rates under control, the Federal Open Market Committee (FOMC) often steps in and raises the federal funds rate, which is the interest rate charged to other financial institutions using the Federal Reserve Bank.

As the cost of home loans goes up, many consumers are squeezed out of the market, leading to a slowdown in home sales. With homes on the market for longer periods, sellers tend to drop their asking price to attract buyers. 

Lower interest rates helped the U.S. housing market make its recovery after the gut punch of the 2007-2008 financial crisis and then again during the COVID-19 pandemic.

What Is the Relationship Between Inflation and the Cost of Living?

Inflation is the increase in the average price of a basket of goods. Inflation reduces the purchasing power of consumers, meaning that a unit of currency buys less than it did before inflation. The cost of living measures the average cost of the accepted standard of living in a specific area. Inflation can increase the cost of living.

What Are the 3 Causes of Inflation?

The three causes of inflation are demand-pull (when the demand for goods and services is greater than the supply, putting an upward pressure on prices), cost-push (when the total supply of goods and services that can be produced, falls), and built-in inflation, also known as inflation expectations (when workers believe that inflation will continue and demand higher wages to maintain their cost of living; higher wages means higher costs to businesses, which are passed onto consumers as an increase in prices).

Why Is Inflation So High in 2022?

Economists attribute the high inflation in 2022 to shortages due to the supply-chain problems that arose from the Covid-19 pandemic. The difficulty in obtaining materials to produce goods due to the supply-chain issues from the pandemic caused a shortage in the supply of products, driving prices higher. This was combined with a rapid increase in consumer spending from the pandemic due to federal stimulus checks; supply could not meet demand. Exasperating these issues, Russia invaded Ukraine, which threw into disarray the supply of gas and food, causing shortages on that front, which also increased prices.

The Bottom Line

Inflation and cost of living are related metrics but not identical. While inflation measures the average increase in prices of a basket of goods, cost of living looks at the cost of a certain standard of living, which can change by location. Increases in inflation do increase the overall cost of living and if wages are not increasing to match the increase in the cost of goods and services, the value of a consumer's dollar will decrease.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. The World Bank. "Inflation, Consumer Prices (Annual %) - United States."

  2. U.S. Bureau of Labor Statistics. "Consumer Price Index-June 2021," Page 1.

  3. Board of Governors of the Federal Reserve System. "Policy Tools. Open Market Operations."

  4. U.S. Bureau of Labor Statistics. "Consumer Prices Up 9.1 Percent Over the Year Ended June 2022, Largest Increase in 40 Years."

  5. U.S. Bureau of Labor Statistics. "Consumer Price Index: Home."

  6. U.S. Bureau of Labor Statistics. "Consumer Price Index Frequently Asked Questions," Select "What goods and services does the CPI cover?"

  7. Payscale. "Cost of Living Chapel Hill, North Carolina."

  8. Payscale. "Cost of Living in New York, New York."

  9. Social Security Administration. "Cost-of-Living Adjustment (COLA) Information."

  10. U.S. Bureau of Labor Statistics. "Consumer Price Index: September 2022," Page 1.

  11. U.S. Bureau of Labor Statistics. "Usual Weekly Earnings of Wage and Salary Workers Third Quarter 2022," Page 1.

  12. Board of Governors of the Federal Reserve System. "About the FOMC."

  13. Board of Governors of the Federal Reserve System. "FAQs: What Is Inflation and How Does the Federal Reserve Evaluate Changes in the Rate of Inflation?"

  14. U.S. Bureau of Labor Statistics. "Consumer Price Index Frequently Asked Questions," Select "Is the CPI a cost-of-living index?"

  15. Congressional Research Service. "Introduction to U.S. Economy: Inflation," Pages 1-2.

  16. Federal Reserve Bank of San Francisco. "How Much Do Supply and Demand Drive Inflation?"

  17. World Economic Forum. "Why Is Inflation So High and Will It Stay That Way? An Economist Explains."

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