Inflation
Also known as: inflation rate
Inflation is a sustained rise in the general price level of goods and services, which reduces the purchasing power of money. It is usually measured as the percentage change in a price index such as the consumer price index.
Inflation describes what happens when the overall price level rises, not merely when one product gets more expensive. Economists track it with price indices: the consumer price index (CPI) follows a fixed basket of goods bought by a typical household, while the GDP deflator covers everything an economy produces. The inflation rate is the percentage change in the index between two periods — if a basket costing 200 one year costs 210 the next, inflation is 5%.
Two mechanisms generate inflation. Demand-pull inflation occurs when aggregate demand outruns the economy's capacity to produce, bidding up prices; cost-push inflation occurs when input costs such as energy or wages rise and producers pass them along, shifting short-run aggregate supply. Sustained inflation is generally tied to growth in the money supply outpacing growth in real output. Related terms describe the extremes: disinflation is a slowing rate of inflation, deflation is a falling price level, and hyperinflation is an accelerating collapse in the value of money.
Inflation matters because it redistributes wealth and distorts decisions. It erodes the real value of fixed payments, hurting savers, retirees on fixed incomes, and lenders holding fixed-rate loans, while benefiting borrowers who repay in cheaper money. It also drives the distinction between nominal and real values — a nominal interest rate minus the inflation rate gives the approximate real return, and unexpected inflation is the reason engineering economics problems convert between current-dollar and constant-dollar cash flows.
Inflation appears across several exams. AP Macroeconomics tests measurement, the causes of demand-pull and cost-push inflation, and the self-adjustment mechanism that closes output gaps. The CIMA Certificate BA business economics paper pairs inflation with unemployment, and the FE Mechanical exam requires you to adjust cash flows for inflation in engineering economics calculations.
Key takeaways
- Inflation is a sustained increase in the general price level, measured by indices such as the CPI and the GDP deflator.
- Demand-pull inflation comes from excess aggregate demand; cost-push inflation comes from rising input costs.
- Inflation erodes purchasing power, hurting lenders and fixed-income recipients while benefiting borrowers.
- Real values subtract inflation from nominal values, a conversion tested in both economics and engineering economics.