What can three dollars and fifty-nine cents buy in the U.S. today?

You’ll likely get some basic groceries like a gallon of milk or a few pounds of rice.

Rewind to January 1915 and three dollars and fifty-nine cents went a lot further.

It had the same buying power as $100 did in January 2022, meaning the price of goods has gone up by over $95.

Why do prices increase over time?

This is inflation: Unpacked.

Inflation is a broad economic term that describes price rises over time. This decreases real spending power and can squeeze household budgets.

Inflation happens across all categories of goods and services – from groceries to takeout, travel to gasoline. Anything that has a price can experience inflation.

Inflation can happen in different ways and at different paces.

When prices rise quickly and excessively, this is known as hyperinflation. It’s an extreme form of inflation that is rare in developed economies.

When prices decrease, deflation, or negative inflation, occurs.

When prices rise but there is low or no economic growth, this is known as stagflation. This is a complex phenomenon that can be difficult to battle.

Inflation affects both consumers and producers.

The consumer price index, or CPI, measures changes in cost of living.

And the producer price index, or PPI, measures changes in production costs.

CPI and PPI inflation are not directly linked, but they often move in similar patterns because they are affected by the same economic factors.

The factors that lead to inflation are called inflationary pressures.

One common example is a tight labor market. When employment levels are high and available labor is in short supply, wages generally rise. To pay employees more, employers must choose between absorbing higher overheads or passing the cost to consumers, resulting in CPI inflation.

Another factor is demand shock, where a sudden increase in demand pushes up prices.

Take the COVID-19 pandemic – consumers began purchasing goods instead of services and supply couldn’t keep up with demand. This led to higher CPI inflation, meaning consumers had to pay more for goods such as cars and electronics.

The opposite of a demand shock is a supply shock. When supply is short, prices can rise – a lack of raw materials, for example, can lead to higher PPI inflation by pushing prices up for producers. If product prices go up to cover these costs, CPI inflation rises as well.

In a healthy economy, inflation is managed to prevent prices becoming prohibitively high. The U.S. Federal Reserve has a mandate to promote maximum employment and maintain price stability, which involves keeping inflation under control. When inflation is high, the Fed might respond by tightening policy and raising interest rates to cool off demand and slow down the economy.

Inflation isn’t all bad news though, as it’s often a byproduct of strong demand and more spending. The Fed generally aims for an inflation target rate of around 2% annually, keeping it in check while allowing the economy to grow.

So what lies ahead for the economy and could rising inflation be a risk? Only time will tell, but with higher interest rates and increasing prices across many markets, inflationary pressures are likely to keep making headlines.