Inflation is the process that determines the purchasing power of money.

Inflation is a phenomenon that each of us feels when prices for goods in stores gradually increase. Your grandmother was right when she talked about a time when life was cheaper – this is a direct consequence of inflation. Economists define inflation as a decrease in the purchasing power of a currency, meaning that the same amount of money in the future will buy fewer goods and services than today.

It is important to understand the difference between inflation and regular fluctuations in the prices of individual goods. When we talk about inflation, we mean a long-term and continuous increase in the value of almost all goods and services in the economy simultaneously. Most countries measure the inflation rate annually in percentage terms, showing how much prices have changed compared to the previous period.

How does inflation occur: three main mechanisms

Inflation has several causes, which economists generally categorize into three groups. American economist Robert Gordon proposed the so-called “triangle model,” which helps understand where inflation comes from in the modern economy.

Excess money in circulation as the primary cause

When central banks significantly increase the amount of money in circulation, inflation becomes almost inevitable. A historical example is the 16th century, when European conquerors brought large quantities of gold and silver from America. This influx of precious metals caused inflation across Europe. Today, a similar mechanism operates through quantitative easing, when central banks print new money to stimulate the economy.

Demand-pull inflation: when everyone wants to buy at the same time

Inflation also occurs when demand for goods exceeds supply. Imagine a bakery that produces 1,000 loaves of bread a week and sells all of them. If economic conditions suddenly improve and people have more money to spend, demand for bread might jump to 2,000 loaves. The ovens and bakers work at full capacity and cannot produce more. Naturally, some buyers are willing to pay more, so inflation manifests as rising bread prices. If this happens simultaneously with increased demand for milk, butter, and other products, inflation spreads across the entire economy.

Cost-push inflation: when production costs rise

Another type of inflation occurs when companies’ production expenses increase regardless of demand. If our baker faces a wheat crop failure and has to pay more for raw materials, they must raise bread prices even if demand remains unchanged. Similarly, an increase in the minimum wage mandated by the government automatically raises costs for all businesses, forcing them to raise prices. Cost-push inflation is often caused by global factors—resource shortages like oil, rising government taxes, or a weakening national currency making imports more expensive.

Internal inflation: when the past determines the future

Inflation can also be driven by expectations formed from previous experiences. If people have lived through a period of high inflation, they start to expect it to continue. Workers demand higher wages to protect their income from anticipated price increases. Companies, in turn, raise prices on their goods. Workers see this and demand even higher wages. Inflation enters a vicious cycle—so-called wage-price spiral—that can last for years, even if the original causes of inflation disappear.

How governments measure and track inflation

Controlling inflation is impossible without measuring it. The main tool is the Consumer Price Index (CPI), which tracks the cost of a “basket” of typical goods and services purchased by households. The U.S. Bureau of Labor Statistics collects data on prices of thousands of goods across the country to calculate this index.

The methodology is simple: in the base year, the index is set at 100. Two years later, if the index is 110, it means prices have increased by 10%. This method allows comparing inflation across different periods and forecasting its impact on the economy.

Tools to combat inflation: monetary policy

When inflation gets out of control, governments and central banks take active measures. The primary tool is managing interest rates.

Raising interest rates

Higher interest rates make borrowing more expensive for businesses and consumers. Loans become less attractive, people buy less on credit, and savings become more beneficial. The result is a decrease in demand, which should theoretically slow down price increases. However, there is a side effect: economic growth may slow down as companies and individuals are less willing to take loans for investments and spending.

Quantitative tightening and other tools

Central banks can also resort to quantitative tightening—the process of reducing the money supply in the economy, the opposite of quantitative easing. During easing, the central bank prints new money and buys assets, which increases inflation. Quantitative tightening works in the opposite direction, but evidence of its effectiveness in fighting inflation remains limited.

Fiscal policy as an alternative

Besides monetary policy, governments can change taxes and spending. Increasing taxes reduces disposable income, which decreases demand and, in theory, fights inflation. However, this approach is politically risky and can cause public discontent.

Why inflation is a double-edged sword

At first glance, it may seem that inflation should be avoided at all costs. However, this problem is more complex than it appears. Moderate inflation has advantages, while its absence or excessive growth carries risks.

Pros of inflation

Inflation stimulates economic activity. When people know that money will be worth less tomorrow, they tend to spend and invest more today. Companies are encouraged to produce more and hire workers. Loans become more attractive (especially with moderate inflation), as borrowed money can be repaid with cheaper dollars.

Inflation also allows companies to increase profits by raising prices above the necessary level to cover rising costs. This provides more funds for development and innovation.

Moreover, moderate inflation is better than deflation. When prices fall, people delay purchases expecting even lower prices, which paralyzes the economy. Historically, periods of deflation have led to unemployment and economic stagnation.

Cons of inflation

Uncontrolled inflation is destructive. If you have $100,000 today, high inflation in ten years could significantly reduce its purchasing power. Savings lose value—people prefer to spend or seek alternative assets.

Hyperinflation is an extreme phenomenon where prices increase by more than 50% per month. It completely destroys the economy and trust in the national currency. People quickly switch to foreign currencies or goods as a store of value.

High inflation also creates uncertainty. Companies do not know what their future expenses will be, so they postpone investments. Economic growth slows down.

Some critics also oppose government interference in the economy. The ability of governments to “print money” to stimulate the economy, in their view, undermines natural market mechanisms, although in crypto circles this phenomenon is humorously called “printing money forward.”

Conclusion: finding a balance in managing inflation

Inflation is a phenomenon that cannot be completely eliminated from the modern economy based on fiat money. Its impact is so significant that rising prices constantly increase the cost of living, and each generation feels it. However, with proper management, inflation can be beneficial.

Modern economists have concluded that the optimal strategy for fighting inflation involves flexible monetary and fiscal policies. Governments must constantly adapt by adjusting interest rates, taxes, and spending to keep price growth at an acceptable level. Inflation requires constant monitoring; otherwise, policies aimed at fighting it can cause more harm than good.

Understanding what inflation is and how it works is critically important for policymakers and ordinary people alike, who seek to protect their wealth and make informed financial decisions.