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What Is Inflation?

A Short and Simple Answer to the Question, "What Is Inflation?"


What Is Inflation?

If you have ever asked the question, "What is inflation?", the simple answer is that inflation is an increase in the cost of living due to rising prices of essentials such as milk, meat, coffee, wheat, clothing, and medical services.

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Have you ever asked yourself "What is inflation?" If you have, you aren't alone. It is one of the most popular questions I receive from new investors.

In simple terms, inflation can be defined as either a rise in prices or a fall in the value of money. That means if someone asks you, "What is inflation?" the short answer is, "An increase in the cost of things that are necessary for humans to live and enjoy life, such as bread, butter, milk, cheese, coffee, oil, shelter, clothing, medical services, chicken, cotton, electronics, etc." Or "a decrease in the value of money so that it takes more dollars, or yen, or pounds sterling, to buy the same goods and services it did in the past."

There Are Two Major Causes of Inflation

Some inflation is caused because a country has printed too much money or experienced financial disaster, causing its currency to plummet. Other sources of inflation can be higher input or transportation costs such as gas, which makes it more expensive to ship good to retail stores, increasing costs for consumers. The consumers, in turn, have a harder time affording stuff such as toilet paper, toothpaste, jeans, paper, cars, lamps, furniture … you get the idea. At this point, the consumers demand pay raises at their companies, possibly pressuring profits further, which can lead to additional price increases, and the cycle begins. This is when economists say that inflation has become “embedded” in the economy. For more information, read What Causes a High Inflation Rate?, in which I walk you through the two causes of a high rate of inflation. You may also want to read, What Are the Effects of Inflation? to understand how it can hurt (or in rare cases, help) your pocketbook.

Now That You Know the Answer to the Question, "What Is Inflation?", Is There Any Way You Can Profit from an Increase in the Rate of Inflation?

Yes! In the article, Profiting from Inflation, I explained how certain types of businesses have some degree of natural protection from inflation, allowing you to maintain your purchasing power if you invest in them. Although not always possible, it’s the firms that sell things such as brand name cornflakes or baby powder (think Kellogg’s or Johnson & Johnson) that have the easiest time passing on higher prices to customers and recouping their investment.

How Is the Rate of Inflation Measured?

The inflation rate is typically measured by using an inflation index. The most popular inflation index is the Consumer Price Index, which is a basket of goods such as coffee, apparel, etc. The United States has typically had much lower inflation rates than the rest of the world, in the range of 3% to 4% per annum for the past few decades.

Another option to protect your investments from inflation is to buy Series I savings bonds. These bonds are guaranteed by the United States Government to never lose money and the interest rate is based upon a combination fixed rate and inflation rate that changes as prices increase or decrease.

More Information About Inflation and the Inflation Rate

To learn more, read The New Investor's Guide to Inflation and the Inflation Rate, a special that answers questions such as:

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