Inflation is a common money term, but do you understand what it is? Bankrate explains.

What is inflation?

The cost of living, which is what consumers pay for goods and services, goes up over time. In 2016 a gallon of milk cost, on average, $3.98. That same gallon of milk cost $2.41 in 1996, $2.22 in 1986 and $1.57 a decade before that. Economists use the term inflation to describe this general rise in prices, which lowers the purchasing power of the local currency. Inflation plays a significant role in the economy and affects everything from the cost of groceries to housing and wages.

Deeper definition

For many people, trying to make sense of how inflation works is challenging. Inflation is a complex concept, and in order to understand it, consumers need to know a few key terms economists use when discussing inflation.

  • Consumer Price Index is a tool for measuring the effects of inflation on consumers. It takes into account what consumers in urban areas pay for typical purchases like food, clothing, housing costs, transportation and medical expenses.
  • Deflation, the opposite of inflation, happens when the prices of goods and services fall.
  • Hyperinflation refers to inflation that occurs at an unusually quick pace and leads to a severe devaluation of the local currency.
  • Producer Price Index is an economic indicator tracking the cost of raw goods and services that manufacturers use to produce products.
  • Stagflation is a combination of high unemployment and stagnation happening at the same time as inflation.

Economists do not agree on a single cause of inflation, but two theories stand out: demand-pull inflation and cost-push inflation. The demand-pull theory asserts that inflation occurs when there is too much money in the market and too few goods available for purchase. The increased demand raises prices. The cost-push inflation theory suggests that inflation results from price increases implemented to help businesses maintain their profit margins.

One role of the United States’ central bank, the Federal Reserve, is to monitor inflation and adjust monetary policy as necessary to keep the value of the dollar stable. It does this by evaluating the Consumer Price Index and Producer Price Index. It also tracks workers’ wages to gauge how much disposable income people have and how much businesses must spend to attract and maintain employees.

The Fed isn’t the only group that monitors the economy for signs of inflation. Banks want to make sure they can accommodate increasing and decreasing interest rates and don’t find themselves surprised by unanticipated inflation. Employers, workers and unions also pay attention to inflation indicators to help them negotiate contracts that ensure the business stays viable and employees have the ability to earn a living.

Inflation example

Even if you don’t fully understand how inflation works, you live with its effects. The first, and most obvious, effect is that you must spend more money to buy the same goods and services. Ideally, your wages also go up so you don’t have to cut back in other spending areas. If your wages do not increase, you and other consumers won’t have as much money to spend, which actually hurts the economy over time.

When consumers don’t buy goods and services, businesses take action to cover their expenses, leading to increased prices, lower wages and higher levels of unemployment. If inflation in the United States surpasses that of other countries, domestic products become less competitive because they cost more to produce. For this reason, monitoring and managing inflation is a priority for the government and financial institutions.

Use our calculator to compare the cost of living between two cities.

More From Bankrate