Key Takeaways
Inflation is the sustained increase in the price of goods and services in an economy, which reduces the purchasing power of fiat currency over time.
The three main causes of inflation are demand-pull (excess demand), cost-push (rising production costs), and built-in inflation (a self-reinforcing wage-price cycle from expectations).
Inflation is typically measured using a Consumer Price Index (CPI), which tracks changes in the price of a basket of goods and services over time.
Central banks primarily control inflation by raising interest rates, making borrowing more expensive and reducing spending and demand.
A moderate level of inflation is considered normal in modern economies and can encourage spending and investment. Very high inflation or hyperinflation can destabilize an economy.
Introduction
Inflation refers to the general increase in prices across an economy over time, which reduces how much a given amount of money can buy. It is a normal feature of modern economies, but its rate matters a great deal: too little can signal weak demand, while too much can erode savings and destabilize financial systems.
This article covers what inflation is, its main causes, how it is measured, the tools used to control it, and its advantages and disadvantages. It also includes context from 2024 to 2026, a period marked by a gradual cooling of inflation after a multi-decade high, followed by a modest re-acceleration in early 2026.
What Is Inflation?
Inflation is the sustained increase in the price of goods and services in an economy. It differs from a relative-price change, where just one or two items become more expensive. Inflation affects nearly all goods and services over a prolonged period, and it is measured as a percentage change relative to a previous period, usually year over year.
The practical consequence of inflation is a reduction in purchasing power: the same amount of money buys fewer goods and services than it did in the past. This is why prices in any given country tend to be significantly higher today than they were several decades ago.
Causes of Inflation
Economists describe several types of inflation based on what drives it. Three of the most widely cited are demand-pull, cost-push, and built-in inflation.
Demand-pull inflation
Demand-pull inflation occurs when demand for goods and services grows faster than supply. When consumers and businesses have more money to spend, they may try to buy more than the economy can produce, pushing prices up. This can happen during periods of strong economic growth or when governments significantly expand the money supply.
Cost-push inflation
Cost-push inflation occurs when the cost of production rises, forcing producers to charge more even if demand has not increased. Common causes include rising raw material prices (such as oil or wheat), higher wages driven by labor shortages or minimum wage increases, and falling exchange rates that make imports more expensive. These cost increases are effectively passed on, or "pushed," to consumers.
Built-in inflation
Built-in inflation, sometimes called a wage-price spiral, arises when workers and businesses expect inflation to continue and act accordingly. If workers anticipate higher prices, they may demand higher wages. Employers, facing higher labor costs, raise prices for their goods. This can create a self-reinforcing cycle where expectations of inflation generate further inflation, making it harder to bring under control.
Remedies to Inflation
When inflation rises too high, governments and central banks typically respond using monetary policy or fiscal policy. The two most common tools are adjusting interest rates and modifying the money supply.
Raising interest rates
Raising interest rates is the primary tool most central banks use to combat inflation. Higher rates make borrowing more expensive for consumers and businesses, which tends to reduce spending and investment. This cools demand and, in turn, reduces upward pressure on prices. The trade-off is that economic growth may slow, and unemployment can rise.
After the inflation spike of 2021 to 2022, the US Federal Reserve raised interest rates aggressively. By 2024, US inflation had declined to around 2.9% annually on average, and by 2025 it averaged approximately 2.6%, closer to the Fed's 2% target. Markets began pricing in rate cuts from mid-2025 onward. However, by early 2026, inflation re-accelerated to around 3.8% year over year, driven largely by rising energy prices, complicating the path toward further easing.
Adjusting the money supply
Central banks can also influence inflation by expanding or contracting the money supply. Quantitative easing (QE) involves a central bank purchasing assets to inject money into the financial system, which can stimulate the economy but may also contribute to inflation. The reverse process, quantitative tightening (QT), reduces the money supply by allowing assets to mature off the balance sheet or by selling them, which can help reduce inflationary pressure.
Fiscal policy
Governments can also use fiscal policy (adjusting spending and taxation) to influence inflation. Raising taxes or reducing government spending decreases disposable income and cools demand. However, fiscal tightening tends to be politically difficult and is used less frequently than monetary policy as a direct inflation-control tool.
Measuring Inflation With a Price Index
Inflation is most commonly measured using a Consumer Price Index (CPI). A CPI tracks the average change in prices of a basket of goods and services commonly purchased by households, including food, housing, transport, healthcare, and clothing. Statistical agencies collect price data from retailers and service providers regularly to calculate the index.
If a CPI baseline is set at 100 in a given year and rises to 110 two years later, that represents 10% cumulative inflation over the period. Economists also track core CPI, which excludes volatile food and energy prices, to get a clearer picture of underlying inflation trends.
Pros and Cons of Inflation
Pros of inflation
A low and stable rate of inflation, typically around 2%, is generally considered healthy for an economy. It encourages consumers to spend and invest sooner rather than waiting, because money will have slightly less purchasing power in the future. Businesses may also benefit from being able to charge higher prices, which can support revenue growth. In contrast, deflation (falling prices) tends to delay spending and investment, as buyers wait for lower prices, which can slow economic activity.
Cons of inflation
When inflation rises significantly, it erodes the real value of savings. People who hold cash or fixed-income assets may find their purchasing power declining over time. Very high inflation can lead to hyperinflation, a condition in which prices rise by more than 50% per month. Hyperinflation can effectively destroy a currency's usefulness, as seen in historical examples such as Zimbabwe in the 2000s and Germany in the 1920s. Even moderate inflation above target can create uncertainty for businesses planning investments, and may disproportionately affect lower-income households who spend a larger share of their income on necessities.
The risk of deflation is a key reason why central banks aim for a small positive inflation rate rather than zero: a small buffer above zero reduces the risk of tipping into deflationary conditions, which historically have been associated with prolonged recessions.
FAQ
What is the difference between inflation and deflation?
Inflation is a sustained increase in the general price level, reducing purchasing power. Deflation is the opposite: a sustained decrease in prices, which increases purchasing power but can reduce economic activity as consumers and businesses delay spending in anticipation of further price declines. Central banks generally target a low positive inflation rate to avoid the risks of deflation.
What causes inflation to rise?
Inflation typically rises when demand outpaces supply (demand-pull), when production costs increase and are passed on to consumers (cost-push), or when inflation expectations become self-fulfilling through a wage-price spiral (built-in inflation). External shocks, such as a spike in oil prices or a major supply chain disruption, can also trigger or amplify inflation.
How do central banks control inflation?
The primary tool is adjusting the policy interest rate. Raising rates increases borrowing costs, which tends to reduce consumer spending and business investment, cooling demand and easing upward pressure on prices. Central banks can also use quantitative tightening to reduce the money supply. These tools work with a lag: the full effect of a rate change on inflation can take six to eighteen months to materialize.
What is the CPI and how is it used to measure inflation?
The Consumer Price Index (CPI) measures the average change in prices paid by consumers for a fixed basket of goods and services. It is calculated by tracking prices across categories such as food, housing, transportation, and healthcare over time. By comparing the index at two points in time, statisticians can determine the percentage change in prices. Most countries publish CPI data monthly, and central banks use it as a key input when setting monetary policy.
How does inflation affect cryptocurrencies?
Inflation can affect cryptocurrencies in several ways. High inflation tends to strengthen the narrative that assets with a fixed or limited supply (such as Bitcoin) may serve as a hedge against fiat currency debasement. However, during periods of aggressive interest rate hikes to combat inflation, risk assets including cryptocurrencies have historically come under pressure, as higher rates increase the attractiveness of traditional fixed-income alternatives. The relationship is not straightforward and varies across market cycles.
Closing Thoughts
Inflation is a fundamental feature of modern economies. At moderate levels, it encourages spending and investment. At elevated levels, it erodes purchasing power, creates uncertainty, and can lead to destabilizing outcomes if left unchecked. Central banks and governments use a range of monetary and fiscal tools to keep inflation near a target range, typically around 2%. The 2021 to 2026 period has provided a recent example of how inflation can surge, be partially tamed through aggressive policy, and then re-accelerate, highlighting the ongoing challenge of maintaining price stability in a complex global economy.
Further Reading
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