Inflation occurs when the general price of the goods and services you are buying are rising and, as a result of the increase in cost, the purchasing power of your money is falling. The term may also be used to describe a rising price level within a narrower set of assets, goods or services within the economy. These include commodities (such as food, fuel, metals), tangible assets (such as real estate), financial assets (such as stocks, bonds), services (such as entertainment and health care), and labor.
Most economists today use the term inflation to refer to a rise in the price level. An increase in prices is called price inflation, which distinguishes it from monetary inflation, which occurs when there is a rise in money supply. Other economic terms related to inflation include:
- Asset Price Inflation – a general rise in the prices of financial assets without a corresponding increase in the prices of goods or services.
- Deflation – a fall in the general price level.
- Disinflation – a decrease in the rate of inflation.
- Hyperinflation – an out-of-control inflationary spiral.
- Reflation – an attempt to raise the general level of prices to counteract deflationary pressures.
- Stagflation – a combination of inflation, slow economic growth, and high unemployment.
The rising costs/loss of purchasing power affects economies in various ways; both positive and negative. As a consequence, there are hidden costs to some and benefits to others. From a negative perspective, the uncertainty about the future purchasing power of money discourages investing and saving. For example, inflationary expectations and interest rates will determine the risks associated with bond investments. Inflation is a bond’s worst enemy; it erodes the purchasing power of a bond’s future cash flows.
Generally speaking, economists favor a low and steady rate of inflation. This is because a low figure, as opposed to zero or negative, reduces the chance that an economic recession will occur, and it reduces the risk that inflation will undermine the performance of your investment portfolio.