Definition of inflation and purchasing power

Summary

In economics, inflation is defined as an increase in the average price of goods and services measured in money terms. It is typically tracked using a price index—most commonly the Consumer Price Index (CPI). As the general price level rises, each unit of currency buys fewer goods and services, meaning inflation reduces the purchasing power of money. The opposite of inflation is deflation, which is a decrease in the general price level. Inflation is commonly expressed as the inflation rate, usually the annualized percentage change in a general price index. Changes in inflation are widely attributed to factors such as increases in the money supply, demand shocks (including shifts in fiscal or monetary policy), supply shocks (such as energy crises), changes in central-bank interest rates, and changes in inflation expectations, which can become self-fulfilling. Central banks generally aim for low and stable inflation, since high inflation can create economic distortions while low inflation helps reduce recession risk and the likelihood of policy being constrained by liquidity traps.

Key Points

• 1

  Inflation is an increase in the average money-measured prices of goods and services, tracked using price indices like the CPI.

• 2

  When prices rise, money’s purchasing power falls; inflation is often reported as the annualized percentage change in a general price index.