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 quantified using a price index—most commonly the Consumer Price Index (CPI). When 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. While inflation can be traced to multiple causes—such as changes in the money supply, demand shocks, supply shocks (including energy disruptions), interest-rate changes, and shifts in inflation expectations—its central implication for households is the erosion of purchasing power over time. If inflation is sufficiently rapid, it can also lead to shortages as consumers hoard goods out of concern that prices will rise further.

Key Points

• 1

  Inflation is an increase in the average price level of goods and services, typically measured with a price index such as the CPI.

• 2

  Rising general prices mean money buys fewer goods and services, so inflation corresponds to a reduction in the purchasing power of money.

• 3

  Inflation is usually reported as an inflation rate (annualized percentage change in a price index) and can be driven by money-supply changes, demand shocks, supply shocks, interest-rate changes, and inflation expectations.