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What is inflation, and how does it affect you?
Inflation is a term that refers to prolonged price increases. Put simply, inflation is the reason why your dollar doesn't go as far as it used to in the past. As prices rise, you get less for your money.
For example, in 2020, the average price of a gallon of milk was $3.19. In 2024, it’s $3.98.
You can calculate the inflation rate for a specific product or service with a simple formula:
[(Current Price-Original Price) / Original Price] x 100
For example, to measure the inflation rate for a gallon of milk, you'd enter the following:
[($3.98-$3.19) / $3.19] x 100
[0.79 / $3.19] x 100
0.248 x 100 = 24.8
As you can see, the price of a gallon of milk has increased by about 25% over four years.
When inflation rates are high, it gets harder to afford everyday essentials. Unless your pay has increased along with inflation, your salary won't go as far, and you'll have to trim your budget or take on another job to afford your lifestyle.
How is inflation measured?
The Federal Reserve, the central bank of the U.S., is responsible for measuring inflation and creating policies to regulate the economy. It doesn't look at a single product or category; it calculates inflation by looking at market indices that track the price changes of some of the most common goods and services to gauge inflation.
One of the most commonly used indices is the Consumer Price Index (CPI) for all Urban Consumers — an index that tracks expenses such as food, gas, housing, utilities, and transportation. The CPI tracks price changes over a specific period; price changes over 12-month periods are usually what experts refer to when discussing inflation.
For instance, the inflation rate was 2.9% in August 2024. That means the CPI shows prices have increased 2.9% since August 2023.
What causes inflation?
There are many factors that contribute to inflation, but economists tend to focus on two main ones: demand-pull inflation and cost-push inflation.
Demand-pull inflation
Demand-pull inflation occurs when there is widespread demand for goods and services, and that demand outpaces the supply or what the economy can produce. When companies can't keep up with the demand, prices skyrocket, driving inflation.
Demand-pull inflation was evident during the COVID-19 pandemic. With some workplaces shut down and international shipments paused or delayed, the supply of certain items, such as cars and electronics, was down. As a result, prices increased rapidly, driving the record inflation rates we saw in 2020 through 2022.
Cost-push inflation
With cost-push inflation, the cost of producing goods and services causes businesses to raise prices. This can occur if labor costs increase or if it becomes more difficult to import necessary raw supplies. When these price increases occur across several industries, it can cause widespread inflation.
How inflation impacts your finances
Some level of inflation is normal and even necessary for the economy to thrive. However, when inflation rates get too high, it can erode the value of your money, and you may find it more difficult to get by on your current income.
With less disposable income, you may have to reduce your retirement contributions or put off putting extra money toward your student loans. And, as money gets tighter, you may have to make changes to your spending or lifestyle to make ends meet.
For example, let's say you earned $40,000 at your job in 2020. To maintain the same buying power in 2024, you'd have to earn $48,502. If your job hasn’t raised your pay to that level, it will be harder to cover your bills even though your salary hasn't actually decreased. (You can use the U.S. Bureau of Labor Statistics' inflation calculator to see how the value of your income has changed over time.)
To address inflation, the Fed can increase the federal funds rate. Rate hikes can be beneficial to your savings account since banks will typically raise their rates alongside the Fed. However, it makes borrowing money much more expensive, so it may cost you more to take out a mortgage or car loan.
Protecting your money against inflation
Inflation is unavoidable and it fluctuates over time. However, there are some steps you can take to protect your finances when the inflation rate is high:
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Open a high-yield savings account (HYSA): One of the best ways to beat inflation is to stash your savings in a high-yield savings account. Right now, there are banks and credit unions offering rates over 5.00% APY — significantly higher than the national average.
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Pay down debt: If you're carrying a balance on a credit card or have a high-interest loan, one of the easiest ways to better your finances is to pay down debt. Paying off the highest-interest debt first will help you save money and get out of debt faster, freeing up cash for other goals.
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Trim your spending: When money is tight and inflation is up, keeping track of where your money goes is key. Trimming any unnecessary purchases can help free up money and give you more breathing room in your budget.
Invest in the stock market: Although seeing the market fluctuate can be nerve-racking, investing is critical to outpacing inflation and growing your money. In fact, Vanguard found that an all-stock portfolio would average 10% in annual returns over the long term.
