Inflation is the sustained rate of change in prices across the economy, resulting in a loss of purchasing power over time. It means that what you get for your dollar today will not be the same tomorrow.

Price changes can occur in nearly any product or service and are often reflected in need-based expenses like housing, food, medical expenses, and utilities. Though inflation can be a concern and often frustrating to think your money is losing value, most economists consider small amounts of inflation as signs of a healthy economy.

To calculate inflation, an economy uses the Consumer Price Index, the best inflation indicator, which measures a “market basket” of goods and services from month to month. In developed countries, Central Banks, including the U.S. Federal Reserve, focus on the PCE Price Index in its inflation targeting while trying to maintain a target of around 2%.

What causes inflation

The gradual rise of prices associated with inflation can be caused by demand-pull inflation and cost-push inflation, based on the fundamental principles of supply and demand.

In short, high inflation can be the result of a hot economy. However, there are numerous economic conditions and factors that can move either of these needles.

1. Demand-pull inflation

can arise due to strong consumer demand for a product or service. If sellers don’t raise the price, they will sell out and eventually realize they now have the luxury of hiking prices, and when enough sellers do this, they create inflation.

For example, the Hamilton Live on Broadway only had a limited number of seats available, and, since the demand for the show far exceeded the capacity, the standard ticket price increased from $139 to $2,000 on third-party sites.

2. Cost-push inflation

occurs when prices increase due to a supply shortage combined with enough demand to allow the producer to raise prices.  When this inflation happens, it causes prices for goods and services to go up, resulting in supply chain disruptions.

A company that can create a monopoly also contributes to cost-push inflation. One example of cost-push inflation is the oil crisis in the 1970s when members of the OPEC proclaimed an oil embargo that resulted in oil prices rising nearly 300%.

Should I be worried?

If a country allows inflation to get out of hand and rise dramatically, it can become a destructive force in an economy.

However, with interest rates on savings accounts already hovering just above 0% in most countries, even a moderate inflation rate means that monies held in cash or low-interest savings accounts will be worth even less.

“Savings is not designed to make you rich,” says certified financial planner and CEO of Blue Ocean Global Wealth, Marguerita Cheng. It’s meant to provide a financial cushion, should you need it.

One alternative to potentially beat inflation is to invest in stocks. Although individual stock prices may drop and offer no guarantees, broader stock market indexes rise over the long term, thus beating inflation.

To put things in perspective, the S&P 500, which tracks the performance of 500 of the largest companies in the U.S., generated an average annual return of just over 10% between 1920 and 2020, with dividends reinvested.

According to Forbes estimates, even adjusting for inflation, investments in an S&P 500 index fund have averaged over 6% returns from June 1930 to June 2020.

Conclusion

With the current environment rapidly changing and uncertainty about where the global economy is heading next, the best course of action is diversification, says Brian Byrnes, Head of Personal Finance at Moneybox.

To achieve this, investors should hold assets in all major classes, including bonds, equities, and commodities, since their returns tend to diverge from one another over the short term.

And in doing so, investors will have the best possible chance of maintaining the real value of their wealth once inflation is taken into account.