Understanding Inflation: Definition, Causes and Impact

Inflation is a word that evokes extremely negative emotions in the average person. For the majority of individuals, this phenomenon is directly comparable to impoverishment and diminished purchasing power. We still remember vivid crisis moments from the past with huge inflation figures. People with more knowledge are aware of countries like Turkey and Venezuela, where inflation is surpassing all previous records. In 2024, Donald Trump received huge support and won the US presidential election, largely due to his promises to bring inflation under control.

However, the economy works a little more complicated than that. We, as financial market participants, need to be clear about what inflation percentages mean and what its real effects are. So, in this article, we offer a detailed breakdown of what inflation is, how it works, and how to stop being afraid of it. Let’s go!

What is Inflation and Why is it Important?

Inflation is the process of reducing the purchasing power of the population due to the rise in prices of a broad list of goods and services over time. Inflation can be high, in which case prices rise rapidly, or it can be low, with relatively slow price increases. It is measured in percent, and if, for example, the annual inflation rate in your country is 4%, this means that over the year, the prices of the main groups of goods and services rose by 4% compared to the previous year.

The inflation rate is calculated once in a certain period (week to week, month to month, year to year). The calculation involves the so-called ‘basket’ of goods and services, which includes various items from bread and milk to a trip to the doctor and an appointment with a car mechanic. You can read more about how this ‘basket’ is formed and monitored in our recent article on the Consumer Price Index (CPI).

Is Inflation Inevitable?

In modern economic theory, inflation is a necessary evil. For example, the US Reserve System and the central banks of many countries consciously strive to keep inflation low, but not zero. Often around 2-3% per year. But why does inflation exist at all?

It is largely due to the loose monetary policy of central banks. They lower interest rates, allowing people to take on more debt and put the money they get into the economy. Businesses are created, stocks rise, buying activity increases—all these actions are positive for the economy. When you know that in 10 years, your money will be worth less, what’s the point of keeping it on the nightstand? Better to go out and do something you’ve wanted to do for a long time.

We recommend that you read our recent article on central banks and their role in the economy to better understand inflation.

However, inflation can also have negative consequences. When it rises rapidly, as it does in times of crisis or negligent monetary policy (hello, Turkey!), uncertainty arises. People lose confidence in their economy and prefer more stable currencies, and the poor become even poorer without being able to save at least part of their money.

But how to understand whether inflation is high or low? And how is inflation calculated?

How is Inflation Calculated?

The inflation rate is determined by assessing the current cost of a ‘basket’ of goods and services and comparing it to the cost of similar goods in the past period (week, month or year). In other words, if you look at your grocery receipt from last year and compare it to the same receipt from yesterday, you will know how much the inflation rate has risen this year.

Nationwide, however, inflation is measured in more complex ways. The U.S. Bureau of Labor Statistics regularly publishes the Consumer Price Index, which tracks the prices of more than 80,000 goods and services across the country. The selected items are primarily those in demand among typical urban consumers. The resulting average price undergoes a mathematical process where all goods and services are weighted based on their importance to consumers. The final result is then presented as an index.

To calculate inflation, we should take the Consumer Price Index (CPI) data and use the formula:

Inflation in percent = (final value of CPI index / initial value of CPI) x 100

For example, in January 2025, the CPI was 317.67 points. In December 2024, the Index was at 315.61 points. Let’s substitute the figures into the formula:

Inflation in percent = (317.67/315.61)x100 = 100.65%

We can conclude that the monthly inflation rate was about 0.65%. Let’s take another example.

In January 2016, the CPI index was 236.916 points. We already know the values of January 2025. Let’s use the formula:

Inflation in percent = (317.67/236.916)x100 = 134.085%

So over 9 years, inflation in the US is 34.085%.

To better understand how inflation fluctuates over time, let’s take a look at the historical U.S. Consumer Price Index (CPI) data below. This chart highlights key periods of rising and falling inflation, reflecting major economic events and policy decisions:

Interestingly, there are other indices that count inflation. For example, the U.S. Bureau of Economic Analysis maintains the Personal Consumption Expenditure (PCE) price index, which the Federal Reserve uses to determine the interest rate.

What Are the Different Types of Inflation?

Inflation can be classified into three main types, each driven by different economic forces. Understanding these types helps to explain why prices rise and how inflation impacts the economy.

Demand-Pull Inflation

This type of inflation occurs when the demand for goods and services outpaces supply, causing prices to rise. Imagine a situation where everyone suddenly wants to buy the latest smartphone, but production can’t keep up. The limited supply drives prices higher. A real-world example of this happened during the COVID-19 pandemic, when a shortage of semiconductors led to a surge in car prices. With demand exceeding supply, automakers had no choice but to increase prices.

Cost-Push Inflation

Cost-push inflation happens when the cost of production increases, forcing businesses to raise prices to maintain profitability. This can be caused by rising wages, higher raw material costs, or supply chain disruptions. A clear example was seen during the pandemic when global supply chains collapsed, making key materials like oil, metals, and lumber significantly more expensive. As businesses paid more for these inputs, they passed the costs onto consumers through higher prices.

Built-In Inflation

Also known as the wage-price spiral, built-in inflation is a self-reinforcing loop in which rising prices lead to higher wage demands, which in turn push prices even higher. When workers see that the cost of living is increasing, they negotiate higher salaries to keep up. However, businesses needing to cover these increased labor costs raise their prices again. This cycle continues and fuels ongoing inflation.

While moderate inflation is a normal part of economic growth, Venezuela serves as a striking example of what happens when inflation spirals out of control. The chart below highlights key moments when the country’s inflation rate exceeded 300,000%, showcasing the devastating effects of economic mismanagement and political instability.

The Role of Inflation Expectations

One of the most powerful yet intangible drivers of inflation is inflation expectations—what people think will happen to prices in the future. If businesses and consumers expect inflation to rise, they behave in ways that actually make it happen. Workers demand higher wages anticipating future price increases, and businesses preemptively raise prices to protect their margins. This psychological factor plays a crucial role in shaping real inflation trends.

For instance, when inflation is expected to remain high, people rush to spend money before prices rise further. This increased spending fuels even more inflation. Central banks, like the Federal Reserve, monitor inflation expectations closely because if people start believing that inflation will spiral out of control, it becomes much harder to slow it down.

What Are the Limitations of Inflation Measures?

Measuring inflation may seem straightforward. Compare prices over time and calculate the percentage increase. What’s difficult here? But in reality, inflation measures have significant limitations, and the numbers we see in official reports don’t always reflect the full picture of what people experience in their daily lives.

Inflation calculations rely on a basket of goods and services, a representative set of items that households typically buy. This basket includes food, fuel, rent, healthcare, and entertainment, among other things. However, no two people or families spend money in exactly the same way. While official inflation figures might show a 4% increase, some people may feel the impact much more—especially if they rely heavily on goods that have seen higher price spikes, like housing or fuel.

Another major limitation is that inflation indexes don’t always account for changes in product quality. The smartphone you buy today is far more advanced than the one you could buy ten years ago, yet official inflation measures attempt to account for this by adjusting for technological improvements. This means that even if a new phone costs twice as much, statisticians might record a smaller inflation increase because the newer model is “better.” But for an average consumer who just wants a working phone, this adjustment might not feel very relevant.

There’s also the challenge of substitution bias. When prices for one product rise, consumers often switch to a cheaper alternative. If the price of beef skyrockets, for example, many people might switch to chicken instead. Inflation calculations try to account for this, but it means that the official numbers might not fully capture how inflation affects those who can’t easily substitute, such as people with specific dietary needs.

A great real-world example of these limitations occurred in 2022, when inflation was officially reported at around 8% in many countries. However, certain essential goods like food and energy rose much more—sometimes 20% or more—putting an outsized burden on lower-income households. This created a feeling that “real” inflation was much higher than the official figures suggested.

Finally, inflation calculators are useful, but they have their own flaws. Websites and financial portals offer ready-made inflation calculators, allowing people to estimate how much purchasing power has changed over time. However, these tools often rely on simplified formulas and averages that may not reflect personal spending habits or regional price differences.

How Is Inflation Used?

While inflation is often seen as an economic threat, it is also a powerful tool used by governments and central banks to shape economic policies. By managing inflation, policymakers can influence interest rates, employment, and overall economic growth. There are several key measures that can be taken to handle inflation:

• Monetary policy adjustments
• Fiscal policy measures
• Price controls and subsidies
• Foreign exchange policie
• Wage and income policies

Let’s break them down.

Monetary Policy Adjustments

Monetary policy is the primary tool for controlling inflation, and it is managed by central banks such as the Federal Reserve (Fed) in the U.S. or the European Central Bank (ECB). The goal of monetary policy is to regulate the money supply and interest rates to keep inflation within a target range.

For example, when inflation rises too fast, central banks increase interest rates to make borrowing more expensive. This discourages excessive spending and slows down the economy, reducing price pressures. Conversely, if inflation is too low or the economy is struggling, central banks lower interest rates to encourage borrowing, investment, and spending, which can boost growth.

A historical example of the impact of monetary policy on inflation comes from Spain in the 16th century. After conquering the Aztec and Inca empires, Spain flooded its economy with large amounts of gold and silver. This sudden increase in the money supply led to rapid inflation as the value of money fell and prices soared. A classic case of how excessive money supply drives inflation.

Fiscal Policy Measures

Governments can also control inflation through fiscal policy, which involves taxation and government spending. When inflation is high, governments can reduce spending or increase taxes, taking money out of circulation and cooling demand. On the other hand, when inflation is too low, governments may increase spending or cut taxes to stimulate economic activity.

For example, during times of high inflation, some governments reduce subsidies on fuel or food to discourage overconsumption and ease price pressures. On the flip side, during economic recessions, stimulus checks or tax cuts can be used to boost demand and push inflation back up.

Price Controls and Subsidies

In some cases, governments impose price controls on essential goods to prevent inflation from spiraling out of control. For example, rent control laws in major cities limit how much landlords can increase rents each year to protect tenants from skyrocketing housing costs. Similarly, governments may subsidize certain goods like fuel or food to keep prices affordable for consumers.

However, price controls can sometimes backfire. When prices are artificially capped, producers may reduce supply, leading to shortages and black markets. A well-known example is Venezuela’s price controls, which led to severe shortages of basic goods, as businesses could no longer afford to produce them at government-mandated prices.

Foreign Exchange Policies

For countries that rely heavily on imports or exports, exchange rate management can help stabilize inflation. A strong currency can reduce import costs, making goods cheaper for consumers, while a weaker currency can make exports more competitive. Some central banks intervene in foreign exchange markets to prevent excessive currency fluctuations that could drive inflation up or down too quickly.

Wage and Income Policies

Another way to control inflation is by managing wage growth. When wages rise too quickly, businesses may pass these costs onto consumers, creating a wage-price spiral where higher wages lead to higher prices, which in turn leads to demands for even higher wages.

Some governments negotiate wage agreements with labor unions to keep inflation under control. In some European countries, automatic wage indexation ensures that wages rise in line with inflation, preventing sudden economic shocks but also making inflation harder to reduce.

Inflation Around the World

Inflation has been a persistent concern globally in recent years, with many countries struggling to bring it under control. However, its impact varies significantly depending on economic structure, monetary policies, and regional factors.

In June 2022, inflation in the United States peaked at 9.1%, reaching its highest level since February 1982. Since then, inflation rates in the U.S., Europe, Japan, and the United Kingdom have gradually declined, particularly throughout late 2023. However, despite this downward trend, inflation remains higher than pre-pandemic levels, when it hovered around 2%, and is only now returning to historical norms.

Many economists compare today’s inflationary period to the post-World War II era, when a combination of price controls, supply shortages, and massive consumer demand in the U.S. led to double-digit inflation, peaking at 20% in 1947 before eventually stabilizing by the decade’s end. Similarly, the COVID-19 pandemic distorted global consumption patterns and disrupted supply chains, contributing to inflationary pressures worldwide.

Another historical reference point is the Great Inflation of the 1960s–1980s. During this period, inflation in the U.S. reached 14.8% in 1980, prompting the Federal Reserve to take drastic measures. Interest rates were raised to nearly 20% in an attempt to curb inflation, eventually restoring stability at the cost of short-term economic contraction.

Yet, inflation tolerance differs across nations. Countries with higher economic growth rates can generally withstand higher inflation levels. For example, India targets an inflation range of 2% to 6%, aiming for an optimal 4%, while Brazil maintains a target of 3.25%, with an acceptable range between 1.75% and 4.75%. These differences reflect each country’s economic priorities and ability to absorb inflationary pressures without causing instability.

In some regions, inflation is a chronic issue rather than a cyclical fluctuation. Countries like Turkey and Argentina have been battling persistently high inflation for years due to weak monetary policies, excessive government spending, and currency devaluation. Meanwhile, nations with stronger monetary policies and stable fiscal management, such as Switzerland and Japan, have historically kept inflation under control.

The Future of Inflation

While inflation has slowed in many markets, uncertainty remains. Without a significant increase in productivity and innovation, Western economies may face a prolonged period of moderate but persistent inflation or even a major economic reset, similar to what Japan experienced in the early 21st century.

One key concern is regional disparities in inflation expectations. According to the 2023 McKinsey Global Economic Survey, respondents in Europe remain most concerned about inflation’s impact on economic growth, while those in North America are more optimistic about inflation stabilizing.

Monetary Policy and Inflation Management

Central banks worldwide have taken aggressive measures to stabilize inflation. In the U.S., quantitative easing (QE) programs implemented after the 2008 financial crisis aimed to stimulate economic recovery. However, critics feared that printing more money would lead to uncontrolled inflation. In reality, inflation peaked in 2007 and steadily declined over the next eight years. The simplest explanation is that the recession itself created a highly deflationary environment, which counterbalanced any inflationary pressures from QE.

As a result, U.S. policymakers have since sought to maintain inflation around 2% per year. A level believed to encourage sustainable economic growth without causing excessive price increases. Similarly, the European Central Bank (ECB) has pursued aggressive monetary policies, including negative interest rates in some cases, to combat deflation and economic stagnation in the Eurozone.

Will Inflation Return to Pre-Pandemic Levels?

The global economy is now entering a delicate balancing phase, where inflation must be kept under control without stifling economic growth. Policymakers must navigate various risks, including:

• Geopolitical instability (e.g., supply chain disruptions from conflicts and trade wars)
• Energy price fluctuations (e.g., oil and gas supply constraints)
• Technological advancements (e.g., automation and AI impacting labor costs)
• Shifts in consumer behavior (e.g., post-pandemic spending patterns)

The challenge for central banks and governments will be to strike a balance: keeping inflation low enough to maintain stability but high enough to avoid deflation and economic stagnation.