What Is Inflation?

April is Financial Literacy Month, and our goal is to help you raise your money IQ. In this series, we'll tackle key economic concepts -- ones that affect your everyday finances and investments -- to help you make smarter choices with every dollar decision you face.

Today's term: inflation.

You probably think you've got the term down pat: Inflation means prices rising over time. Well, yes, that's pretty much right. But there's much more to inflation, and it's much more relevant to your life than you might think. Inflation can go in the opposite direction, for example, and it can spiral out of control.

First, a quick review.

Inflation is about purchasing power. It's a way to measure the changing purchasing power of our currency by tracking changes in the prices of things we buy. The national banks of various countries try to keep inflation under control through their actions and policies (such as via the interest rates they set); many aim for an annual inflation rate of about 2 percent to 3 percent.

If inflation is at our long-term national average rate of about 3 percent, you can expect that something that costs you $100 today will cost you $103 next year, and $116 in five years. Plenty of online inflation calculators can give you a peek into the past, too. For example, per the U.S. Department of Labor's calculator, it would cost you $62 in 1993 dollars to buy what costs you $100 today.

It's not as simple as it seems

While the concept of inflation seems simple, as in the examples above, it's actually a bit more complicated. For one thing, prices of various goods and services tend to grow -- and sometimes shrink -- at significantly different rates.

Think of college tuition, room and board, for example. Between the 2000-2001 and 2010-2011 school years, that cost has grown by an annual average of 5.5 percent overall, at both private and public schools combined. Meanwhile, the average selling price of a new vehicle rose just 1.7 percent, on average, annually between 2001 and 2011, and the price of gas averaged 8.9 percent annual growth during that same period.

Changes can be quite different in different time periods, for different items, and even in different regions -- think of the housing market, for example.

Inflation is calculated in different ways, too. Its most basic form, as calculated by the Bureau of Labor Statistics, is the Consumer Price Index or CPI, which reflects the changes in prices of a basket of goods and services, such as food, gasoline, newspapers, postage, lodging, furniture, dental services, socks, cigarettes, pet food and more. There's also the "Core CPI," which excludes energy and food prices, as they can be especially volatile.

Another key thing to understand is that each of us will experience a different level of inflation over time, depending on what we spend our money on. If you live in a city and have no car, for example, you've been far less affected by the surging price of gas. If you're feeding a family of 8, you're much more affected by the price of food.

Going to extremes

Finally, know that there are related phenomena such as deflation, when the prices of items fall over time, and hyperinflation, when inflation is at nosebleed levels.

Deflation may sound good, and it does offer an increase in purchasing power and an incentive to save. But it can also hurt the economy, with people putting off purchases as they wait for even lower prices. (Conversely, high inflation can lead people to purchase more, before prices rise further.)

Then there's hyperinflation, which can result when economies get out of control, such as in Germany between 1922 and 1923, when average prices doubled every 28 hours. In July of 1946 in Hungary, inflation averaged 207 percent per day. More recently, in late 2008, Zimbabwe experienced inflation of about 98 percent daily, and ended up issuing a $100 trillion bill.

Learning about simple economic concepts like inflation can make you a better financial thinker and decision maker.

More money terms:
Net worth
Cash flow
Compound interest
See all Money Terms to Know

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