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What is an Inflation Rate?

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  • Written By: Dale Marshall
  • Edited By: Kristen Osborne
  • Last Modified Date: 19 November 2016
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Inflation is a sustained increase in the cost of goods and services within a definable economy, such as that of a region, a nation, or a continent. It occurs for a number of reasons, one of the most common of which is the act of merchants increasing their prices to maintain profit margins in the face of rising costs, such as labor and energy. The percentage by which these costs rise — the inflation rate — is measured very carefully and reported regularly.

From the perspective of the average consumer, the immediate effect of inflation is that currency loses some of its purchasing power; the higher the inflation rate, the greater the loss. That is, if the annual rate of inflation is 2% annually, the consumer will need $1.02 US Dollars (USD) to purchase what cost $1 USD a year earlier.

Inflation can become a vicious cycle — the consumer who today needs $1.02 USD to buy what cost him $1 USD a year earlier will petition his employer for an increase in wages to compensate for the loss of purchasing power. The employer who grants the increase is in turn is faced with increased labor costs, which can be recovered by raising prices of goods or services.

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Although some people consider any inflation to be bad for the economy, the fact is that most economists consider it to be desirable in a dynamic, growing economy. Although there's no consensus on what the ideal inflation rate should be, governments and central banks worldwide attempt to manage the supply and cost of money so as to maintain it at a reasonable rate, but not to eliminate it completely. An annual inflation rate under 5% would likely please most financial authorities.

Inflation has profound effects on areas of an economy other than the average consumer's purchase decisions. For example, investors are concerned with inflation because it reduces the real return they receive on their investments. An investor who experiences a return of 10% on his investments in a year in an economy whose rate of inflation is 4% has actually earned 6% real growth; if the rate is greater than 10%, then the investor has actually lost because his purchasing power has been diminished.

There's also a strong relationship between the rate of inflation and the cost of credit, or interest rates. Interest rates on borrowed money will always be higher than the inflation rate because otherwise, the lender would be losing purchasing power. Thus, in an economy with low inflation, interest rates charged on borrowed money will also be low, making credit more easily affordable. In an economy with a high rate of inflation, though, the interest charged on borrowed funds will be high. High credit costs tend to stifle an economy because business expansion is frequently funded with borrowed money. In addition, some businesses and governments must sometimes borrow funds to meet their operating costs because of irregular cash flow.

Inflation also occurs when the government simply prints too much money, often leading to a phenomenon called hyperinflation. This occurred in several countries at different times during the 20th century. At one point in 1923, Germany's Weimar Republic printed banknotes with a face value of 100 trillion German marks, and $1 USD was worth 4 trillion (4,000,000,000,000) German marks. The highest rate of inflation measured worldwide in the 20th century was in Hungary, in July, 1946, measured at over 41 quintillion percent one month &emdash; a rate at which prices doubled every thirteen hours. The most severe case of hyperinflation noted in the 21st century, by contrast, was in Zimbabwe in 2008, where the rate was about 5,500% per month, and prices doubled about every five days. Hyperinflation is a critical threat to any country's national security, because the populace loses confidence in the nation's currency and the government that issued it.

Inflation is monitored closely in the United States, with the prime responsibility for measuring and reporting the inflation rate falling to the government's Labor Department. They do this by calculating the average cost of a market basket of typical consumer goods and services, including such things as housing and energy costs. The inflation rate is calculated by comparing this data with that collected earlier. By drawing this data from sources nationwide, the department is also able to identify regional inflation rates, which may vary greatly because of the differing costs of such items as energy and housing in different parts of the country. This data is compiled and reported monthly as the Consumer Price Index (CPI), which is widely accepted as the official measure of the inflation rate.

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