Definition of inflation (economics): A measure of the general rise in consumer prices over time.

What is inflation?

Prices of good and services tend to go up over time. Inflation is how economists measure that increase. Economics books use the term inflation as commonly as the word ‘economics’. It’s ubiquitous in economics titles because of the powerful impact inflation can have upon an economy.

It’s usually expressed as a year-on-year increase. An inflation rate of 2% tells us that prices are, on average, 2% higher than the same point a year ago.

Is inflation healthy or unhealthy for an economy?

Inflation is generally seen in a negative light, however, it’s a fairly normal part of a healthy economy.

If we exclude instances of negligent monetary policy, inflation is actually a sign that an economy is booming.

Why does inflation occur in a healthy economy?

When an economy expands very quickly, it will eventually use up all the available and qualified workers which industry demands. What then?

The workforce is only a fraction of the total number of working-age adults. Some adults may be re-training, enjoying a semi-retirement, purposefully not in work, or more commonly are looking after children.

When job interview shortlists begin to shorten, business is forced to increase the pay on offer to attract the right talent. This should work – with the right increase in pay, business will tempt some additional adults out of unemployment and into the workforce, and therefore the labour pool begins to expand again in line with the needs of the economy.

As wage increases creep into the market, household incomes will generally rise.

Why is this? There are two main reasons:

Businesses need to increase the prices of their products to recoup the additional spend on wages.

When consumers are armed with extra money, but are competing for the same set of houses, theatre seats and games consoles – vendors can charge higher prices and still make a sale.

So this is why it’s perfectly normal for a growing economy to experience some level of inflation.

What are the benefits of inflation?

Inflation is helpful because it encourages consumers to buy now rather than wait indefinitely. It makes sense to make a purchase soon if you think that prices will eventually rise. This mindset naturally promotes economic activity.

The Bank of England targets a rate of 2%. This means that they will set their interest rates at a level they believe will help nudge inflation up, or knock it down to that level if actual inflation veers off course.

What are the drawbacks of inflation?

If inflation rises higher than 2%, the BoE will take measures to reduce it because while a moderate amount of inflation can be healthy – a high rate of inflation is not.

If inflation is too high, savers will find that the real value of their savings accounts reduces, rather than increases over time. This provides little incentive for citizens to save for their future and behave in a fiscally responsible way.

The other side of the coin is that borrowers will see the real value of their borrowings erode as well. This has a positive impact – those borrowers can now afford to consume more goods & services. But if this happens in a very significant or high profile way, it can cause discontent and societal unrest.

Furthermore, if inflation feels higher than ‘virtually nothing’ in the mind of consumers, they may demand inflationary pay rises to maintain their standard of living.

It’s rational for employees to do this, however, any arbitrary rise in wages will simply feedback into inflation and cause the price increases to continue, in a vicious circle.

Of course, the extreme examples of inflationary issue can be seen in cases of hyperinflation (see definition of hyperinflation). Under extreme inflation rates, cash quickly becomes worthless and it becomes very difficult for the economy to function.

The wealth of pensioners and savers will slowly disappear, causing panic, as the money in their savings account becomes worthless.

This can cause significant damage to an economy which can last for a generation.

Is inflation always positive?

Not all goods increase in price. Due to more efficient manufacturing techniques and cheaper materials, products like TVs and vehicles are actually cheaper to buy now than 30 years ago – even though they’re objectively better products in almost every way.

These savings will partially offset increases in other types of goods. This is why it’s important that the basket of goods used to measure inflation is broad and consistent each year.

Generally speaking, aggregate inflation (total prices) is almost always positive. Negative inflation – known as deflation, is incredibly rare but it did occur in Japan in the 1990s.

How is the word inflation used in a sentence?

“The inflationary environment is encouraging consumers to take on excessive debts through unsecured loans.“

“Gross margin has been negatively impacted by input cost inflation, which has increased variable costs by 4% year to date.“

“Profit was inflated by fraudulent transactions recorded in turnover, and the inappropriate deferral of overheads into the next financial year.”

How does the definition of inflation relate to investing?

Investing books about economic history will help you to understand more about the massive impact that inflation can have on an economy and the stock market.

Investors need to take heed of inflation too. A beginner mistake is to exclude inflation when making long term financial decisions.

For example, people may take out a life insurance policy or set a savings target for a specific amount, without appreciating that in 20 or 30 years time, that same amount of spending money will not go as far as it does now.

As a general rule, 2% inflation is equivalent to prices doubling every 30 years. Therefore you can expect that your dream retirement home will cost twice as much in 30 years as it does now, and you should plan accordingly.

Property investing is probably the most common areas where investors fail to consider inflation. Take a look at our historic house prices adjusted for inflation. It shows that in real terms, houses were actually cheaper in 2020 than they were in 2008.

Few people on the street will appreciate this fact, because we generally only hear about house prices in nominal (unadjusted) terms, and indeed nominal house prices are higher than in 2008.

As any investing course will explain, you should compare the returns of asset classes in ‘real terms’, i.e. adjusted for inflation.

Because inflation applies equally to all returns (e.g. -2% off the nominal return), it has a disproportionate impact on the returns of savings accounts and bonds.

Savings accounts sometimes offer a negative return, when you consider that prices will be 1-3% higher next year.

This can encourage investors to take more risk when building their investment portfolio, however, you should always stay within your personal risk tolerances.