The rate at which prices change can affect many facets of the economy, from influencing people’s purchasing power to boosting or deflating investment returns and raising or lowering interest rates on government debt. Understanding and properly managing inflation is critical to promoting a healthy, stable economy.
One of the most popular measures of inflation is the consumer price index (CPI), which includes the prices of a “basket” of goods and services that most consumers purchase on a regular basis, such as food, clothing and motor fuel. The CPI is based on a weighted system that accounts for the relative importance of each item in the basket. This helps to ensure that changes in the prices of a few items do not overly influence the overall inflation rate.
A low and steady level of inflation is generally considered positive for the economy, as it signals a growth in demand for goods and services. Businesses then respond by hiring more workers to increase production, which in turn leads to higher wages and economic growth. This cycle of increasing demand, wages and output ultimately leads to lower inflation over time.
High levels of inflation, however, can be dangerous because the value of money erodes over time and lessens purchasing power. When inflation is too high, governments and central banks often raise interest rates, reduce the amount of cash that must be kept in reserve or cut back on the issuance of new currency.
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