All About Inflation
What exactly is inflation and how does it affect the economy and your finances? This article breaks down the basics of inflation.
By Kaitlin Meyer — February 21, 2023
What is Inflation?
Very simply, inflation is a rise in prices. This constitutes a decrease in purchasing power: money becomes less valuable. Inflation is measured by tracking and calculating the average price change of a "basket of goods." The Bureau of Labor Statistics (BLS) tracks this conceptual basket by sampling the monthly prices of roughly 94,000 goods and services. These include food, energy, rent, clothing, and services priced in over 75 urban areas. This "basket of goods" is used to calculate the consumer price index (CPI), which represents the spending habits of 93% of the US population.
What Causes Inflation?
In general, inflation is caused by an influx of money in some way or another. This can happen in three ways: demand-pull inflation, cost-push inflation, and built-in inflation. Demand-pull inflation is when more money enters the economy on the consumer level. This causes an increase in demand for goods and services, which in turn causes a rise in prices. In other words, there is an increase in demand for goods and services and no change in the supply. Cost-push inflation is when there is a decrease in the supply of goods and services and the demand remains the same. Interruptions in the supply chain caused by a worldwide pandemic or natural disasters could cause this type of inflation. Built-in inflation is when consumers expect the current inflation rates to continue, and in anticipation of higher prices and higher rent, they demand higher pay. This increase in wages drives up prices.
How is Inflation Calculated?
Inflation is calculated using price indices. The CPI generally indicates inflation rates for consumers. In order to calculate the inflation rate from the price index, the following equation is used:
Inflation Rate = (Current CPI Index / Original CPI Index) * 100
Suppose you wanted to monitor the price of bananas in your local town. You could use this equation and substitute the price of the banana for the CPI Index. The index balances out price changes in all directions. For example, suppose the cost of gas increases by 5%, but the cost of groceries decreases by 5%. These price changes would likely cancel each other out in the final inflation rate. Knowing how the inflation rate is calculated can help you understand what is going on in the economy and can inform your own financial decisions.
How Does Inflation Affect Students?
Inflation affects students primarily by causing an increase in prices. Students pay more for tuition, textbooks, and cost of living. On campus, room and board costs often rise, and off campus, rent, groceries, and other necessities become more expensive. These changes can create a need to take out more or larger student loans, driving up student debt.
Inflation, however, is not always bad for students. Inflation can be favorable for those paying off loans since the money going back to the lender is less valuable than the money originally loaned. Higher inflation rates will give you an advantage if you are currently or will soon be paying off student loans.
What Can Students Do to Protect Themselves?
The first thing students should do to protect themselves against rising prices and a higher cost of living is learning how to budget and manage personal finances. SAGE Scholars offers many resources to help students learn how to budget and save money. Stud ents who take out loans are often not required to make payments until after graduation. This allows students to save some money while attending school. While academics should be a student's primary focus, cutting down on a few expenses can facilitate small recurring savings, which can add up to significant amounts over time.
The second thing students can do is save money well. What does this mean? As discussed above, inflation causes a decrease in the real value of cash. Suppose a student learns to budget well and is saving $100 every week. If the student keeps this money in cash or a checking account for long periods, inflation can erode the value of these savings. Suppose I put $5000 into a savings account ten years ago in 2013. That money now has a buying power of only $3,879. While a student is unlikely to spend ten years in college, the effect of inflation on savings can still be significant, especially with current high inflation rates.
To counter the devaluing of savings caused by inflation, people often invest in the stock market, as the market as a whole does a pretty good job of rising and falling with inflation. Students can invest some money in the stock market by purchasing index funds in several different stocks. This is called a diversified portfolio; if one stock crashes, the other stocks you are investing in make up the difference. If investing money in the stock market is too intimidating, students should at least set up a high-yield savings account. While these accounts may not track inflation exactly, they are much better than letting money sit in checking accounts with little to no interest. Another option open to students is buying federal bonds.
These generally have mid to high-interest rates. The downside to all of these options is that money invested in such a way is a little less accessible. High-yield savings accounts only allow a certain number of withdrawals each month. Federal bonds usually cannot be withdrawn for a year after the start date. This is where the art of budgeting comes in: some money should be readily accessible for recurring expenses and emergencies. Some percentage of the budget is usually allocated to savings. This money should go into the harder-to-access investments or savings accounts that keep up with inflati on.
A third thing that students can do is to evaluate their loan options thoroughly before choosing one. Having a loan with a low fixed interest rate can be extremely beneficial when it comes time to pay it.
Kaitlin Meyer
Kaitlin Meyer is a Master's student at Ohio State University (OSU), and is writing a thesis on snow microstructure inspired by her love for skiing. She earned a B.A. in Liberal Arts from Wyoming Catholic College (WCC).
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