Foundations
Inflation
Prices don't rise on their own — inflation is what happens when the amount of money chasing goods grows faster than the goods themselves.
Definition
Inflationis a sustained rise in the general price level of an economy — meaning, on average, each unit of currency buys a little less than it used to. It isn't any single price going up (that can happen for all sorts of reasons); it's prices rising broadly, across most goods and services, over time.
Why this exists
Money has no value for its own sake — it's only useful because people accept it in exchange for goods and services. That means the "value" of a unit of currency is really about how much it can be traded for. When the amount of money circulating in an economy grows faster than the amount of goods and services available to buy with it, there's more money competing for the same stuff — and, per supply and demand, more buyers chasing a limited supply pushes prices up.
This can happen a few different ways: a government or central bank adds more money to the economy than the economy's output grows to match, demand for goods rises faster than producers can supply them, or the cost of producing goods (materials, wages) rises and gets passed on in higher prices. In every case the root shape is the same: more money, or more demand, chasing the same or fewer goods.
Inflation matters for nearly every financial decision because it erodes the purchasing power of money that just sits still. A dollar held as cash loses a little of its buying power every year inflation is positive — a large part of why people invest instead of only holding cash, and why interest needs to outpace inflation to grow real wealth, rather than just keep up with rising prices.
Worked example
Imagine a small island economy with exactly 10 lemonade stands, each selling one cup a day, and everyone on the island has $10 to spend. At that supply of cups and that amount of money, cups settle around $1 each.
Now imagine everyone on the island suddenly receives an extra $10 — but the island still only produces 10 cups of lemonade a day, no more. People now have more money but the same amount of lemonade to buy. Buyers start offering more than $1 to make sure they get a cup, and the price rises — say, to $2 a cup. Nothing changed about the lemonade; what changed is how much money was chasing it.
Common misconceptions
“Inflation happens because businesses get greedy and raise prices.”
A business raising its price is the symptom, not the cause. Prices rise across the board when more money or demand is chasing the same supply of goods — not because sellers as a group suddenly decided to charge more.
“Inflation is always bad for everyone.”
Low, steady inflation is a normal feature of a growing economy and can even help borrowers, since fixed debts get easier to pay off in real terms. Very high or unpredictable inflation is what causes the real damage.
“Inflation means everything gets more expensive by the same amount.”
Inflation is an average across many goods — some prices rise much faster than the average, others rise slower or even fall, even while the overall price level goes up.
Also in the Glossary: Inflation