What is inflation and how does it affect you?

A woman seated at her kitchen table uses a calculator and laptop to create a budget.Image: A woman seated at her kitchen table uses a calculator and laptop to create a budget.

In a Nutshell

Inflation rates are higher than they’ve been in 40 years — which can directly affect your living expenses, job, interest rates, investments and more.
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Inflation occurs when the prices for goods and services increase over time. But when inflation accelerates at a much higher rate than average, it can have a major effect on the economy — and your finances.

Inflation in the U.S. hit the highest rate in 40 years — climbing to a 7.9% annual rate in February 2022, according to the U.S. Bureau of Labor Statistics.

But what exactly is inflation? Why does it matter, and how can it affect you directly — especially when rates are rising faster than they normally do?

What is inflation?

Over time, the prices for various goods and services can increase — which is typically a result of increased demand from consumers or decreased supply from manufacturers. Inflation is an economic term that measures the rate at which those prices rise.

How inflation is measured

The federal government measures inflation by using the consumer price index, which tracks the average prices of various goods and services across several categories such as food, energy, vehicles, apparel and medical services. This “market basket” of goods and services is designed to be a sampling of what an average consumer might include in their budget on a regular basis.

Why inflation matters

When inflation rates go up, your purchasing power — or the value of a dollar — generally goes down. If you don’t earn enough money to keep up with rising prices, inflation can make it a challenge to cover the cost of day-to-day necessities like food and gas.

The recent 12-month increase in inflation is the largest since 1982. And in times when inflation rates are rising at a historically higher-than-average pace, you’re likely to feel the effects of inflation much more than you would in a typical year.

6 effects of inflation

Inflation can play out in many ways, but here are six common ways you may see the effects of inflation on your life and finances.

1. Your cost of living may go up

Inflation raises the average price on a broad range of goods and services. So depending on your spending habits, the increases could put a strain on more than one area of your budget.

For example, while overall inflation in February 2022 was 7.9% over the previous year, energy prices increased by a whopping 25.6% over that time period, driven primarily by gasoline prices, which were up by 38%. At the same time, food prices increased by 7.9%.

In other words, the effects of inflation can affect people differently, depending on where they spend most of their money. People who have long commutes can get hit much harder by the price of gas than those who work from home.

2. Supply may not be able to keep up with demand

As the value of a dollar declines, people may try to get ahead of inflation by stocking up on goods they use regularly. And if supply hasn’t necessarily increased, this increased demand could result in shortages and potentially make it difficult to find necessities. What’s more, this increased demand pushes prices for day-to-day items up even higher.

3. Wages and job opportunities may increase

Rising inflation can create higher consumer demand for goods and services, which could, in turn, cause manufacturers, retailers and other companies to increase hiring and wages to keep up with demand.

When inflation is on the rise, it could be good time to ask for a raise or hunt for a better-paying job — maybe even in a growing industry. But before doing so, it’s a good idea to do your research as inflation’s effects can vary across different industries.

4. Things can be tougher for those on fixed incomes

If you’re on a fixed income, such as Social Security, you may have an even harder time adjusting to inflation. Though you’ll get increases that are designed to keep pace with inflation, they may not be enough, particularly in times of high inflation rates.

For example, Social Security payments increased by 5.9% beginning with the December 2021 benefits. But with steadily rising inflation, the boost may not be enough to cover higher expenses.

5. Interest rates could be on the rise

The Federal Reserve helps keep inflation under control by adjusting the federal funds rate. This is the rate that banks pay to lend money to one another.

Because the federal funds rate can influence short-term interest rates — including the prime rate that many lenders use to determine rates for borrowers — lenders may increase their interest rates on certain kinds of loans.

If you’re shopping for a loan or thinking about making a large purchase, do your research to see if or when it makes sense for your situation.

6. Short term investments might see lower returns

Where you put your money can be important regardless of the inflation rate, but it could be challenging during times of accelerated inflation. For example, if your high-yield savings account offers a 1% annual percentage yield and the inflation rate is 3%, you’re not earning enough to combat the decreased purchasing power.

That said, it may still be a good idea to use a savings account for short-term needs, such as an emergency fund or a down payment for a home. If you have money for long-term investing, you might want to consider opportunities that could provide you with a higher long-term return like stocks and real estate.

Next steps

If you’re curious to see how inflation has changed the buying power of your money over time, check out our inflation calculator. If you don’t already have one, it may be a good time to create a budget. You can try our budget calculator to take a closer look at your income versus expenses. Sticking to a budget can help you work toward making the best financial decisions and set goals — no matter what inflation rates may be doing.

About the author: Ben Luthi is a personal finance freelance writer and credit cards expert. He holds a bachelor’s degree in business management and finance from Brigham Young University. In addition to Credit Karma, you can find his wo… Read more.