What Is Inflation? Causes, Effects and Examples

Inflation is a sustained rise in the general level of prices, which reduces the purchasing power of money over time. It is usually measured by the Consumer Price Index (CPI). A little inflation is normal: most central banks aim for about 2% a year.

Table of Contents

What is inflation?

Inflation is the rate at which prices across an economy rise over time. When prices go up, each unit of currency buys less, so $100 does not stretch as far this year as it did last year. Economists track it mainly through the Consumer Price Index, which follows the average price of a fixed basket of goods and services that households buy.

What causes inflation?

There are two classic drivers. Demand-pull inflation happens when demand outstrips supply: too much money chasing too few goods. Cost-push inflation happens when the cost of producing goods rises, through higher wages, energy or raw materials, and firms pass those costs on to customers. Both push the general price level higher.

A shopper choosing fresh fruit in a supermarket — Inflation raises the prices of everyday goods. Photo: Pexels.

Macroeconomists show both causes on one aggregate demand and aggregate supply (AD–AS) diagram. The price level sits on the vertical axis and real output on the horizontal one; inflation is a move up the vertical axis, and what happens to output tells you which kind it is.

Two causes of inflation

Demand-pull and cost-push in the AD–AS model

In demand-pull inflation, aggregate demand (AD) shifts right: spending outruns what the economy can produce, so the price level and output both rise. In cost-push inflation, short-run aggregate supply (SRAS) shifts left after a jump in costs such as energy: prices rise while output falls, the mix known as stagflation. Illustrative diagram, not real data. Tap or click to pause.

How much have prices been rising?

After a sharp spike earlier in the decade, inflation has cooled. In the United States, consumer prices rose 2.9% in 2024 and 2.7% in 2025 (US Bureau of Labor Statistics). Worldwide, the IMF expects global inflation to ease to about 3.7% in 2026. That is close to the roughly 2% that most central banks target as healthy.

Source: US Bureau of Labor Statistics.

Why inflation matters

Inflation quietly reshapes everyday life. It erodes savings and fixed incomes, because money loses value over time. It can also distort decisions if it is high or unpredictable. Yet mild inflation is generally seen as healthy: it encourages spending and investment and helps the economy avoid the opposite danger, deflation, when falling prices can stall growth. That is why central banks try to keep it low and steady rather than zero.

Neat stacks of US dollar bills on a surface — Inflation erodes the value of money over time. Photo: Pexels.

Key takeaways

Inflation is a sustained rise in the general price level, reducing purchasing power.
It is measured mainly by the Consumer Price Index (CPI).
Its two main causes are demand-pull and cost-push pressures.
Most central banks target about 2% inflation a year.

The Phillips curve: inflation versus unemployment

In 1958 the economist A. W. Phillips noticed that, in Britain, years of low unemployment tended to be years of fast-rising wages. The idea, known as the Phillips curve, suggests a short-run trade-off: when the economy is booming and jobs are plentiful, firms compete for workers and pass higher wages on as higher prices. When unemployment is high, wage and price pressure eases.

For a while in the 1960s, policymakers treated the curve as a menu: accept a little more inflation to get a little less unemployment.

The Phillips curve

The short-run trade-off between inflation and unemployment, and why it shifts

In the short run, lower unemployment comes with higher inflation. When people come to expect higher inflation, the whole curve shifts up, and the economy can end up with both higher inflation and higher unemployment. Illustrative diagram, not real data. Tap or click to pause.

The menu turned out to be unreliable. The economists Milton Friedman and Edmund Phelps argued that once people come to expect higher inflation, they build it into wage demands and prices, and the whole curve shifts up. That is what happened in the 1970s, when many economies suffered stagflation: high inflation and high unemployment at the same time. Today central banks keep the trade-off in mind but focus on keeping inflation expectations anchored, which is why most of them aim for a steady inflation target of about 2%.

Concept check

Is a little inflation normal?

Yes. Most central banks aim for around 2% inflation a year, because mild, steady price rises support spending and wages while avoiding deflation, when falling prices can stall the economy. Very high inflation, however, is harmful.

Does inflation mean my money loses value?

Yes. As the general price level rises, each unit of currency buys fewer goods and services, so your purchasing power falls unless your income rises at least as fast as prices.

What is the difference between demand-pull and cost-push inflation?

Demand-pull inflation comes from too much demand chasing too few goods. Cost-push inflation comes from rising production costs, such as wages or energy, that firms pass on as higher prices. Both raise the overall price level.

Sources

US Bureau of Labor Statistics, CPI 2025 in review — retrieved 2026-07-05 — bls.gov
IMF, World Economic Outlook, October 2025 — retrieved 2026-07-05 — imf.org
Encyclopaedia Britannica, Inflation — retrieved 2026-07-05 — britannica.com

Last updated: October 22, 2026

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Two causes of inflation: Aggregate demand and aggregate supply diagram. First aggregate demand shifts right: the price level and real output both rise (demand-pull inflation). Then short-run aggregate supply shifts left: the price level rises while real output falls (cost-push inflation).

Post Author

Juan David Montoya

Economist & Senior Economic Researcher. Editorial Director of EconomicActivity.org. Specializes in macroeconomic indicators, international trade flows, and economic sector taxonomy (ISIC Rev. 4). Analyzes multilateral data from the World Bank, IMF, UN Comtrade, and OECD.