The process of living in society involves making and spending money to purchase goods and services. Over time, inflation reduces a dollar's buying power so that the same dollar buys you less from one year to the next year. By learning the fundamentals of inflation and how it works, you'll have a better idea of how a financial system operates.

Inflation Definition

Inflation involves the increase of product and service prices over a set period of time. Instead of tracking one commodity or service, the U.S. Federal Reserve tracks the overall price changes of items bought and sold in the economic system by using price indices. By examining price indices, the Federal Reserve can make predictions about future inflation rates to help manufacturers and consumers plan and prepare.

Purchasing Power

Purchasing power involves the connection between a dollar and the amount of or quality of the goods or services a consumer can purchase. As inflation constantly changes the value of a dollar, the purchasing power of the dollar goes up or down depending on whether inflation rises or falls.

Consumer Price Index

The price of average goods and services purchased by consumers changes from month to month. These tracked changes make up the Consumer Price Index. Another statistic, Personal Consumption Expenditures, tracks the adjustments made in response to the CPI. If the price of one item rises, spending choices often change as people choose less expensive items.

Inflation and Income

The average inflation rate in the U.S. has remained steady at 3 percent overall for roughly 100 years. Optimally, over time your income will exceed inflation to ensure that your earnings grow and expand.

Planning for the Future

Inflation has a negative impact on retirement planning when you realize that your purchasing power will be vastly different by the time you reach retirement age and are ready to spend your retirement savings. To ensure that your savings will have the necessary purchasing power, your savings will need to outpace inflation. The amount you save will need to increase by the same percentage of inflation every year to ensure purchasing power parity.