Inflation Explained: Why Prices Rise and How It Affects Your Money
Learn what inflation is, why prices increase, how it affects your purchasing power, and why governments use interest rates to control it.
By Ana Marlene Gilles
5 min read
You go to the supermarket and notice that the same groceries you bought last month now cost a little more. Your parents talk about how things were cheaper when they were young. A coffee that cost €1 a few years ago is now €1.50. You didn't buy anything different. Nothing changed. And yet, somehow, everything costs more.
That's inflation.
And understanding it matters much more than most people realise.
Inflation is the general and sustained increase in the prices of goods and services over time.
The key word is general. Inflation does not mean that one specific product becomes more expensive; it means that the prices of most things increase at the same time.
Economists measure inflation using something called the Consumer Price Index (CPI). The CPI tracks the average price of a basket of everyday goods and services, such as food, transport, housing, and energy, and monitors how those prices change over time.
When inflation is low and stable, around 2% per year, most economists consider it a sign of a healthy, growing economy. However, when inflation rises much higher than that, or falls below zero (a situation known as deflation), economic problems can start to appear.
The Simple Idea: Why Are Prices Going Up?
Here is the part that affects everyone directly: inflation reduces purchasing power. Purchasing power simply means how much your money can actually buy.
For example, if a €10 note allows you to buy ten items today but only eight of those same items next year, your purchasing power has decreased, even though you still have the same €10. This is where wages become important.
If prices rise by 5% but your salary only increases by 2%, you are effectively earning less than before, even if the number on your payslip remains the same. These are called real wages — wages adjusted for inflation — and they have actually fallen.
This is one of the main reasons inflation affects lower-income households the most. People with fewer savings and less control over their wages are more vulnerable when prices rise.
Meanwhile, people who own assets such as property, shares, or businesses may see the value of those assets increase during periods of inflation. This can widen the gap between those who own assets and those who do not, increasing inequality in society.
What Happens to Your Money?
Inflation does not have just one cause. Economists usually identify several main reasons why it happens.
WHEN EVERYONE WANTS MORE: DEMAND-PULL INFLATION
Demand-pull inflation happens when there is too much money chasing too few goods. If people are spending a lot because employment is high, interest rates are low, or governments have injected money into the economy, demand for products can become greater than supply. As a result, businesses raise prices. Think of it like too many people trying to buy the same limited product: competition pushes the price higher.
WHEN PRODUCING THINGS GETS MORE EXPENSIVE: COSTS PUSH INFLATION
Cost-push inflation happens when the cost of producing goods increases. When raw materials, energy, or wages become more expensive, businesses often pass those higher costs onto consumers through higher prices. The energy crisis of 2021 and 2022 is a recent example. When natural gas prices increased sharply, the cost of producing many goods and services also rose.
THE CYCLE THAT KEEPS GROWING: BUILT-IN INFLATION
Built-in inflation, sometimes called the wage-price spiral, happens when workers expect prices to continue rising and demand higher wages to compensate. Higher wages increase production costs for businesses, which leads to higher prices. Those higher prices then cause workers to demand even higher wages. The cycle continues and reinforces itself.
MORE MONEY, SAME AMOUNT OF GOODS
Another factor is the money supply. When governments or central banks create significantly more money without a similar increase in the amount of goods and services available, there can be more money competing for the same number of products. As a result, prices may increase. This was one of the concerns discussed after many countries introduced large economic support programs during the COVID-19 pandemic.
Where Does Inflation Come From?
The main tool used to control inflation is monetary policy, which is managed by central banks such as the European Central Bank and the Federal Reserve System. Their most powerful tool is the interest rate.
When inflation becomes too high, central banks usually raise interest rates. Higher interest rates make borrowing more expensive, meaning people and businesses take fewer loans and spend less. Less spending reduces demand, which can slow down price increases.
However, this approach has a downside: it can also slow economic growth and increase unemployment. When inflation is too low or the economy is struggling, central banks usually do the opposite and lower interest rates to encourage borrowing and spending. The challenge is finding the right balance. Move too slowly, and inflation can become difficult to control. Move too aggressively, and the economy could fall into a recession. Central banks are essentially trying to cool down an overheating engine without turning it off completely.
How Do Governments Fight Inflation?
Inflation does not affect everyone equally. That is what makes it not only an economic issue, but also a social and political one. For people living paycheck to paycheck, a constant increase in the cost of food, rent, and energy can quickly become a serious problem.
People with fixed incomes, such as some pensioners, are particularly vulnerable because their income does not automatically increase with prices. Savings kept as cash can also lose real value when inflation is higher than the interest earned on those savings.
However, inflation can sometimes benefit people who owe money. For example, if someone borrowed €100,000 ten years ago and inflation has averaged 3% annually, the real value of that debt has decreased. They are repaying the loan with money that is worth less than when they originally borrowed it. This is one reason why governments with large national debts often have a complicated relationship with inflation.
Politically, inflation is extremely unpopular. Unlike many economic issues, people experience it every day when they buy groceries, pay rent, or fill up their car. When people feel that wages are not keeping up with rising prices, frustration and political pressure often increase.
Why Inflation Is More Than Just an Economics Problem
Like most things in economics, inflation is rarely caused by one single factor and rarely solved with one simple solution. It reflects the deeper tensions within an economy: the balance between growth and stability, between savers and borrowers, and between people who own assets and those who do not. A moderate level of inflation is considered normal and even healthy for a growing economy. But when inflation becomes too high, it can reduce living standards, increase inequality, and create political instability.
Understanding inflation is not just about understanding prices. It is about understanding how economies work, and how those changes affect people's everyday lives.
The Complicated Reality of Inflation
Author: Ana Marlene Gilles
Editor & Publisher: Lucía Lobato
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