What is inflation? How it is measured and what it does to your money

Inflation is the pace at which prices rise across an economy. At 3% a year, something that costs 100 today costs about 103 next year. That sounds small, but it adds up: after 25 years at 3%, cash buys less than half of what it used to.

What inflation is

Inflation means the same money buys less over time. A coffee, a bus ticket or a month of rent slowly costs more, so every banknote in your wallet is worth a little less each year. Central banks aim for a small, steady rise. It keeps people spending and investing without eating savings too fast.

The opposite, prices falling across the whole economy, is called deflation. It sounds pleasant, but it usually comes with weak demand and job losses. Japan struggled with it for years after the 1990s. At the other extreme, hyperinflation destroys a currency in months, as Zimbabwe saw in 2008 and Venezuela in 2018.

How inflation is measured

Every month, statisticians record the prices of a typical household shopping basket: food, rent, transport, energy, health, education, phone bills and more. Each item gets a weight that reflects how much households really spend on it. In the US basket, housing is about a third of the total. In India and Indonesia, food takes a much bigger share than in the US or the UK.

Here is how the weights work. Take a simple basket where food is 40% of spending, rent 40% and transport 20%. Food prices rise 10%, rent rises 5% and bus fares fall 5%. Food adds 4 points (40% of 10%), rent adds 2 points (40% of 5%) and transport takes away 1 point (20% of 5%). Inflation is 5%.

The price of the whole basket is the consumer price index (CPI). Its change over 12 months is the inflation rate you see in the news. Most countries publish it once a month, and traders compare each release with economists' forecasts.

What inflation rate is normal?

Most central banks publish an inflation target. In rich economies it is usually 2% a year. Many emerging economies aim a little higher, often with a band around the target, because their prices tend to move more.

What causes inflation

• Energy shocks. Oil and gas feed into transport, factories and food, so a price spike spreads everywhere. The 1973 oil embargo roughly quadrupled oil prices.
• Supply problems. When factories close or ships get stuck, fewer goods meet the same demand, and prices rise.
• Strong demand. When people and governments spend faster than the economy can produce, shops can raise prices without losing customers.
• Too much money. When money grows much faster than the goods it can buy, prices climb. Printing money to pay the bills is how hyperinflation starts.
• A weaker currency. When a currency falls, imports cost more in local money, and shops pass those costs on.
• Expectations. If everyone expects prices to keep rising, workers ask for bigger pay rises and shops raise prices in advance. Inflation can feed itself.

The 2022 inflation wave

After the pandemic, demand came back faster than supply. Then Russia's invasion of Ukraine pushed energy and food prices up sharply. Inflation hit multi-decade highs in one country after another, almost at the same time. In Indonesia, it peaked in September 2022, the month the government raised subsidised fuel prices.

Some countries went much further. Argentina's inflation passed 200% at the end of 2023 and peaked near 290% in April 2024, before falling sharply in 2025. Central banks answered with the fastest run of interest-rate rises in decades, and by 2024 inflation in most major economies had fallen back towards target. In 2025, euro area inflation was close to 2%, while US and UK inflation stayed above target.

What inflation does to your money

Here is what 100 in cash can buy after 10, 20 and 30 years at different inflation rates. The currency doesn't matter: the maths is the same everywhere.

That is why savers look for returns above inflation. Your real return is roughly your return minus inflation. A deposit paying 4% while inflation is 3% grows your buying power by only about 1% a year. In 2022, a saver earning 1% while prices rose about 9% lost roughly 7% of their buying power in a single year.

Over long periods, growth assets such as shares have usually beaten inflation, with big ups and downs along the way. Some governments also sell inflation-linked bonds, such as US TIPS and UK index-linked gilts, whose payments rise with prices. Cash still has a job: an emergency fund should be safe and easy to reach.

How central banks fight inflation

When inflation runs hot, central banks raise interest rates. Loans and mortgages get more expensive, spending cools and prices rise more slowly. When the economy is weak and inflation is low, they cut rates to help.

The 2022 wave showed how far they will go. Between March 2022 and July 2023, the US Federal Reserve lifted its main rate from near zero to between 5.25% and 5.5%. Between December 2021 and August 2023, the Bank of England went from 0.1% to 5.25%. From July 2022 to September 2023, the ECB raised its deposit rate from minus 0.5% to 4%. As inflation fell, most of them began cutting rates in 2024.

Markets react to the surprise, not to the number itself. If inflation comes in above the forecast, traders expect higher interest rates for longer, so that country's currency often jumps and its share prices often fall. A miss of just 0.1 percentage point can move currencies and shares within seconds.

FAQ

Sources: National statistics offices (US Bureau of Labor Statistics, UK Office for National Statistics, Eurostat, INE Spain, BPS Indonesia, INEGI Mexico, India MoSPI, Statistics Canada, Statistics Bureau of Japan and others); central bank publications (Federal Reserve, ECB, Bank of England, Bank Indonesia, Banxico, Reserve Bank of India). Educational content, not financial advice.

Feel inflation for yourself

Fill the inflation basket, then see how fuel, rent and food move the number.

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