Inflation: what it is, how it works and why prices rise

What “inflation” really means

Imagine doing the same grocery run today and one year from now. Same cart, same products: if the total at the till is higher, you have just touched inflation with your own hands. Technically, it is the general, sustained increase in the price level of goods and services in an economy.

The key word is general: if only the price of coffee rises after a bad harvest, that’s not inflation. It is inflation when the increase touches a bit of everything — food, utility bills, transport, rents — and lasts over time.

How it’s measured

Statistical agencies measure inflation through a “basket”: a list of hundreds of products and services representing what households actually buy, from bread to fuel, from streaming subscriptions to the dentist. Every month they record the prices of these items across the country and compare them with the previous year.

Practical example: if the basket that cost 1,000 a year ago costs 1,030 today, annual inflation is 3%.

The result is the consumer price index (CPI) — the number you hear on the news when they say “inflation is at 2%”.

Why prices rise: the two main causes

1. Demand-pull inflation

It happens when too many people want to buy more than the system can produce. If everyone wants the same thing and there is little of it, sellers can raise prices.

Practical example: after the pandemic, millions of people started travelling again at the same time. Airlines and hotels couldn’t meet all the demand: flight and room prices shot up.

2. Cost-push inflation

It happens when producing gets more expensive: energy, raw materials, transport or wages rise, and companies pass those costs on to final prices.

Practical example: in 2022 the price of gas exploded. For a bakery, the oven costs more to run and the flour costs more to ship: the result is that the bread on the shelf costs more, even though the demand for bread hasn’t changed.

What it does to your money

Inflation works like an invisible tax on idle savings. With inflation at 5% a year, 10,000 left in a non-interest-bearing account can buy, one year later, roughly what 9,500 buys today. The number on the account doesn’t change — its real value does.

The same goes for wages: if your salary stays flat while prices rise 5%, in real terms you are earning 5% less. That is why high-inflation periods come with intense debates about wage adjustments.

Who keeps inflation in check

That’s the job of central banks — in the euro area, the European Central Bank, whose declared target is inflation at 2% over the medium term. Their main tool is the interest rate:

It is a slow mechanism — the effects show up months later — but it is the most powerful lever there is for steering prices.

And if prices fell? Deflation

The opposite of inflation is deflation: a general, prolonged fall in prices. It sounds like a dream, but it’s a trap: if you know the car you want will cost less in six months, you wait. If everyone waits, companies sell less, cut production and wages, and the economy spirals downward, all the way into a recession. Japan fought this for nearly two decades.

That is why central banks don’t aim for “zero inflation” but for low and stable inflation: the famous 2%.