Different types of inflation explained

Inflation figures are reported each month. The figure (a percentage) is usually accompanied by comments about how the cost of filling our cars with fuel has increased or decreased and whether or not the weekly trip to the supermarket has become cheaper or more expensive.

But what is inflation? Is it good or bad for our finances? We take a look:

What is inflation?

Simply put, inflation is the increase in the price of our everyday goods and services. It is calculated using a ‘basket’ of commonly-used goods and services, the average price of which is shown through the Consumer Price Index (or CPI).

When we are in an inflationary environment, it essentially means we have the same amount of money to spend each month but, as things cost more, it doesn’t go as far as it used to – the real value of our cash is being eroded.

There are two main types of inflation: demand-pull, which is when there is more demand for goods than there is supply, and cost-push, which is when the cost of making goods increases and companies have to raise their prices in order to cover the shortfall. The former is typically a ‘healthier’ type of inflation – it usually moves in-line with a rise in employment and wages and because we have more money in our pockets, we tend to spend more. In contrast, the latter can put a strain on the consumer and therefore negatively impact the economy.

What is disinflation?

Disinflation is still a period of inflation, but prices are rising by smaller amounts than they were before. In other words, the rate of inflation is falling. Disinflation can, in some cases, suggest unemployment is rising or economic growth is slowing. It can also come about when central banks raise interest rates.

What is deflation?

Deflation is the opposite of inflation: when the rate of inflation drops below zero and goods and services become cheaper. This may at first sound like a positive. After all, if your salary is the same but the things you want to buy become relatively cheaper, surely this would encourage spending and boost the economy? Not necessarily.

The issue is that, because the value of your cash increases, you are more incentivised to hold onto your money in savings, rather than spend it. After all, what is the point in buying something today when it could be even cheaper tomorrow? As fewer products are bought, companies’ revenues fall and this can then lead to higher rates of unemployment and a continued downturn in spending. This is known as a “deflationary spiral”.

What is stagflation?

Stagflation is when there is no economic growth and unemployment is rising, but there is still inflation in the system. In other words, your wages would be falling, but the price of goods would keep rising. Of course, this is not an ideal environment for anybody! Stagflation tends to be the result of ‘bad’ or ‘cost-push’ inflation.

What is reflation?

Reflation essentially signifies the start of the inflationary cycle after a recession – it should not be confused with full-blown inflation and it tends to happen more gradually.

It is when the economy starts to experience stronger growth in conjunction with rising prices. It is often caused by central banks reducing taxes, printing money or lowering interest rates – in other words, by injecting more cash into the economy.

It means that, as economic growth improves, demand for goods increases, companies make more products and more staff get hired. It should also lead to higher wages as companies continue to thrive.

It also benefits the government because, as corporate profits improve and more people return to the workforce, they receive more tax revenue. The government should also spend less money as benefit payments fall.

The views of the author and any people interviewed are their own and do not constitute financial advice. However the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions. Before you make any investment decision make sure you’re comfortable and fully understand the risks. If you invest in fund or trust make sure you know what specific risks they’re exposed to. Past performance is not a reliable guide to future returns. Remember all investments can fall in value as well as rise, so you could make a loss.