Inflation Explained: Causes, Effects on Purchasing Power, and Its Link to Interest Rates

Inflation is a sustained increase in the general price level across an economy, leading to a reduction in the purchasing power of money. Unlike a single price hike, inflation reflects a broad and continuous rise in prices for a wide range of goods and services, measured systematically by the Consumer Price Index (CPI). For example, if a basket of goods cost 100 shekels last year and now costs 105 shekels, the real value of money has decreased, meaning consumers can buy less with the same amount.

Moderate inflation, typically between 1% and 3%, is considered healthy for a developed economy as it encourages economic activity and prevents deflation. However, high inflation rates can significantly harm living standards. Inflation erodes purchasing power when incomes do not keep pace with rising prices, effectively reducing real wages and savings. Savings with returns below the inflation rate lose real value over time, even if nominal amounts increase.

Inflation impacts everyday expenses such as groceries, housing costs (including rent and mortgage payments linked to the CPI), utility bills, and other recurring charges. It also affects savings, especially when interest rates on deposits are lower than inflation.

The main causes of inflation include excess demand exceeding supply, rising production costs (like raw materials, energy, and wages), and supply shortages due to disruptions or geopolitical events. It is important to distinguish inflation from isolated price increases, which may be temporary or localized and do not reflect the overall economic trend.

The relationship between inflation, interest rates, and the CPI is interconnected. The CPI measures inflation annually, and the Bank of Israel is legally mandated to maintain inflation within a 1%-3% target range. To control inflation, the central bank adjusts interest rates: raising them to cool demand when inflation is too high, or lowering them when inflation is too low.

A hypothetical example shows that with a constant 3% annual inflation, the real value of 1,000 shekels would decline to 863 shekels in five years, 744 in ten years, and 412 in thirty years, illustrating the long-term erosion of money’s purchasing power.