An increase in the overall level of prices in the economy is referred to as inflation.
Inflation is measured as an annual percentage increase. As inflation rises, every dollar you own buys a smaller percentage of a good or service.
The value of a dollar does not stay constant when there is inflation. The value of a dollar is observed in terms of purchasing power, which is the real, tangible goods that money can buy. When inflation goes up, there is a decline in the purchasing power of money.
There are several variations on inflation:
Deflation is when the general level of prices is falling. This is the opposite of inflation.
Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one month!
Stagflation is the combination of high unemployment and economic stagnation with inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with OPEC raising oil prices.
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Tip: Monevator shares ten ways to stop inflation destroying your wealth.