Prices of the goods we buy seem to be getting higher and higher every year. Inflation is caused when the central bank (the Federal Reserve in the United States) allows the amount of money in circulation to grow too fast, or equivalently, if the central bank sets interest rates too low. Inflation causes the value of your money to decline, so you bear a direct cost.

What Does a Dollar Buy Today?

When inflation occurs, prices of goods rise, on average. So, a dollar buys less than it used to buy. How much is a dollar worth today, compared to the past?

As the table suggests, a dollar buys nowhere near what it used to. It now takes $8 to buy what $1 bought in 1962.

To get an idea of how much prices have changed in a year, we can calculate the inflation rate as the percentage increase in prices from one year earlier. The graph below shows the results of this calculation from 1960 to 2025.

In the chart, you can see that inflation in the early 1960s was very low. But inflation began to rise steadily in the late 1960s and into the early 1970s. Then, from 1974 to 1975, inflation jumped to double-digit levels. Inflation dropped for a short time later in the 1970s, but jumped up again in 1979 and 1980. Inflation began to decline in the early 1980s, rose a bit in the late 1980s, and then declined to below 2 percent in the 1990s. The 2000s saw volatility in inflation, though on average inflation remained fairly low. The inflation rate was negative for a short time in 2009, mainly because of a sharp decline in prices during the financial crisis. In the 2010s, the inflation rate remained below 2 percent, which is sometimes thought to be the optimal rate of inflation. But in March 2021, inflation jumped up sharply, as the effects of the pandemic subsided. Today, the inflation rate is about 2.5 percent.

What Causes Inflation?

In the short run, inflation can rise or fall from a number of factors, especially from temporary increases in food or energy prices. But in the long run, it turns out that only an economy’s central bank determines the inflation rate.

Historically, most of the periods in which a country has allowed inflation to reach high levels, as in the United States in the 1970s and early 1980s, were periods in which the central bank of the country allowed the amount of money in circulation to grow at a faster pace than it should have. The central bank is the entity that is in charge of distributing money in a country; in the United States, the central bank is the Federal Reserve, called the Fed for short. In the 1970s and early 1980s, the Fed made severe errors in judgment. The Fed’s leaders thought that the Fed should increase the money supply at a faster pace because the economy was growing slowly. But the increase in the money supply caused high inflation and did not help the economy grow faster at all.

Here is a plot of the relationship between the growth rate of the money supply and the inflation rate from 1960 to 1979. As you can see, increases in money growth were followed by higher inflation rates about two years later. Decreases in money growth were followed by decreases in inflation about two years later. This illustrates one of the difficulties the Fed faces in setting monetary policy—it doesn’t know if its policy was right or wrong until two years have passed. Then, if it has made a mistake, it takes another two years to correct it.

Another difficulty the Fed faces in setting monetary policy is that innovations in the banking sector cause the demand for money to change and this disrupts the relationship between the growth rate of the money supply and the inflation rate. In the graph above, which showed data from 1960 to 1979, you can see that as the money growth rate changes, the inflation rate responds with a lag of about two years. But the relationship changed after 1980 because of technological improvements in the banking system, which led the Fed to abandon the attention it paid to the money supply. Essentially, after 1980, U.S. money demand became so erratic that the Fed could no longer judge the appropriate size of the money supply necessary to control inflation. So, it gradually switched to a different method, which was to judge the appropriate level of the interest rate in the economy. Instead of money demand driving inflation, the idea is that the nominal interest rate on short-term securities needs to be at the right level. If the interest rate is too high, then inflation will decline; if the interest rate is too low, then inflation will rise. However, the difficulty in this approach is figuring out what the appropriate level of the interest rate is when conditions in the market are changing.

Today, inflation is about 2.5 percent. The Fed targets it at 2 percent, so inflation remains higher than desirable. It is the Fed’s duty to reduce it to 2 percent over the next few years. Given how the Fed operates, the current inflation rate calls for the Fed to increase interest rates slightly now, to bring inflation down to a lower level.