What inflation is, and why central banks aim for about 2 percent

Inflation is the rate at which the general level of prices rises over time. When inflation runs at 3 percent a year, a basket of goods that cost $100 last year costs about $103 this year — and each dollar buys a little less than it used to.

What drives it

Economists usually group the causes into two families. “Demand-pull” inflation happens when demand for goods and services outpaces what the economy can supply, pushing prices up. “Cost-push” inflation happens when the cost of producing things rises — for example when energy or wages climb — and businesses pass those costs on. Expectations matter too: if people broadly expect prices to keep rising, that belief can become self-fulfilling.

Why a little is considered healthy

It may seem like zero inflation would be ideal, but most central banks deliberately target a small positive rate, commonly around 2 percent. A gentle, predictable rise in prices gives the economy room to adjust, encourages spending and investment rather than hoarding cash, and keeps a safe distance from deflation — falling prices — which can be far more damaging, because it encourages people to delay purchases and can deepen downturns.

How central banks respond

The main tool is the interest rate. When inflation runs too hot, a central bank tends to raise rates, which makes borrowing more expensive, cools demand, and slows price rises. When the economy is weak and inflation is low, it tends to cut rates to encourage borrowing and spending. These moves ripple through markets, mortgages, and business investment, which is why rate decisions draw so much attention.

The takeaway

Inflation is not simply “prices going up” — it is a signal about the balance between demand, supply, and expectations in an economy. A low, stable rate is generally the goal precisely because it is predictable, and predictability is what lets households and businesses plan.