The economy is the organized system of human activity involved in the production,

consumption, exchange, and distribution of goods and services.

Economy is important not only because of its implications for human production and
activity, but also because it has engendered one of the most studied of all
disciplines: economics.

Inflation is the rate at which prices rise and purchasing power falls. It is why
something that cost $1 in 1980 cost $2.37 in 2005.
Purchasing power is a phrase to describe the quantity of goods or services that a
dollar can buy. A decrease in purchasing power is called inflation.

How it works/Example:
Two general theories explain inflation. The first, the demand-pull theory, says that
prices increase when demand for goods and services exceeds their supply. The
second, the cost-push theory, says that companies create inflation when they raise
their prices to cover higher supply prices and maintain profit margins.

Why it matters:
Inflation's fundamental relationship with supply and demand means that inflation
directly or indirectly affects nearly every financial decision, from consumer choices to
lending rates, and from asset allocation to stock prices. The inflation rate also offers
important clues about the state of an economy. Most economists agree that
moderate inflation is a sign of a growing economy and that deflation is a sign of
stagnation.

When inflation is high, overall prices are rising within the economy. In this type of
environment, businesses generally have little trouble raising prices to their
customers. What's more, there's a certain momentum to inflation data; when
consumers see inflation they usually expect prices to rise. That makes it easier for
businesses to justify price hikes. However, when inflation is fairly low, it makes it
extremely difficult for most companies to raise prices for goods and services.
Furthermore, inflation can influence the following areas:
Corporate Performance
Inflation can distort a company's financial performance. For example, a company that
reports high revenue growth during a period of rising inflation could be misleading
shareholders if those revenues were the result of inflationary pressure rather than
managerial skill. For this reason, many analysts use inflation information to "deflate"
or adjust certain financial measures so that they can compare them accurately over
time. Inflation can also influence a company's choices in accountingmethods.

Securities Analysis
Although all of the factors above can affect a company's stock price, perhaps the
largest effect inflation has on securities is found in the discount rate. When inflation
is high or rising, the future dividends or interest payments from an investment are
worth less. In broad terms, the higher inflation goes, the higher the discount rate
goes, and the lower the value of the security goes. The reverse is also true.

Monetary Policy
Because the Federal Reserve's job is to maintain long-term economic prosperity
through the execution of monetary policy, it takes a keen interest in inflation rates
when deciding whether to raise or lower the buyout. This is one reason some
analysts consider inflation a measure of the effectiveness of certain government
policies.

Contracts and Obligations

Contracts and other obligations involving payments over time often consider
inflation. For example, many labor contracts tie wage adjustments to changes in
the CPI, as do some alimony, child support, rent, royalty, and other obligations
affected by changes in purchasing power. People living off fixed incomes are
particularly affected by inflation, and this is why the government usually
adjusts Social Security checks and food stamps, as well as the wages of federal
employees and members of the military on a regular basis.