The Federal Reserve is responsible for monitoring inflation and adjusting monetary policy when prices get too high too quickly.

But what exactly is inflation? And why is it important for investors to know what it is?

Inflation has become a hot topic lately as progress has been made on the vaccine rollout and efforts to stimulate the economy. As a result, many investors are bracing themselves for an increase in inflation.

Here is what you need to know about inflation, along with a few other common "-flations" in finance.

What is inflation?

Inflation occurs when the price of goods and services rises over a period of time. Each unit of currency buys fewer goods and services, and as a result, the purchasing power of currency falls.

How does inflation happen?

There are several factors that can cause inflation, such as rising wages, scarcities, and increased costs for imported goods.

When the demand for goods and services grows faster than the economy's production capacity, a gap is created. High demand and low supply results in high prices. This is known as demand-pull inflation. At the beginning of the coronavirus pandemic in 2020, consumers eager to fill their carts with the necessities to shelter at home came face-to-face with many product shortages, including bicycles, webcams, beverages, and toilet paper.

On the supply side, when the cost increases for labor, raw materials, and production, this leads to an increase in prices. This is called cost-push inflation.

What is deflation?

Deflation occurs when the price of goods and services falls over a period of time because of high supply but low demand. In turn, the purchasing power of currency rises because consumers are less incentivised to purchase the goods or services. Simply put, products and services have a generously discounted price tag and are inexpensive.

On the surface, deflation appears to be a good thing for consumers because they can purchase more with the same income they have had. However, there are consequences. The falling prices hurt the economy and reduce activity.

How does deflation happen?

Deflation can be caused by excess production, decreased consumption, too much market competition, or too little market concentration.

When the supply of money and credit falls, prices tend to follow suit. This is what happened during the Great Depression, when prices dropped an average of 10 per cent every year between 1930 and 1933 following the collapse of the financials sector and banks. During the Great Recession, deflation was less severe, but it lasted from December 2007 to June 2009 because of a drop in commodity prices, specifically oil.

What is disinflation?

When the pace of inflation starts to slow down, this is called disinflation. It is often mistaken as being synonymous with deflation. Whereas deflation refers to the direction of prices and can have harmful impacts on the economy, disinflation refers to how the rate of inflation changes and is actually necessary for the economy in healthy doses so it does not "overheat."

How does disinflation happen?

Disinflation is represented as a change in the rate of inflation and reflects the contractions in the economy.

In the 1970s, the United States experienced some of its highest inflation. Throughout that decade, prices increased more than 110 per cent, and the annual rate of inflation was just over 14 per cent by the early 80s. The Federal Reserve carried out monetary policies to combat the rising prices, and inflation steadily slowed down in the following decades. This decrease in inflation from decade to decade was a period of disinflation.

What is stagflation?

Stagflation happens when the economy is experiencing slow growth and high unemployment rates simultaneously with inflation.

How does stagflation happen?

The US economy is not a stranger to stagflation. There are typically two reasons stagflation occurs.

First: supply shock. When the economy faces a sudden increase or decrease in the supply of a commodity or service, prices rise at the same time economic growth slows, as seen in the 1970s when oil prices rapidly increased. Production becomes more expensive and less profitable, resulting in stagflation.

Secondly, stagflation can arise if the government creates a policy harmful to a certain industry while growing the money supply too quickly.

Inflation, deflation, disinflation, and stagflation are all like tides, caused by the effects of economic activities and creating natural rises and falls in the economy. As investors, it is important to prepare for these occurrences to protect your portfolio. Make sure you have the right tools so you can ride out the wave.

Carole.Hodorowicz is an audience engagement associate at Morningstar.com.