Inflation
Inflation is a general increase in the prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money. The opposite of inflation is deflation, a decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualised percentage change in a general price index, typically a consumer price index (CPI).[1]
Inflation is a central concept in macroeconomics and is monitored closely by governments and central banks. Most economists today favour a low and steady rate of inflation rather than zero or negative inflation, because a small positive rate helps labour markets adjust and reduces the risk of a deflationary spiral.[1]
Terminology
The term originates from the Latin inflare (to blow into or inflate). Conceptually, inflation refers to the general trend of prices, not to changes in any specific price. For example, if consumers choose to buy more cucumbers than tomatoes, cucumbers become relatively more expensive and tomatoes less expensive; such relative price changes reflect a shift in tastes and are not, in themselves, inflation. Inflation relates to the value of currency itself.[2]
Related concepts include:
- Deflation — a fall in the general price level.
- Disinflation — a decrease in the rate of inflation (prices still rise, but more slowly).
- Hyperinflation — an out-of-control inflationary spiral, often defined as exceeding 50% per month.
- Stagflation — a combination of inflation, slow economic growth, and high unemployment.
- Reflation — an attempt to raise the general price level to counteract deflationary pressures.
- Asset price inflation — a general rise in the prices of financial assets without a corresponding increase in the prices of goods or services.
- Agflation — an increase in the price of food and agricultural crops relative to the general rise in prices.
Measurement
Inflation is measured using price indexes, which track the weighted average price of a basket of representative goods and services. The most widely used measures are:
| Measure | Description |
|---|---|
| Consumer price index (CPI) | The percentage change in the price of a basket of goods and services purchased by households. It is the most commonly cited measure of inflation. |
| Producer price index (PPI) | Measures the average change in selling prices received by domestic producers for their output. |
| GDP deflator | The ratio of nominal GDP to real GDP; a broader index that covers all domestically produced goods and services, including investment and government spending. |
A simple illustration of how inflation is calculated: if the base-year CPI is 100 and the current CPI is 110, the inflation rate over the period is 10 percent. Core inflation excludes prices set by government and the more volatile prices of products such as food and energy, in order to reveal the underlying trend.[1]
The inflation rate is the annualised percentage change in a general price index. Inflation rates are commonly classified by severity:
| Category | Typical annual rate |
|---|---|
| Creeping (mild) inflation | about 1–3% |
| Moderate inflation | about 3–6% |
| Galloping inflation | double-digit to triple-digit rates |
| Hyperinflation | extremely rapid, often defined as over 50% per month |
Causes
Changes in inflation are widely attributed to several interrelated factors:
Demand-pull inflation
Demand-pull inflation occurs when aggregate demand in an economy outpaces aggregate supply—described as "too much money chasing too few goods." It may be triggered by demand shocks, such as a stock market rally, or by expansionary policies, such as a central bank lowering interest rates or a government increasing spending. When demand exceeds production capacity, prices rise across the economy.[1]
Cost-push inflation
Cost-push inflation results from rising costs of production. Supply shocks that disrupt production (such as natural disasters) or raise production costs (such as high oil prices) can push prices upward. A classic example is the food and fuel inflation of 2008, which was transmitted across countries through trade.[1]
Monetary causes
In monetary economics, persistent high inflation is often attributed to lax monetary policy: if the money supply grows too large relative to the size of an economy, the currency's purchasing power falls. This relationship is summarised by the quantity theory of money, expressed in the equation of exchange MV = PT, where M is the money supply, V is the velocity of circulation, P is the price level, and T is the volume of transactions.[3]
Expectations and inertia
If people and firms anticipate higher prices, they build those expectations into wages and contractual price adjustments, making expectations partly self-fulfilling and contributing to inflation inertia. The credibility of a central bank enhances its ability to influence these expectations.[1]
Effects
Moderate inflation affects economies in both positive and negative ways.
Negative effects include:
- An increase in the opportunity cost of holding money.
- Uncertainty over future inflation, which may discourage investment and saving.
- If inflation is rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will rise further.
- An erosion of real income and purchasing power, which is often described as the single biggest cost of inflation, particularly for those on fixed incomes.[1]
Positive effects include:
- Reducing unemployment due to nominal wage rigidity.
- Allowing the central bank greater freedom in carrying out monetary policy.
- Encouraging lending and investment rather than hoarding of money.
- Avoiding the inefficiencies associated with deflation.
A borrower with a fixed-rate loan benefits from inflation, because the real value of the debt declines; conversely, lenders suffer when inflation is not factored into nominal interest rates.[1]
Controlling inflation
The task of keeping the rate of inflation low and stable is usually assigned to central banks, which control monetary policy, normally through the setting of interest rates and open market operations. The appropriate policy response depends on the cause of inflation:
- When the economy is overheated, contractionary monetary policy—usually by raising interest rates—can rein in aggregate demand.
- Some central banks impose monetary discipline by fixing the exchange rate, tying their currency and monetary policy to that of another country.
- Administrative price-setting can prevent the pass-through of high global prices, but it typically leads to large subsidy bills.
- Managing expectations is increasingly used as a disinflation tool: central banks announce their intentions to keep economic activity temporarily low in order to bring inflation down, shaping wage and price-setting behaviour.
In the most extreme cases, hyperinflation has forced countries to take painful measures, sometimes including abandoning their national currency. Zimbabwe, for instance, experienced estimated annual inflation at one point in 2008 of 500 billion percent. Conversely, prolonged deflation can lead consumers to delay purchases, reducing economic activity; Japan has been cited as an example of a long period of nearly no economic growth attributable largely to deflation.[1]
See also
- Deflation
- Hyperinflation
- Stagflation
- Consumer price index
- Monetary policy
- Central bank
- Quantity theory of money
- Purchasing power