Inflation

Inflation

Overview

In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, inflation is a rise in the general level of prices
Price level
A price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...

 of goods and services in an economy
Economy
An economy consists of the economic system of a country or other area; the labor, capital and land resources; and the manufacturing, trade, distribution, and consumption of goods and services of that area...

 over a period of time.
When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power
Purchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...

 of money – a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...

, the annualized percentage change in a general price index
Price index
A price index is a normalized average of prices for a given class of goods or services in a given region, during a given interval of time...

 (normally the Consumer Price Index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...

) over time.

Inflation's effects on an economy are various and can be simultaneously positive and negative.
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Encyclopedia

In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, inflation is a rise in the general level of prices
Price level
A price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...

 of goods and services in an economy
Economy
An economy consists of the economic system of a country or other area; the labor, capital and land resources; and the manufacturing, trade, distribution, and consumption of goods and services of that area...

 over a period of time.
When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power
Purchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...

 of money – a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...

, the annualized percentage change in a general price index
Price index
A price index is a normalized average of prices for a given class of goods or services in a given region, during a given interval of time...

 (normally the Consumer Price Index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...

) over time.

Inflation's effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include a decrease in the real value of money and other monetary items over time, uncertainty over future inflation may discourage investment and savings, and high inflation may lead to shortages of goods if consumers begin hoarding
Hoarding
Hoarding or caching is a general term for a behavior that leads people or animals to accumulate food or other items in anticipation of future need or scarcity.-Animal behavior:...

 out of concern that prices will increase in the future. Positive effects include ensuring central banks can adjust nominal interest rate
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...

s (intended to mitigate recession
Recession
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...

s), and encouraging investment in non-monetary capital projects.

Economists generally agree that high rates of inflation and hyperinflation
Hyperinflation
In economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...

 are caused by an excessive growth of the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

. Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand
Demand
- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...

 for goods and services, or changes in available supplies such as during scarcities
Scarcity
Scarcity is the fundamental economic problem of having humans who have unlimited wants and needs in a world of limited resources. It states that society has insufficient productive resources to fulfill all human wants and needs. Alternatively, scarcity implies that not all of society's goals can be...

, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

.

Today, most mainstream economists favor a low, steady rate of inflation. Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap
Liquidity trap
A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...

 prevents monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

 from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities
Monetary authority
Monetary authority is a generic term in finance and economics for the entity which controls the money supply of a given currency, and has the right to set interest rates, and other parameters which control the cost and availability of money...

. Generally, these monetary authorities are the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

s that control the size of the money supply through the setting of interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

s, through open market operations, and through the setting of banking reserve requirements.

History


Increases in the quantity of money or in the overall money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

 (or debasement of the means of exchange) have occurred in many different societies throughout history, changing with different forms of money used. For instance, when gold was used as currency, the government could collect gold coins, melt them down, mix them with other metals such as silver, copper or lead, and reissue them at the same nominal value. By diluting the gold with other metals, the government could issue more coins without also needing to increase the amount of gold used to make them. When the cost of each coin is lowered in this way, the government profits from an increase in seigniorage
Seigniorage
Seigniorage can have the following two meanings:* Seigniorage derived from specie—metal coins, is a tax, added to the total price of a coin , that a customer of the mint had to pay to the mint, and that was sent to the sovereign of the political area.* Seigniorage derived from notes is more...

. This practice would increase the money supply but at the same time the relative value of each coin would be lowered. As the relative value of the coins becomes less, consumers would need to give more coins in exchange for the same goods and services as before. These goods and services would experience a price increase as the value of each coin is reduced.

Historically, infusions of gold or silver into an economy also led to inflation. From the second half of the 15th century to the first half of the 17th, Western Europe
Western Europe
Western Europe is a loose term for the collection of countries in the western most region of the European continents, though this definition is context-dependent and carries cultural and political connotations. One definition describes Western Europe as a geographic entity—the region lying in the...

 experienced a major inflationary cycle referred to as the "price revolution
Price revolution
Used generally to describe a series of economic events from the second half of the 15th century to the first half of the 17th, the price revolution refers most specifically to the relatively high rate of inflation that characterized the period across Western Europe, with prices on average rising...

", with prices on average rising perhaps sixfold over 150 years. This was largely caused by the sudden influx of gold
Gold
Gold is a chemical element with the symbol Au and an atomic number of 79. Gold is a dense, soft, shiny, malleable and ductile metal. Pure gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. Chemically, gold is a...

 and silver
Silver
Silver is a metallic chemical element with the chemical symbol Ag and atomic number 47. A soft, white, lustrous transition metal, it has the highest electrical conductivity of any element and the highest thermal conductivity of any metal...

 from the New World
New World
The New World is one of the names used for the Western Hemisphere, specifically America and sometimes Oceania . The term originated in the late 15th century, when America had been recently discovered by European explorers, expanding the geographical horizon of the people of the European middle...

 into Habsburg Spain
Habsburg Spain
Habsburg Spain refers to the history of Spain over the 16th and 17th centuries , when Spain was ruled by the major branch of the Habsburg dynasty...

. The silver spread throughout a previously cash-starved Europe
Commercial Revolution
The Commercial Revolution was a period of European economic expansion, colonialism, and mercantilism which lasted from approximately the 16th century until the early 18th century. It was succeeded in the mid-18th century by the Industrial Revolution. Beginning with the Crusades, Europeans...

 and caused widespread inflation. Demographic factors also contributed to upward pressure on prices, with European population growth after depopulation caused by the Black Death
Black Death
The Black Death was one of the most devastating pandemics in human history, peaking in Europe between 1348 and 1350. Of several competing theories, the dominant explanation for the Black Death is the plague theory, which attributes the outbreak to the bacterium Yersinia pestis. Thought to have...

 pandemic.

By the nineteenth century, economists categorized three separate factors that cause a rise or fall in the price of goods: a change in the value
Value (economics)
An economic value is the worth of a good or service as determined by the market.The economic value of a good or service has puzzled economists since the beginning of the discipline. First, economists tried to estimate the value of a good to an individual alone, and extend that definition to goods...

 or production costs of the good, a change in the price of money which then was usually a fluctuation in the commodity
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....

 price of the metallic content in the currency, and currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency. Following the proliferation of private banknote
Banknote
A banknote is a kind of negotiable instrument, a promissory note made by a bank payable to the bearer on demand, used as money, and in many jurisdictions is legal tender. In addition to coins, banknotes make up the cash or bearer forms of all modern fiat money...

 currency printed during the American Civil War
American Civil War
The American Civil War was a civil war fought in the United States of America. In response to the election of Abraham Lincoln as President of the United States, 11 southern slave states declared their secession from the United States and formed the Confederate States of America ; the other 25...

, the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of redeemable banknotes outstripped the quantity of metal available for their redemption. The term inflation then referred to the devaluation
Devaluation
Devaluation is a reduction in the value of a currency with respect to those goods, services or other monetary units with which that currency can be exchanged....

 of the currency, and not to a rise in the price of goods.

This relationship between the over-supply of banknotes and a resulting depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....

 in their value was noted by earlier classical economists such as David Hume
David Hume
David Hume was a Scottish philosopher, historian, economist, and essayist, known especially for his philosophical empiricism and skepticism. He was one of the most important figures in the history of Western philosophy and the Scottish Enlightenment...

 and David Ricardo
David Ricardo
David Ricardo was an English political economist, often credited with systematising economics, and was one of the most influential of the classical economists, along with Thomas Malthus, Adam Smith, and John Stuart Mill. He was also a member of Parliament, businessman, financier and speculator,...

, who would go on to examine and debate what effect a currency devaluation (later termed monetary inflation
Monetary inflation
Monetary inflation is a sustained increase in the money supply of a country. It usually results in price inflation, which is a rise in the general level of prices of goods and services . Originally the term "inflation" was used to refer only to monetary inflation, whereas in present usage it...

) has on the price of goods (later termed price inflation, and eventually just inflation).

The adoption of fiat currency (paper money) by many countries, from the 18th century onwards, made much larger variations in the supply of money possible. Since then, huge increases in the supply of paper money
Paper Money
Paper Money is the second album by the band Montrose. It was released in 1974 and was the band's last album to feature Sammy Hagar as lead vocalist.-History:...

 have taken place in a number of countries, producing hyperinflation
Hyperinflation
In economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...

s -- episodes of extreme inflation rates much higher than those observed in earlier periods of commodity money
Commodity money
Commodity money is money whose value comes from a commodity out of which it is made. It is objects that have value in themselves as well as for use as money....

. The hyperinflation in the Weimar Republic of Germany is a notable example.

Related definitions


The term "inflation" originally referred to increases in the amount of money in circulation, and some economists still use the word in this way. However, most economists today use the term "inflation" to refer to a rise in the price level. An increase in the money supply may be called monetary inflation
Monetary inflation
Monetary inflation is a sustained increase in the money supply of a country. It usually results in price inflation, which is a rise in the general level of prices of goods and services . Originally the term "inflation" was used to refer only to monetary inflation, whereas in present usage it...

, to distinguish it from rising prices, which may also for clarity be called 'price inflation'. Economists generally agree that in the long run, inflation is caused by increases in the money supply. However, in the short and medium term, inflation is largely dependent on supply and demand pressures in the economy.

Other economic concepts related to inflation include: deflation
Deflation (economics)
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% . This should not be confused with disinflation, a slow-down in the inflation rate...

 – a fall in the general price level; disinflation
Disinflation
Disinflation is a decrease in the rate of inflation – a slowdown in the rate of increase of the general price level of goods and services in a nation's gross domestic product over time. It is the opposite of reflation. Disinflation occurs when the increase in the “consumer price level” slows down...

  – a decrease in the rate of inflation; hyperinflation
Hyperinflation
In economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...

 – an out-of-control inflationary spiral; stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...

 – a combination of inflation, slow economic growth and high unemployment; and reflation
Reflation
Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes, seeking to bring the economy back up to the long-term trend, following a dip in the business cycle...

 – an attempt to raise the general level of prices to counteract deflationary pressures.

Since there are many possible measures of the price level, there are many possible measures of price inflation. Most frequently, the term "inflation" refers to a rise in a broad price index representing the overall price level for goods and services in the economy. The Consumer Price Index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...

 (CPI), the Personal Consumption Expenditures Price Index
Personal consumption expenditures price index
The PCE price index is a United States-wide indicator of the average increase in prices for all domestic personal...

 (PCEPI) and the GDP deflator
GDP deflator
In economics, the GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy...

 are some examples of broad price indices. However, "inflation" may also be used to describe a rising price level within a narrower set of assets, goods or services within the economy, such as commodities
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....

 (including food, fuel, metals), financial asset
Financial asset
A financial asset is an intangible asset that derives value because of a contractual claim. Examples include bank deposits, bonds, and stocks. Financial assets are usually more liquid than tangible assets, such as land or real estate, and are traded on financial markets....

s (such as stocks, bonds and real estate), services (such as entertainment and health care), or labor. The Reuters-CRB Index
Reuters-CRB Index
The Thomson Reuters/Jefferies CRB Index is a commodity price index. It was first calculated by Commodity Research Bureau, Inc. in 1957 and made its inaugural appearance in the 1958 CRB Commodity Year Book....

 (CCI), the Producer Price Index
Producer price index
A Producer Price Index measures average changes in prices received by domestic producers for their output. It is one of several price indices.Its importance is being undermined by the steady decline in manufactured goods as a share of spending....

, and Employment Cost Index
Employment Cost Index
The Employment Cost Index is a quarterly economic series detailing the changes in the costs of labor for businesses in the United States economy. The ECI is prepared by the Bureau of Labor Statistics , in the U.S...

 (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Core inflation
Core inflation
Core inflation is a measure of inflation which excludes certain items that face volatile price movements, notably food and energy.The preferred measure by the Federal Reserve of core inflation in the United States is the core Personal consumption expenditures price index...

 is a measure of inflation for a subset of consumer prices that excludes food and energy prices, which rise and fall more than other prices in the short term. The Federal Reserve Board pays particular attention to the core inflation rate to get a better estimate of long-term future inflation trends overall.

Measures


Inflation is usually estimated by calculating the inflation rate
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...

 of a price index, usually the Consumer Price Index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...

.
The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer". The inflation rate is the percentage rate of change of a price index over time.

For instance, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is
The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007.

Other widely used price indices for calculating price inflation include the following:
  • Producer price indices
    Producer price index
    A Producer Price Index measures average changes in prices received by domestic producers for their output. It is one of several price indices.Its importance is being undermined by the steady decline in manufactured goods as a share of spending....

    (PPIs) which measures average changes in prices received by domestic producers for their output. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any eventual increase in the CPI. Producer price index measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset by increasing productivity. In India and the United States, an earlier version of the PPI was called the Wholesale Price Index
    Wholesale price index
    The Wholesale Price Index is the price of a representative basket of wholesale goods. Some countries use WPI changes as a central measure of inflation. However, United States now report a producer price index instead.The Wholesale Price Index or WPI is "the price of a representative basket of...

    .
  • Commodity price indices
    Commodity price index
    A commodity price index is a fixed-weight index or average of selected commodity prices, which may be based on spot or futures prices...

    , which measure the price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee.
  • Core price indices
    Core inflation
    Core inflation is a measure of inflation which excludes certain items that face volatile price movements, notably food and energy.The preferred measure by the Federal Reserve of core inflation in the United States is the core Personal consumption expenditures price index...

    : because food and oil prices can change quickly due to changes in supply and demand conditions in the food and oil markets, it can be difficult to detect the long run trend in price levels when those prices are included. Therefore most statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a broad price index like the CPI. Because core inflation is less affected by short run supply and demand conditions in specific markets, central bank
    Central bank
    A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

    s rely on it to better measure the inflationary impact of current monetary policy
    Monetary policy
    Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

    .


Other common measures of inflation are:
  • GDP deflator
    GDP deflator
    In economics, the GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy...

    is a measure of the price of all the goods and services included in gross domestic product
    Gross domestic product
    Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....

     (GDP). The US Commerce Department publishes a deflator series for US GDP, defined as its nominal GDP measure divided by its real GDP measure.
  • Regional inflation The Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of the US.
  • Historical inflation Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology.
  • Asset price inflation
    Asset price inflation
    Asset price inflation is an economic phenomenon denoting a rise in price of assets, as opposed to ordinary goods and services. Typical assets are financial instruments such as bonds, shares, and their derivatives, as well as real estate and other capital goods.-Price inflation and assets...

    is an undue increase in the prices of real or financial assets, such as stock
    Stock
    The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

     (equity) and real estate
    Real estate
    In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...

    . While there is no widely accepted index of this type, some central bankers have suggested that it would be better to aim at stabilizing a wider general price level inflation measure that includes some asset prices, instead of stabilizing CPI or core inflation only. The reason is that by raising interest rates when stock prices or real estate prices rise, and lowering them when these asset prices fall, central banks might be more successful in avoiding bubbles
    Economic bubble
    An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...

     and crashes in asset prices.

Issues in measuring


Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services, and distinguishing them from those price shifts resulting from changes in value such as volume, quality, or performance. For example, if the price of a 10 oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price difference represents inflation. This single price change would not, however, represent general inflation in an overall economy. To measure overall inflation, the price change of a large "basket" of representative goods and services is measured. This is the purpose of a price index
Price index
A price index is a normalized average of prices for a given class of goods or services in a given region, during a given interval of time...

, which is the combined price of a "basket" of many goods and services. The combined price is the sum of the weighted average prices of items in the "basket". A weighted price is calculated by multiplying the unit price
Unit price
Average prices represent, quite simply, total sales revenue divided by total units sold. Many products, however, are sold in multiple variants, such as bottle sizes. In these cases, managers face a challenge: they must determine “comparable” units. Average prices can be calculated by weighting...

 of an item to the number of those items the average consumer purchases. Weighted pricing is a necessary means to measuring the impact of individual unit price changes on the economy's overall inflation. The Consumer Price Index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...

, for example, uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly. Those weighted average prices are combined to calculate the overall price. To better relate price changes over time, indexes typically choose a "base year" price and assign it a value of 100. Index prices in subsequent years are then expressed in relation to the base year price. While comparing inflation measures for various periods one has to take into consideration the base effect
Base effect (inflation)
The Base effect relates to inflation in the corresponding period of the previous year. If the inflation rate was too low in the corresponding period of the previous year, even a smaller rise in the Price Index will arithmetically give a high rate of inflation now...

 as well.

Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods and services from the present are compared with goods and services from the past. Over time, adjustments are made to the type of goods and services selected in order to reflect changes in the sorts of goods and services purchased by 'typical consumers'. New products may be introduced, older products disappear, the quality of existing products may change, and consumer preferences can shift. Both the sorts of goods and services which are included in the "basket" and the weighted price used in inflation measures will be changed over time in order to keep pace with the changing marketplace.

Inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost shifts. For example, home heating costs are expected to rise in colder months, and seasonal adjustments are often used when measuring for inflation to compensate for cyclical spikes in energy or fuel demand. Inflation numbers may be averaged or otherwise subjected to statistical techniques in order to remove statistical noise
Statistical noise
Statistical noise is the colloquialism for recognized amounts of unexplained variation in a sample. See errors and residuals in statistics....

 and volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...

 of individual prices.

When looking at inflation, economic institutions may focus only on certain kinds of prices, or special indices, such as the core inflation index
Core inflation
Core inflation is a measure of inflation which excludes certain items that face volatile price movements, notably food and energy.The preferred measure by the Federal Reserve of core inflation in the United States is the core Personal consumption expenditures price index...

 which is used by central banks to formulate monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

.

Most inflation indices are calculated from weighted averages of selected price changes. This necessarily introduces distortion, and can lead to legitimate disputes about what the true inflation rate is. This problem can be overcome by including all available price changes in the calculation, and then choosing the median
Median
In probability theory and statistics, a median is described as the numerical value separating the higher half of a sample, a population, or a probability distribution, from the lower half. The median of a finite list of numbers can be found by arranging all the observations from lowest value to...

 value.

General


An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services. The effect of inflation is not distributed evenly in the economy, and as a consequence there are hidden costs to some and benefits to others from this decrease in the purchasing power of money. For example, with inflation, lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments.

Increases in the price level (inflation) erode the real value of money (the functional currency) and other items with an underlying monetary nature (e.g. loans and bonds).

Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The real interest on a loan is the nominal rate minus the inflation rate (approximately

). For example if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial stated interest rate or by setting the interest at a variable rate. As the rate of inflation decreases, this has the opposite (negative) effect on borrowers.

Negative


High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation. Uncertainty about the future purchasing power of money discourages investment and saving. And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates unless the tax brackets are indexed to inflation.

With high inflation, purchasing power is redistributed from those on fixed nominal incomes, such as some pensioners whose pensions are not indexed to the price level, towards those with variable incomes whose earnings may better keep pace with the inflation. This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

s are imposed, higher inflation in one economy than another will cause the first economy's exports to become more expensive and affect the balance of trade
Balance of trade
The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation's imports and exports...

. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation.

Cost-push inflation: High inflation can prompt employees to demand rapid wage increases, to keep up with consumer prices. In the cost-push theory of inflation, rising wages in turn can help fuel inflation. In the case of collective bargaining, wage growth will be set as a function of inflationary expectations, which will be higher when inflation is high. This can cause a wage spiral
Price/wage spiral
In macroeconomics, the price/wage spiral represents a vicious circle process in which different sides of the wage bargain try to keep up with inflation to protect real incomes. Thus, this process is one possible result of inflation...

. In a sense, inflation begets further inflationary expectations, which beget further inflation.

Hoarding
Hoarding
Hoarding or caching is a general term for a behavior that leads people or animals to accumulate food or other items in anticipation of future need or scarcity.-Animal behavior:...

: People buy durable and/or non-perishable commodities and other goods as stores of wealth, to avoid the losses expected from the declining purchasing power of money, creating shortages of the hoarded goods.

Social unrest and revolts: Inflation can lead to massive demonstrations and revolutions. For example, inflation and in particular food inflation is considered as one of the main reasons that caused the 2010–2011 Tunisian revolution
Tunisian revolution
The Tunisian Revolution is an intensive campaign of civil resistance, including a series of street demonstrations taking place in Tunisia. The events began in December 2010 and led to the ousting of longtime President Zine El Abidine Ben Ali in January 2011...

 and the 2011 Egyptian revolution
2011 Egyptian revolution
The 2011 Egyptian revolution took place following a popular uprising that began on Tuesday, 25 January 2011 and is still continuing as of November 2011. The uprising was mainly a campaign of non-violent civil resistance, which featured a series of demonstrations, marches, acts of civil...

, according to many observators including Robert Zoellick
Robert Zoellick
Robert Bruce Zoellick is the eleventh president of the World Bank, a position he has held since July 1, 2007. He was previously a managing director of Goldman Sachs, United States Deputy Secretary of State and U.S. Trade Representative, from February 7, 2001 until February 22, 2005.President...

, president of the World Bank
World Bank
The World Bank is an international financial institution that provides loans to developing countries for capital programmes.The World Bank's official goal is the reduction of poverty...

. Tunisian president Zine El Abidine Ben Ali
Zine El Abidine Ben Ali
Zine El Abidine Ben Ali is a Tunisian political figure who was the second President of Tunisia from 1987 to 2011. Ben Ali was appointed Prime Minister in October 1987, and he assumed the Presidency on 7 November 1987 in a bloodless coup d'état that ousted President Habib Bourguiba, who was...

 was ousted, Egyptian President Hosni Mubarak
Hosni Mubarak
Muhammad Hosni Sayyid Mubarak is a former Egyptian politician and military commander. He served as the fourth President of Egypt from 1981 to 2011....

 was also ousted after only 18 days of demonstrations, and protests soon spread in many countries of North Africa and Middle East.

Hyperinflation
Hyperinflation
In economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...

: If inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply goods. Hyperinflation can lead to the abandonment of the use of the country's currency, leading to the inefficiencies of barter.

Allocative efficiency
Allocative efficiency
Allocative efficiency is a theoretical measure of the benefit or utility derived from a proposed or actual selection in the allocation or allotment of resources....

: A change in the supply or demand for a good will normally cause its relative price
Relative price
A relative price is the price of a commodity such as a good or service in terms of another; i.e., the ratio of two prices. A relative price may be expressed in terms of a ratio between any two prices or the ratio between the price of one particular good and a weighted average of all other goods...

 to change, signaling to buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, price changes due to genuine relative price signal
Price signal
A price signal is a message sent to consumers and producers in the form of a price charged for a commodity; this is seen as indicating a signal for producers to increase supplies and/or consumers to reduce demand.- Free price system :...

s are difficult to distinguish from price changes due to general inflation, so agents are slow to respond to them. The result is a loss of allocative efficiency.

Shoe leather cost
Shoe leather cost
Shoe leather cost refers to the cost of time and effort that people spend trying to counter-act the effects of inflation, such as holding less cash and having to make additional trips to the bank...

: High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe leather" with each trip.

Menu costs
Menu costs
In economics, a menu cost is the cost to a firm resulting from changing its prices. The name stems from the cost of restaurants literally printing new menus, but economists use it to refer to the costs of changing nominal prices in general...

: With high inflation, firms must change their prices often in order to keep up with economy-wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly.

Business cycles: According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian economists hold this to be the most damaging effect of inflation. According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they become unsustainable.

Positive


Labor-market adjustments: Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster.

Room to maneuver: The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy - this situation is known as a liquidity trap
Liquidity trap
A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...

. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate.

Mundell-Tobin effect: The Nobel
Nobel Memorial Prize in Economic Sciences
The Nobel Memorial Prize in Economic Sciences, commonly referred to as the Nobel Prize in Economics, but officially the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel , is an award for outstanding contributions to the field of economics, generally regarded as one of the...

 laureate Robert Mundell noted that moderate inflation would induce savers to substitute lending for some money holding as a means to finance future spending. That substitution would cause market clearing real interest rates to fall. The lower real rate of interest would induce more borrowing to finance investment. In a similar vein, Nobel laureate James Tobin noted that such inflation would cause businesses to substitute investment in physical capital
Physical capital
In economics, physical capital or just 'capital' refers to any already-manufactured asset that is applied in production, such as machinery, buildings, or vehicles. In economic theory, physical capital is one of the three primary factors of production, also known as inputs in the production function...

 (plant, equipment, and inventories) for money balances in their asset portfolios. That substitution would mean choosing the making of investments with lower rates of real return. (The rates of return are lower because the investments with higher rates of return were already being made before.) The two related effects are known as the Mundell-Tobin effect
Mundell-Tobin effect
The Mundell–Tobin effect suggests that nominal interest rates would rise less than one-for-one with inflation because in response to inflation the public would hold less in money balances and more in other assets, which would drive interest rates down...

. Unless the economy is already overinvesting according to models of economic growth theory
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

, that extra investment resulting from the effect would be seen as positive.

Instability with Deflation: Economist S.C. Tsaing noted that once substantial deflation is expected, two important effects will appear; both a result of money holding substituting for lending as a vehicle for saving. The first was that continually falling prices and the resulting incentive to hoard money will cause instability resulting from the likely increasing fear, while money hoards grow in value, that the value of those hoards are at risk, as people realize that a movement to trade those money hoards for real goods and assets will quickly drive those prices up. Any movement to spend those hoards "once started would become a tremendous avalanche, which could rampage for a long time before it would spend itself." Thus, a regime of long-term deflation is likely to be interrupted by periodic spikes of rapid inflation and consequent real economic disruptions. Moderate and stable inflation would avoid such a seesawing of price movements.

Financial Market Inefficiency with Deflation: The second effect noted by Tsaing is that when savers have substituted money holding for lending on financial markets, the role of those markets in channeling savings into investment is undermined. With nominal interest rates driven to zero, or near zero, from the competition with a high return money asset, there would be no price mechanism in whatever is left of those markets. With financial markets effectively euthanized, the remaining goods and physical asset prices would move in perverse directions. For example, an increased desire to save could not push interest rates further down (and thereby stimulate investment) but would instead cause additional money hoarding, driving consumer prices further down and making investment in consumer goods production thereby less attractive. Moderate inflation, once its expectation is incorporated into nominal interest rates, would give those interest rates room to go both up and down in response to shifting investment opportunities, or savers' preferences, and thus allow financial markets to function in a more normal fashion.

Causes


Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. There were different schools of thought as to the causes of inflation. Most can be divided into two broad areas: quality theories of inflation and quantity theories of inflation. The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory of inflation
Quantity theory of money
In monetary economics, the quantity theory of money is the theory that money supply has a direct, proportional relationship with the price level....

 rests on the quantity equation of money, that relates the money supply, its velocity
Velocity of money
300px|thumb|Similar chart showing the velocity of a broader measure of money that covers M2 plus large institutional deposits, M3. The US no longer publishes official M3 measures, so the chart only runs through 2005....

, and the nominal value of exchanges. Adam Smith
Adam Smith
Adam Smith was a Scottish social philosopher and a pioneer of political economy. One of the key figures of the Scottish Enlightenment, Smith is the author of The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations...

 and David Hume
David Hume
David Hume was a Scottish philosopher, historian, economist, and essayist, known especially for his philosophical empiricism and skepticism. He was one of the most important figures in the history of Western philosophy and the Scottish Enlightenment...

 proposed a quantity theory of inflation for money, and a quality theory of inflation for production.

Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates. The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian economists. In monetarism
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...

 prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. In the Keynesian
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

 view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.

Keynesian view


Keynesian economic theory proposes that changes in money supply do not directly affect prices, and that visible inflation is the result of pressures in the economy expressing themselves in prices.

There are three major types of inflation, as part of what Robert J. Gordon
Robert J. Gordon
Robert James "Bob" Gordon is an American economist. He is the Stanley G. Harris Professor of the Social Sciences at Northwestern University. He is known for his work on productivity, growth, the causes of unemployment, and airline economics.-Education:...

 calls the "triangle model
Triangle model
In macroeconomics, the triangle model employed by new Keynesian economics is a model of inflation derived from the Phillips Curve and given its name by Robert J. Gordon. The model views inflation as having three root causes: built-in inflation, demand-pull inflation, and cost-push inflation...

":
  • Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.
  • Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. Another example stems from unexpectedly high Insured Losses, either legitimate (catastrophes) or fraudulent (which might be particularly prevalent in times of recession).
  • Built-in inflation
    Built-in inflation
    Built-in inflation is a type of inflation that results from past events and persists in the present.Built-in inflation is one of three major determinants of the current inflation rate. In Robert J. Gordon's triangle model of inflation, the current inflation rate equals the sum of demand-pull...

     is induced by adaptive expectations
    Adaptive expectations
    In economics, adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past...

    , and is often linked to the "price/wage spiral
    Price/wage spiral
    In macroeconomics, the price/wage spiral represents a vicious circle process in which different sides of the wage bargain try to keep up with inflation to protect real incomes. Thus, this process is one possible result of inflation...

    ". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.


Demand-pull theory states that the rate of inflation accelerates whenever aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

 is increased beyond the ability of the economy to produce (its potential output
Potential output
In economics, potential output refers to the highest level of real Gross Domestic Product output that can be sustained over the long term. The existence of a limit is due to natural and institutional constraints...

). Hence, any factor that increases aggregate demand can cause inflation. However, in the long run, aggregate demand can be held above productive capacity only by increasing the quantity of money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

 in circulation faster than the real growth rate of the economy. Another (although much less common) cause can be a rapid decline in the demand for money, as happened in Europe during the Black Death
Black Death
The Black Death was one of the most devastating pandemics in human history, peaking in Europe between 1348 and 1350. Of several competing theories, the dominant explanation for the Black Death is the plague theory, which attributes the outbreak to the bacterium Yersinia pestis. Thought to have...

, or in the Japanese occupied territories
Greater East Asia Co-Prosperity Sphere
The Greater East Asia Co-Prosperity Sphere was a concept created and promulgated during the Shōwa era by the government and military of the Empire of Japan. It represented the desire to create a self-sufficient "bloc of Asian nations led by the Japanese and free of Western powers"...

 just before the defeat of Japan in 1945.

The effect of money on inflation is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively. This sometimes leads to hyperinflation
Hyperinflation
In economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...

, a condition where prices can double in a month or less. Money supply is also thought to play a major role in determining moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...

 economists believe that the link is very strong; Keynesian economists, by contrast, typically emphasize the role of aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

 in the economy rather than the money supply in determining inflation. That is, for Keynesians, the money supply is only one determinant of aggregate demand.

Some Keynesian economists also disagree with the notion that central banks fully control the money supply, arguing that central banks have little control, since the money supply adapts to the demand for bank credit issued by commercial banks. This is known as the theory of endogenous money
Endogenous money
In economics, endogenous money refers to the theory that money comes into existence driven by the requirements of the real economy and that banking system reserves expand or contract as needed to accommodate loan demand at prevailing interest rates. It forms part of Post-Keynesian economics...

, and has been advocated strongly by post-Keynesians as far back as the 1960s. It has today become a central focus of Taylor rule
Taylor rule
In economics, a Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the...

 advocates. This position is not universally accepted – banks create money by making loans, but the aggregate volume of these loans diminishes as real interest rates increase. Thus, central banks can influence the money supply by making money cheaper or more expensive, thus increasing or decreasing its production.

A fundamental concept in inflation analysis is the relationship between inflation and unemployment, called the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

. This model suggests that there is a trade-off
Trade-off
A trade-off is a situation that involves losing one quality or aspect of something in return for gaining another quality or aspect...

 between price stability and employment. Therefore, some level of inflation could be considered desirable in order to minimize unemployment. The Phillips curve model described the U.S. experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...

) experienced in the 1970s.

Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations
Adaptive expectations
In economics, adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past...

 implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model.

Another concept of note is the potential output
Potential output
In economics, potential output refers to the highest level of real Gross Domestic Product output that can be sustained over the long term. The existence of a limit is due to natural and institutional constraints...

 (sometimes called the "natural gross domestic product"), a level of GDP, where the economy is at its optimal level of production given institutional and natural constraints. (This level of output corresponds to the Non-Accelerating Inflation Rate of Unemployment, NAIRU
NAIRU
In monetarist economics, particularly the work of Milton Friedman, on which also worked Lucas Papademos and Franco Modigliani in 1975,NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises.It is widely used in...

, or the "natural" rate of unemployment or the full-employment unemployment rate.) If GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that inflation will accelerate as suppliers increase their prices and built-in inflation worsens. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation.

However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change because of policy: for example, high unemployment under British Prime Minister Margaret Thatcher
Margaret Thatcher
Margaret Hilda Thatcher, Baroness Thatcher, was Prime Minister of the United Kingdom from 1979 to 1990...

 might have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed
Structural unemployment
Structural unemployment is a form of unemployment resulting from a mismatch between demand in the labour market and the skills and locations of the workers seeking employment...

 (also see unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

), unable to find jobs that fit their skills. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.

Monetarist view


Monetarists believe the most significant factor influencing inflation or deflation is how fast the money supply grows or shrinks. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation. According to the famous monetarist economist Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

, "Inflation is always and everywhere a monetary phenomenon." Some monetarists, however, will qualify this by making an exception for very short-term circumstances.

Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The quantity theory of money
Quantity theory of money
In monetary economics, the quantity theory of money is the theory that money supply has a direct, proportional relationship with the price level....

, simply stated, says that any change in the amount of money in a system will change the price level. This theory begins with the equation of exchange
Equation of exchange
In economics, the equation of exchange is the relation:M\cdot V = P\cdot Qwhere, for a given period,M\, is the total nominal amount of money in circulation on average in an economy.V\, is the velocity of money, that is the average frequency with which a unit of money is spent.P\, is the price...

:

where is the nominal quantity of money. is the velocity of money
Velocity of money
300px|thumb|Similar chart showing the velocity of a broader measure of money that covers M2 plus large institutional deposits, M3. The US no longer publishes official M3 measures, so the chart only runs through 2005....

 in final expenditures; is the general price level; is an index of the real value of final expenditures;

In this formula, the general price level is related to the level of real economic activity (Q), the quantity of money (M) and the velocity of money (V). The formula is an identity because the velocity of money (V) is defined to be the ratio of final nominal expenditure () to the quantity of money (M).

Monetarists assume that the velocity of money is unaffected by monetary policy (at least in the long run), and the real value of output is determined in the long run by the productive capacity of the economy. Under these assumptions, the primary driver of the change in the general price level is changes in the quantity of money. With exogenous velocity (that is, velocity being determined externally and not being influenced by monetary policy), the money supply determines the value of nominal output (which equals final expenditure) in the short run. In practice, velocity is not exogenous in the short run, and so the formula does not necessarily imply a stable short-run relationship between the money supply and nominal output. However, in the long run, changes in velocity are assumed to be determined by the evolution of the payments mechanism. If velocity is relatively unaffected by monetary policy, the long-run rate of increase in prices (the inflation rate) is equal to the long run growth rate of the money supply plus the exogenous long-run rate of velocity growth minus the long run growth rate of real output.

Unemployment


A connection between inflation and unemployment has been drawn since the emergence of large scale unemployment in the 19th century, and connections continue to be drawn today. In Marxian economics
Marxian economics
Marxian economics refers to economic theories on the functioning of capitalism based on the works of Karl Marx. Adherents of Marxian economics, particularly in academia, distinguish it from Marxism as a political ideology and sociological theory, arguing that Marx's approach to understanding the...

, the unemployed serve as a reserve army of labour
Reserve army of labour
Reserve army of labour is a concept in Karl Marx's critique of political economy. It refers basically to the unemployed in capitalist society. It is synonymous with "industrial reserve army" or "relative surplus population", except that the unemployed can be defined as those actually looking for...

, which restrain wage inflation. In the 20th century, similar concepts in Keynesian economics include the NAIRU
NAIRU
In monetarist economics, particularly the work of Milton Friedman, on which also worked Lucas Papademos and Franco Modigliani in 1975,NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises.It is widely used in...

 (Non-Accelerating Inflation Rate of Unemployment) and the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

.

Rational expectations theory



Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well.

A core assertion of rational expectations theory is that actors will seek to "head off" central-bank decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or economic actors will make bets that the central bank will expand the money supply rapidly enough to prevent recession, even at the expense of exacerbating inflation. Thus, if a central bank has a reputation as being "soft" on inflation, when it announces a new policy of fighting inflation with restrictive monetary growth economic agents will not believe that the policy will persist; their inflationary expectations will remain high, and so will inflation. On the other hand, if the central bank has a reputation of being "tough" on inflation, then such a policy announcement will be believed and inflationary expectations will come down rapidly, thus allowing inflation itself to come down rapidly with minimal economic disruption.

Austrian view

For more details on this topic, see The Austrian view of inflation and monetary inflation
Monetary inflation
Monetary inflation is a sustained increase in the money supply of a country. It usually results in price inflation, which is a rise in the general level of prices of goods and services . Originally the term "inflation" was used to refer only to monetary inflation, whereas in present usage it...



The Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

 asserts that inflation is an increase in the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

, rising prices are merely consequences and this semantic difference is important in defining inflation. Austrians stress that inflation affects prices in various degree, i.e. that prices rise more sharply in some sectors than in other sectors of the economy. The reason for the disparity is that excess money will be concentrated to certain sectors, such as housing, stocks or health care. Because of this disparity, Austrians argue that the aggregate price level can be very misleading when observing the effects of inflation. Austrian economists measure inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time.

Real bills doctrine



Within the context of a fixed specie basis for money, one important controversy was between the quantity theory of money
Quantity theory of money
In monetary economics, the quantity theory of money is the theory that money supply has a direct, proportional relationship with the price level....

 and the real bills doctrine (RBD). Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally gold, held by a bank. Currency and banking schools of economics argue the RBD, that banks should also be able to issue currency against bills of trading, which is "real bills" that they buy from merchants. This theory was important in the 19th century in debates between "Banking" and "Currency" schools of monetary soundness, and in the formation of the Federal Reserve. In the wake of the collapse of the international gold standard post 1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as currency board
Currency board
A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target....

s. It is generally held in ill repute today, with Frederic Mishkin
Frederic Mishkin
Frederic Stanley "Rick" Mishkin is an American economist and professor at the Columbia Business School. He was a member of the Board of Governors of the Federal Reserve System from 2006 to 2008.-Early life and family:...

, a governor of the Federal Reserve going so far as to say it had been "completely discredited."

The debate between currency, or quantity theory, and banking schools in Britain during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence "on the continent", that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.

Anti-classical or backing theory


Another issue associated with classical political economy is the anti-classical hypothesis of money, or "backing theory". The backing theory argues that the value of money is determined by the assets and liabilities of the issuing agency. Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions. There are very few backing theorists, making quantity theory the dominant theory explaining inflation.

Monetary policy




Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping the federal funds lending rate at a low level, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum. A low positive inflation is usually targeted, as deflationary conditions are seen as dangerous for the health of the economy.

There are a number of methods that have been suggested to control inflation. Central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

s such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

s and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a symmetrical inflation target
Symmetrical inflation target
A symmetrical inflation target is a requirement placed on a central bank to respond when inflation is too low as well as when inflation is too high.For example, the Bank of England and the Bank of Canada have symmetrical inflation targets...

 while others only control inflation when it rises above a target, whether express or implied.

Monetarists emphasize keeping the growth rate of money steady, and using monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

 to control inflation (increasing interest rates, slowing the rise in the money supply). Keynesians emphasize reducing aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

 during economic expansions and increasing demand during recessions to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy and fiscal policy
Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

 (increased taxation or reduced government spending to reduce demand).

Fixed exchange rates


Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.

Under the Bretton Woods
Bretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...

 agreement, most countries around the world had currencies that were fixed to the US dollar. This limited inflation in those countries, but also exposed them to the danger of speculative attack
Speculative attack
A speculative attack is a term used by economists to denote a precipitous acquisition of something by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board...

s. After the Bretton Woods agreement broke down in the early 1970s, countries gradually turned to floating exchange rates. However, in the later part of the 20th century, some countries reverted to a fixed exchange rate as part of an attempt to control inflation. This policy of using a fixed exchange rate to control inflation was used in many countries in South America
South America
South America is a continent situated in the Western Hemisphere, mostly in the Southern Hemisphere, with a relatively small portion in the Northern Hemisphere. The continent is also considered a subcontinent of the Americas. It is bordered on the west by the Pacific Ocean and on the north and east...

 in the later part of the 20th century (e.g. Argentina (1991-2002)
Argentine Currency Board
The Argentine Currency Board pegged the Argentine peso to the U.S. dollar between 1991 and 2002 in an attempt to eliminate hyperinflation and stimulate economic growth. While it initially met with considerable success, the board's actions ultimately failed. In contrast of what most people think,...

, Bolivia, Brazil, and Chile).

Gold standard




The gold standard is a monetary system in which a region's common media of exchange are paper notes that are normally freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented, including the amount of specie
Bullion coin
A bullion coin is a coin struck from precious metal and kept as a store of value or an investment, rather than used in day-to-day commerce. Investment coins are generally coins that have been minted after 1800, have a purity of not less than 900 thousandths and are or have been a legal tender in...

 per currency unit. The currency itself has no innate value, but is accepted by traders because it can be redeemed for the equivalent specie. A U.S. silver certificate
Silver Certificate
Silver Certificates are a type of representative money printed from 1878 to 1964 in the United States as part of its circulation of paper currency. They were produced in response to silver agitation by citizens who were angered by the Fourth Coinage Act, which had effectively placed the United...

, for example, could be redeemed for an actual piece of silver.

The gold standard was partially abandoned via the international adoption of the Bretton Woods System
Bretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...

. Under this system all other major currencies were tied at fixed rates to the dollar, which itself was tied to gold at the rate of $35 per ounce. The Bretton Woods system broke down in 1971, causing most countries to switch to fiat money – money backed only by the laws of the country.

Economies based on the gold standard rarely experience inflation above 2 percent annually. Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output. Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining, which some believe contributed to the Great Depression.

Wage and price controls



Another method attempted in the past have been wage and price controls ("incomes policies"). Wage and price controls have been successful in wartime environments in combination with rationing. However, their use in other contexts is far more mixed. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon
Richard Nixon
Richard Milhous Nixon was the 37th President of the United States, serving from 1969 to 1974. The only president to resign the office, Nixon had previously served as a US representative and senator from California and as the 36th Vice President of the United States from 1953 to 1961 under...

. More successful examples include the Prices and Incomes Accord
The Accord
The Prices and Incomes Accord was an agreement between the Australian Council of Trade Unions and the Australian Labor Party government of Prime Minister Bob Hawke and Treasurer Paul Keating. Employers were not party to the Accord. Unions agreed to restrict wage demands and the government...

 in Australia and the Wassenaar Agreement
Wassenaar Agreement
The Wassenaar Agreement was an agreement reached in 1982 between employers organisations and labor unions in the Netherlands to restrain wage growth in return for the adoption of policies to combat unemployment and inflation, such as reductions in working hours and the expansion of part-time...

 in the Netherlands
Netherlands
The Netherlands is a constituent country of the Kingdom of the Netherlands, located mainly in North-West Europe and with several islands in the Caribbean. Mainland Netherlands borders the North Sea to the north and west, Belgium to the south, and Germany to the east, and shares maritime borders...

.

In general wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is overconsumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term.

Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed (see creative destruction
Creative destruction
Creative destruction is a term originally derived from Marxist economic theory which refers to the linked processes of the accumulation and annihilation of wealth under capitalism. These processes were first described in The Communist Manifesto and were expanded in Marx's Grundrisse and "Volume...

).

Cost-of-living allowance


The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. In many countries, employment contracts, pension benefits, and government entitlements (such as social security
Social security
Social security is primarily a social insurance program providing social protection or protection against socially recognized conditions, including poverty, old age, disability, unemployment and others. Social security may refer to:...

) are tied to a cost-of-living index, typically to the consumer price index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...

. A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually in low inflation economies. During hyperinflation they are adjusted more often. They may also be tied to a cost-of-living index that varies by geographic location if the employee moves.

Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments or cost-of-living increases because of their similarity to increases tied to externally determined indexes. Many economists and compensation analysts consider the idea of predetermined future "cost of living increases" to be misleading for two reasons: (1) For most recent periods in the industrialized world, average wages have increased faster than most calculated cost-of-living indexes, reflecting the influence of rising productivity
Productivity
Productivity is a measure of the efficiency of production. Productivity is a ratio of what is produced to what is required to produce it. Usually this ratio is in the form of an average, expressing the total output divided by the total input...

 and worker bargaining power
Bargaining power
Bargaining power is a concept related to the relative abilities of parties in a situation to exert influence over each other. If both parties are on an equal footing in a debate, then they will have equal bargaining power, such as in a perfectly competitive market, or between an evenly matched...

 rather than simply living costs, and (2) most cost-of-living indexes are not forward-looking, but instead compare current or historical data.

Further reading

  • Auernheimer, Leonardo
    Leonardo Auernheimer
    Leonardo Auernheimer was an economist, professor, and international monetary consultant.Auernheimer was born in Argentina on August 27, 1936 to Jose Ignacio Auernheimer and Maria Elena Savanti de Auernheimer. He graduated from the University of Buenos Aires and received his Ph. D in Economics from...

    , "The Honest Government's Guide to the Revenue From the Creation of Money," Journal of Political Economy, Vol. 82, No. 3, May/June 1974, pp. 598–606.
  • Baumol, William J.
    William Baumol
    William Jack Baumol is an American economist. He is a professor of economics at New York University and is also affiliated with Princeton University. Baumol has written extensively about labor market and other economic factors that affect the economy. He also made valuable contributions to the...

     and Alan S. Blinder, Macroeconomics: Principles and Policy, Tenth edition. Thomson South-Western, 2006. ISBN 0-324-22114-2
  • Friedman, Milton
    Milton Friedman
    Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

    , Nobel lecture: Inflation and unemployment 1977
  • Hazlitt, Henry
    Henry Hazlitt
    Henry Stuart Hazlitt was an American economist, philosopher, literary critic and journalist for such publications as The Wall Street Journal, The Nation, The American Mercury, Newsweek, and The New York Times...

    , What You Should Know About Inflation
  • Laguerodie, Stephanie and Vergara, Francisco, The Theory of Price Controls (from Review of Political Economy)
  • Mishkin, Frederic S.
    Frederic Mishkin
    Frederic Stanley "Rick" Mishkin is an American economist and professor at the Columbia Business School. He was a member of the Board of Governors of the Federal Reserve System from 2006 to 2008.-Early life and family:...

    , The Economics of Money, Banking, and Financial Markets, New York, Harper Collins, 1995.
  • Murphy, Robert P.
    Robert P. Murphy
    Robert P. "Bob" Murphy is an Austrian School economist and anarcho-capitalist.-Education and personal life:Murphy completed his Bachelor of Arts in economics at Hillsdale College in 1998. He then moved back to his home state of New York to continue his studies at New York University. Murphy earned...

    , Is Inflation Harmless or Even Good?, Mises Institute
  • Nenovsky. N, (2007). „Exchange Rate and Inflation: France and Bulgaria in the Interwar Period and the Contribution of Albert Aftalion (1874-1956)“.Bulgarian National Bank,(2006)
  • Vasudevan, Ramaa, "What is the relation between inflation and unemployment?," in Dollars & Sense
    Dollars & Sense
    Dollars & Sense is a magazine dedicated to providing left-wing perspectives on economics.Published six times a year since 1974, it is edited by a collective of economists, journalists, and activists committed to the ideals of social justice and economic democracy.It was initially sponsored by the...

    , September/October 2006
  • Federal Reserve Bank of Boston
    Federal Reserve Bank of Boston
    The Federal Reserve Bank of Boston, commonly known as the Boston Fed, is responsible for the First District of the Federal Reserve, which covers most of Connecticut , Massachusetts, Maine, New Hampshire, Rhode Island and Vermont. It is headquartered in the Federal Reserve Bank Building in Boston,...

    , "Understanding Inflation and the Implications for Monetary Policy: A Phillips Curve Retrospective", Conference Series 53, June 9–11, 2008, Chatham, Massachusetts. (Also cf. Phillips curve
    Phillips curve
    In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

     article)

External links