Inflation is the rise in the general level of prices.

This is equivalent to a fall in the value or purchasing power of money. It is the opposite of deflation.

Measuring inflation
Inflation is measured by observing the changes in prices of goods in the economy using econometric techniques. The rises in prices of the various goods are combined to give a price index that reflects the change in prices of these many goods, where the inflation rate is the rate of increase in this index. There is no single true measure of inflation, because the value of inflation will depend on the weight given to each good in the index. Examples of common measures of inflation include:

consumer price indexes which measure the price of a selection of goods purchased by a "typical consumer". In many industrial nations, annualised percentage changes in these indexes are the most commonly reported inflation figure. producer price indexes which measure the price of a selection of inputs purchased by a "typical firm". wholesale price indexes which measure the change in price of a selection of goods at wholesale (i.e., typically prior to sales taxes). GDP deflator which is used to adjust measures of gross domestic product for inflation.

The role of inflation in the economy
A great deal of economic literature concerns the question of what causes inflation and what effects it has. A small amount of inflation is often viewed as having a positive effect on the economy. One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Inflation may also have negative effects on the economy:
• •

Increasing uncertainty may discourage investment and saving. Redistribution o It will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a

for example in more frequent trips to the bank. On balance many economists see moderate inflation as a benefit. Another cause of inflation occurs when there are many people and organisations with enough market power to increase their prices. This has been seen most graphically when governments have financed spending in a crisis by printing money. This is due to the fact that most money in industrialised economies is based on debt (see money and credit money). Thus inflation is sometimes viewed as similar to a hidden tax.) Menu costs: Firms must change their prices more frequently. where the government is a net debtor. people will tend to hold less cash during times of inflation. Keynesian economics by contrast typically emphasise the role of aggregate demand in the economy rather than the money supply in determining inflation. which imposes costs. although there are differences of opinion on how important it is. A government may find some level of inflation to be desirable.Economic Analysis • • • variable income. Monetarist economists believe that the link is very strong. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank. Inflation & its causes and effects Page 2 of 9 . For example. Shoe leather costs: Because the value of cash is eroded by inflation. This imposes real costs. for example with restaurants having to reprint menus. particularly in order to raise funds. International trade: If the rate of inflation is higher than that abroad. it will reduce this debt redistributing money towards the government. a fixed exchange rate will be undermined through a weakening balance of trade. For example. for example from wages and profits which may keep pace with inflation. and so there are a variety of fiscal policy arguments which favor moderate inflation. and so controlling debt is thought to control the amount of money existing and so influence inflation. o Similarly it will redistribute wealth from those who lend a fixed amount of money to those who borrow. Central banks can affect inflation to a significant extent through setting the prime rate of lending and through other operations. as is usually the case. leading to hyperinflation where prices rise at extremely high rates. Causes of inflation Inflation may be caused by an increase in the quantity of money in circulation. The money supply is also thought to play a role in determining levels of more moderate levels of inflation.

Stopping inflation There are a number of methods which have been suggested to stop inflation.Economic Analysis A fundamental concept in such Keynesian analysis is the relationship between inflation and unemployment. often through fiscal policy. Cost push is a type of inflation caused by arbitrary increases in the cost of goods or services where no suitable alternative is available. which was the cause of price increases. most economists regard price controls as counterproductive in that they tend to distort the functioning of the economy. This would not be expected to persist over time due to increases in supply. In some cases of hyperinflation. Keynesians emphasize reducing demand. Therefore some level of inflation could be considered desirable in order to minimize unemployment. A situation that has been often cited as of this was the oil crisis of the Inflation & its causes and effects Page 3 of 9 . called the Phillips curve. One method is simply instituting wage and price controls. This model suggested that price stability was a trade off against employment. Some economists still prefer this meaning of the term. The Philips curve model described the US experience well in the 1960s. inflation meant an increase in the money supply. rather than to mean the price increases themselves. dollar. but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation) experienced in the 1970s. This is commonly described as "too much money chasing too few goods". Types of inflation: • • • Demand pull inflation Cost push inflation Inflation induced by adaptive expectations. Monetarists emphasize increasing interest rates in the hope of reducing the money supply. Demand pull inflation arises where there is an increase in aggregate demand in an economy relative to aggregate supply. using increased taxation or reduced government spending to reduce demand. often termed the "wage-price spiral" Historically. which were tried in the United States in the early 1970s. However. confidence in the currency can be restored by pegging the value of the currency to a commodity such as gold or a stronger currency such as the U. unless the economy is already at a full employment level.S.

Extreme examples include Germany in the early 1920s when the rate of inflation hit 3. one simplistic definition is a monthly inflation rate of 50%. and Hungary during the same approximate time period at 4. No single definition is universally accepted. increases in the cost of a good or service will decrease the money available for other goods and services.19 quintillion percent per month. Hyperinflation was rare before the 20th century. because past a certain level of inflation the economy would revert to either specie metals or barter. Hyperinflation produces some interesting banknotes. Where such an increase in money supply is done without regard for the actual market demand for money then inflation results.25 million percent per month. The widespread use of fiat money created the possibility for hyperinflation as governments often tended to print larger amounts of money to finance their expenses. The argument is that if the money supply is constant. Hyperinflation is just out-of-control inflation at an extremely high rate.55 billion percent per month. Other more moderate examples include Eastern European countries in the period of economic transition in the early 1990s and in Bolivia and Peru in 1985 and 1988. One consequence of this is that monetarist economists do not believe that the rise in the cost of oil was a direct cause of the inflation of the 1970's. which some economists attribute as the cause of the inflation experienced in the Western world in that decade. Greece in the mid-1940s with 8. and therefore the price of some those goods will fall and offset the rise in price of those goods whose prices have increased. Hyperinflation is a form of economic inflation in which the general price level is increasing rapidly. It is argued that this inflation resulted from increases in the cost of oil imposed by the member states of OPEC. Monetarist economists such as Milton Friedman argue against the concept of cost push inflation because they believe that increases in the cost of goods and services do not lead to inflation without the government cooperating in increasing the money supply.Economic Analysis 1970s. respectively. Nations such as Ghana in North Western Africa continue to this day to have inflation in the order of 30% per annum. Rates of inflation of several hundred percent per month are often seen. Inflation & its causes and effects Page 4 of 9 .

This results in low or no inflation.000. demand pull inflation and cost push inflation are usually one off shocks. The Phillips curve. you might set 1 New Dollar = 1. which is associated with Keynesian economics suggests that stagflation is impossible because high unemployment lowers demand for goods and services which lowers prices.000 old Dollars. Adaptive expectations In economics. in which case they will modify their economic behaviour accordingly. even for simple purchases like bread or milk. people would expect it to be high in the future. But some still believe in Keynesian economics. instead of 10. so your new banknote would read "10 New Dollars".000.000 Dollars. if inflation has been high in the past.Economic Analysis One type has a big long row of zeros on the number. By contrast. The coinage of the term has been claimed for the UK Finance Minister Iain Macleod who died in 1970. a series of such shocks may lead people to assume that inflation is a permanent feature of the economy.000.) In countries experiencing hyperinflation it is common to see men and women bringing enormous grocery bags full of banknotes to the store. (like this: "10. monetarism which argues that inflation is due to the money supply rather than to demand predicts that inflation can occur with high unemployment if the government increases the money supply.000"). based on their expectation of future inflation Inflation & its causes and effects Page 5 of 9 . adaptive expectations means that people base their expectations of what will happen in the future based on what has happened in the past. and the difficulty in fitting its existence within a Keynesian framework led to a greater acceptance of monetarist theories in the 1970s and 1980s. However. saying that there was no recession at that time. Stagflation is a portmanteau word used to describe a period with a high rate of inflation combined with an economic recession. For example. Stagflation occurred in the economies of the United Kingdom in the 1960s and 1970s and the United States in the late 1970s. Another type uses words for part or all of the number (like this: "10 Billion" or this: "Ten Billion") Still others avoid the use of large numbers simply by declaring a new unit of currency (so. In the theory of inflation.000.000.000.

It pays overtime rates to its existing work force. This Labor turnover imposes "additional costs on the firm. Departures from Full Employment Redistribution brings gains to some and losses to others.Economic Analysis rates. workers begin to quit the bottling plant to find jobs that pay a real wage rate that is closer to one that prevailed before the outbreak of inflation. leading firms to push their prices higher. But if aggregate demand is expected to increase at a rapid rate and it fails to do so. With a high inflation rate anticipated. and thus to another round of pay-raises. but inflation occurs. as an explanation of some aspects of the economic crisis that the West went through after the 1970s oil shock. and its profits do not increase as much as Inflation & its causes and effects Page 6 of 9 . But because the real wage rate has fallen. These unintended consequences impose costs in both labor markets and capital markets. [hen wages will not have been set high enough. took until the 1990s to achieve stable low inflation rates again suggests there may well be something in the idea. let's return to the soda-bottling plant in Kalamazoo. This "wage-price spiral" builds some inflation directly into the economy! The theory of adaptive expectations was popular in the 1980s. and sometimes they lose. In this case. For instance. Effects of Inflation: Regardless of whether inflation is demand pull or cost-push. The fact that some countries. The real wage rate falls. it incurs higher plant maintenance and parts replacement costs. because the real wage rate has fallen. and because it runs its plant at a faster pace.rate. An alternative theory of how expectations are formed is rational expectations. employers gain at the expense of workers. To see why. and wages will buy fewer goods than expected. they may begin demanding larger pay raises this in itself acts as a cost push. the firm has a hard time attracting the labor it wants to employ. Let's examine these costs. the money wage rate does not rise to keep up with inflation. If an unexpected increase in aggregate demand increases [he inflation. If the bottling plant and its workers do not anticipate inflation. the firm incurs additional costs. workers gain at the expense of employers. Redistribution between employers and workers creates an incentive for both firms and workers to try to forecast inflation correctly. But departures from full employment impose costs on everyone. Unanticipated Inflation in Labor Market Unanticipated inflation has two main consequences for the operation of the labor market: • Redistribution of income • Departure from full employment Redistribution of Income Unanticipated inflation redistributes income between employers and workers. So even though its production increases. wages are set too high and profits are squeezed. Profits will be higher than expected. But also. the failure to correctly anticipate it results in unintended consequences. particularly the UK. Sometimes employers gain at the expense of workers. and the firm tries to hire more labor and increase production.

borrowers wish they had borrowed less and lenders wish they had lent more. So unanticipated inflation imposes costs regard. In this case. so their wages buy a smaller quantity of goods and services than expected. interest rates are set too high. Sometimes borrowers gain at the expense of lenders. But if inflation is expected and then fails to occur. on the extent to which the inflation is anticipated. Forecasting Inflation: Inflation is difficult to forecast. and the real wage rate rises. Redistributions of income between borrowers and lenders create an incentive for both groups to try to forecast inflation correctly.sight about the inflation rate. lenders gain at the expense of borrowers. they discover that prices have increased. there are several sources of inflation--the demand-pull and cost-push sources you've just studied. both groups would have made different lending and borrowing decisions with greater fore. first. which occurs when inflation is higher than expected. Inflation & its causes and effects Page 7 of 9 . the speed with which a change in either aggregate demand or aggregate supply translates into a change in the price level varies. Unanticipated Inflation in the Capital Market Unanticipated inflation has two consequences for the operation of the capital market.wise would. Let's see how people go about this task. which occurs when inflation is lower than expected. Those workers who keep their jobs gain. and sometimes they lose. the interest rate does not incorporate a correct allowance for the falling value of money and the real interest rate is either lower or higher than it otherwise would be. They've worked overtime to produce the extra output. but those who become unemployed lose. the bottling plant loses because its output and profits fall. They are: • Redistribution of income • Too much or too little lending and borrowing Redistribution of Income Unanticipated inflation redistributes income between borrowers and lenders. and those who remain at the bottling plant wind up feeling cheated. and when they come to spend their wages. In this case. Too Much or Too Little Lending and Borrowing If the inflation rate turns out to be either higher or lower than expected. they increase the money wage rate by too much.Economic Analysis they other. borrowers wish they had borrowed more and lenders wish they had lent less-: Both groups would have made different lending and borrowing decisions with greater fore. Again. When the real interest rate turns out to be too low. The workers incur additional costs of job search. as you will see below. The reasons are.sight about the inflation rate. At the higher real wage rate. When inflation is unexpected. When the real interest rate turns out to be too high. the firm lays off some workers and the unemployment rate increases. interest rates are not set high enough to compensate lenders for the falling value of money. If the bottling plant and its workers anticipate a high inflation rate that does not occur. borrowers gain at the expense of lenders. Second. Also. The presence of these costs gives everyone an incentive to forecast inflation correctly.less of whether the inflation turns out to be higher or lower than anticipated. This speed of response also depends.

money wages are sticky. Between last year and this year. The specialist forecasters are economists who work for public and private macroeconomic forecasting agencies and for banks. The most accurate forecast possible is the one that is based on all the relevant information and is called a rational expectation. the aggregate supply curve was SASo. But the expectation was correct. the money wage does not change immediately. A rational expectation is not a correct forecast. the aggregate demand curve is ADl and with the short-run aggregate supply curve SASl the actual price level is 121. Figure 32. the price level increased from 110 to 121 and the economy experienced an inflation rate of 10 percent. people devote considerable resources to improving inflation forecasts. so the LAS curve does not shift. labor unions. the short-run aggregate supply curve shifted from SASo to SASl. but no ocher forecast that could have been made with the information available could be predicted to be better. The returns these specialists make depend on the quality of their forecasts. Suppose that last year the price level was 110 and real GDP was $7 trillion. they will adjust money wage rates so as to keep up with anticipated inflation. It will often turn out to be wrong. But if people correctly anticipate increases in aggregate demand. The combination of the anticipated and actual increases in aggregate demand produced an increase in the price level that was anticipated. which is also potential GDP. money wage rates rise and the short-run aggregate supply curve shifts leftward. Aggregate demand was expected to increase. Because aggregate demand actually did increase by the amount that was expected. the same as the inflation rate that was anticipated.7 explains why. and large corporations. Anticipated Inflation: In the demand-pull and cost-push inflations that we studied earlier in this chapter. When aggregate demand increases. was ADo. Because aggregate demand was expected to increase from ADo to ADl. The price level rises by a further 10 percent to 133. Suppose that potential GDP does not change. In this case. Inflation & its causes and effects Page 8 of 9 . What has caused this inflation? The immediate answer is that because people expected inflation. Some people specialize in forecasting. Let's now see what happens if inflation is correctly anticipated.Economic Analysis Because inflation is costly and difficult to forecast. The. the actual aggregate demand curve shifted from ADo to ADl. The money wage rate rises to reflect the anticipated inflation. aggregate demand curve. You've seen the effects of inflation when people fail to anticipate it. If aggregate demand turns out to be the same as expected. wages were increased and prices increased. If the money wage rate rises by the same percentage as the price level rises. inflation proceeds with real GDP equal to potential GDP and unemployment equal to the natural rate. and the short-run aggregate supply curve shifts to SAS2. the short-run aggregate supply curve for next year is SASl. so they have a strong incentive to forecast as accurately as possible. and others buy forecasts from specialists. either to set off a demandpull inflation or to accommodate cost-push inflation. and the long-run aggregate supply curve was LAS. 1t is simply the best forecast available. and it did increase. If this anticipated inflation is ongoing. in the following year aggregate demand increases (as anticipated) and the aggregate demand curve shifts to AD2. And you've seen why it pays to try to anticipate inflation. Also suppose that aggregate demand is expected to increase and that the expected aggregate demand curve for this year is ADl' In anticipation of this increase in aggregate demand. insurance companies.

there is some unanticipatedinflation that looks just like the demand-pull inflation that you studied earlier. and the money wage rate is set to reflect that expectation. the money wage rate rises. and to some extent. some inflation is expected. If the expected growth rate of aggregate demand is different from its actual growth rate. The SAS curve intersects the LAS curve at the expected price level. but by more than expected.Economic Analysis Only if aggregate demand growth is correctly forecasted does the economy follow the course described in Fig. 32. but by less than expected. Some inflation is expected. If aggregate demand increases again. and the money wage rate is set to reflect that expectation. When inflation is anticipated.. Aggregate demand increases to restore full employment. wages again rise. there is some unanticipated inflation that looks like the cost-push inflation that you studied earlier. When aggregate demand increases by less than expected. short-run aggregate supply again decreases. the expected aggregate demand curve shifts by an amount that is different from the actual aggregate demand curve. there is unanticipated inflation. With real GDP above potential GDP and unemployment below the natural rate. So the price level rises further. So the AD curve intersects the SAS curve at a level of real GDP that exceeds potential GDP. Again. and a cost push spiral unwinds We've seen that only when inflation is unanticipated does real GDP depart from potential GDP. The SAS curve intersects the LAS curve at the expected price level. But if aggregate demand is expected to increase by more than it actually does.7 Unanticipated Inflation: When aggregate demand increases by more than expected. Does this mean that an anticipated inflation has no costs? Inflation & its causes and effects Page 9 of 9 . Aggregate demand then increases. real GDP remains at potential GDP. Page 348 figure 15. The inflation rate departs from its expected level.7. Aggregate demand thenincreases. So the AD curve intersects the SAS curve at a level of real GDP-below potential GDP. a: demand-pull inflation spiral unwinds.