inflation

In

economics

, inflation refers to a general progressive increase in prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money. The opposite of inflation is

deflation

, a sustained decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualised percentage change in a general price index.

Prices will not all increase at the same rates. Attaching a representative value to a set of prices is an instance of the index number problem. The consumer price index is often used for this purpose; the employment cost index is used for wages in the United States. Differential movement between consumer prices and wages constitutes a change in the standard of living.

The causes of inflation have been much discussed (see below), the consensus being that growth in the money supply is typically the dominant causal factor.

If money was perfectly neutral, inflation would have no effect on the real economy; but perfect neutrality is not generally considered believable. Effects on the real economy are severely disruptive in the cases of very high inflation and

hyperinflation

. More moderate inflation affects economies in both positive and negative ways. The negative effects include an increase in the opportunity cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation were rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Positive effects include reducing unemployment due to nominal wage rigidity, allowing the central bank greater freedom in carrying out

monetary policy

, encouraging loans and investment instead of money hoarding, and avoiding the inefficiencies associated with deflation.

Today, most economists favour a low and steady rate of inflation.Hummel, Jeffrey Rogers. "Death and Taxes, Including Inflation: the Public versus Economists" (January 2007

p. 56 Low (as opposed to zero or Deflation, negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents

monetary policy

from stabilising the economy.Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others
Lars E.O. Svensson, ''Journal of Economic Perspectives'', Volume 17, Issue 4 Fall 2003, pp. 145–166 The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the

central bank

s that control monetary policy through the setting of interest rates, by carrying out open market operations and (more rarely) changing commercial bank reserve requirements.

Definition

The term ''inflation'' appeared in America in the mid-nineteenth century, “not in reference to something that happens to prices, but as something that happens to a paper currency”.Bryan, Michael F.
"On the Origin and Evolution of the Word Inflation"
''Federal Reserve Bank of Cleveland, Economic Commentary,'' 15 October 1997. Today, however, it is understood as referring to a sustained increase in the general price level (as distinct from short-term fluctuations).

The expression “price inflation” may either be synonymous with “inflation” or reflect some more restrictive definition of “price”. Changes to the wage level are described as “wage inflation” and changes to the money supply as “

monetary inflation

”. These terms are sometimes assumed to identify the causative factor.

More specific forms of inflation refer to sectors whose prices vary semi-independently from the general trend. “House price inflation” applies to changes in the house price index while “energy inflation” is dominated by the costs of oil and gas.

Related concepts

Other economic concepts related to inflation include:

deflation

a fall in the general price level; disinflationa decrease in the rate of inflation;

hyperinflation

an out-of-control inflationary spiral; stagflationa combination of inflation, slow economic growth and high unemployment; reflationan attempt to raise the general level of prices to counteract deflationary pressures; and asset price inflationa general rise in the prices of financial assets without a corresponding increase in the prices of goods or services; agflation – an advanced increase in the price for food and industrial agricultural crops when compared with the general rise in prices.

Theoretical background

Classical economics

By the nineteenth century, economists categorised three separate factors that cause a rise or fall in the price of goods: a change in the ''value'' or production costs of the good, a change in the ''price of money'' which then was usually a fluctuation in the commodity 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 currency printed during the American Civil War, 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. At that time, the term inflation referred to the devaluation 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

in their value was noted by earlier classical economists such as

David Hume

and

David Ricardo

, who would go on to examine and debate what effect a currency devaluation (later termed ''

monetary inflation

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

History

Historically, large infusions of gold or silver into an economy had led to inflation. For instance, when silver was used as currency, the government could collect silver coins, melt them down, mix them with other metals such as copper or lead and reissue them at the same nominal value, a process known as debasement. At the ascent of

Nero

as Roman emperor in AD 54, the denarius contained more than 90% silver, but by the 270s hardly any silver was left. By diluting the silver with other metals, the government could issue more coins without increasing the amount of silver used to make them. When the cost of each coin is lowered in this way, the government profits from an increase in seigniorage. 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 lower, 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.

The adoption of fiat currency by many countries, from the 18th century onwards, made much larger variations in the supply of money possible. Rapid increases in the money supply have taken place a number of times in countries experiencing political crises, producing

hyperinflation

s episodes of extreme inflation rates much higher than those observed in earlier periods of commodity money. The hyperinflation in the Weimar Republic of Germany is a notable example. Currently, the hyperinflation in

Venezuela

is the highest in the world, with an annual inflation rate of 833,997% as of October 2018.

However, since the 1980s, inflation has been held low and stable in countries with independent

central bank

s. This has led to a moderation of the

business cycle

and a reduction in variation in most macroeconomic indicators - an event known as the Great Moderation.

Historical inflationary periods

Rapid increases in the quantity of money or in the overall money supply have occurred in many different societies throughout history, changing with different forms of money used.

Ancient China

Song Dynasty China introduced the practice of printing paper money to create fiat currency. During the Mongol Yuan Dynasty, the government spent a great deal of money fighting costly wars, and reacted by printing more money, leading to inflation. Fearing the inflation that plagued the Yuan dynasty, the

Ming Dynasty

initially rejected the use of paper money, and reverted to using copper coins.

Medieval Egypt

During the Malian king

Mansa Musa

's hajj to

Mecca

in 1324, he was reportedly accompanied by a camel train that included thousands of people and nearly a hundred camels. When he passed through

Cairo

, he spent or gave away so much gold that it depressed its price in Egypt for over a decade, reducing its purchasing power. A contemporary Arab historian remarked about Mansa Musa's visit:

"Price revolution" in Western Europe

From the second half of the 15th century to the first half of the 17th, Western Europe experienced a major inflationary cycle referred to as the "price revolution", with prices on average rising perhaps sixfold over 150 years. This is often attributed to the influx of gold and silver from the New World_into_Habsburg_Spain,_with_wider_availability_of_ 6c:_from__...