Inflation (economics)

In economics, inflation is an increase in the money one needs to spend to get goods and services. Prices of goods and services constantly fluctuate in market economies, and inflation refers to an increase in prices relative to the value of the products received. In general, people purchasing goods such as bread and gasoline will pay less in the present than they will for the same products in several years. The inflation rate measures price changes across many goods and services during a certain period, usually a year. In general, economists believe that a consistent low level of inflation is good for an economy. High rates of inflation or negative rates of inflation can indicate or cause economic downturns.

Overview

Inflation deals with the value of money. In an economy, people use money to purchase what they need. Before they used money, people bartered for goods and services. People began using money because it stores its value better than goods and services. For example, a farmer can store crops and barter them over time for other goods and services; however, the crops will eventually rot and lose their value. Instead, the farmer could exchange all fresh crops for money. The money the farmer receives stores its value longer than the crops would have. The farmer’s money also expresses value. The value of the money the farmer receives equals the value of the fresh crops. However, the value of money changes. This is called inflation.

Inflation can refer to two different, but related, aspects of the economy. It can refer to an increase on the supply of money in an economy. The amount of money in an economy most often changes because the government (the entity that controls the money) releases more money.

Inflation can also relate to the value of goods and services that one can purchase for a certain amount of money. Inflation decreases the value of what one can buy. This type of inflation occurs because prices rise relative to value. For example, suppose that a person can buy ten pieces of candy for five dollars. The next year, the person can buy only nine pieces of candy for five dollars. The price of the candy increased. Therefore, the person spent the same amount of money but received less value for that money.

The supply of money and the value of goods and services one can purchase with a particular amount of money are related. Economists explain this relationship with an idea called the quantity theory of money. This theory, which first developed in the 1600s, states that prices increase when the supply of money increases. That means that the money’s value decreases as its supply increases. Therefore, the amount of goods and services one can buy with a particular amount of money decreases.

The two concepts of inflation are related. However, when people discuss inflation, they most often refer to a decrease in the value they get for a certain amount of money. This is because it is the aspect of inflation that most affects them. This type of inflation causes prices to rise. Because of inflation, people must pay more money to get the same value.

Inflation occurs because of supply and demand. These re the two most important factors used to determine the cost of goods and services. Supply has an inverse relationship to price. Prices generally increase as supply decreases, and prices decrease as supply increases. Conversely, demand has a positive correlation to price. High demand usually results in higher prices, and low demand results in lower prices. Changes in supply and demand explain price fluctuations for goods and services. However, when the price of many goods and services changes because of supply and demand, it can cause inflation.

Cost-push inflation occurs when supply decreases, but demand remains the same. The law of supply indicates that prices will rise as supply decreases. With cost-push inflation, prices increase because of the decrease in supply. This type of inflation might occur because raw materials for a product become scarcer or labor prices increase. Manufacturers will produce fewer goods if they have fewer raw materials and must pay more to produce them. Decreased production leads to decreased supply. If the demand remains the same for the goods, the prices will increase.

Demand-pull inflation occurs because of a general increase in demand while the supply remains the same. Like cost-push inflation, demand-pull inflation occurs for several reasons. For example, it might occur because unemployment decreases, and more people have money to spend. It could also occur because of a general increase in wages, which also allows people to purchase more goods. Furthermore, demand-pull inflation can be caused by low interest rates, which entice more people to borrow and spend money. This type of inflation often occurs when an economy is strong.

Because inflation plays a key role in an economy, governments and central banks track inflation by collecting economic data. Various indexes are used to relay information about inflation. In the United States, people most often use changes in consumer prices to portray the level of inflation. The US federal government tracks consumer prices in the consumer price index (CPI). To create the CPI, the government tracks the prices of goods and services from different sectors of the economy. Economists compare CPI data from month to month to express a percentage change in inflation, which is called the inflation rate. The CPI is the most popular index for expressing rates of inflation because it reveals how people’s purchasing power changes. Although the CPI is the most common data source for inflation rates, it is not a perfect tool. For example, the government creates the inflation rate off the urban CPI, which tracks prices and spending in urban areas. The government uses this data because most Americans live in urban areas, but this may also skew the data. Furthermore, the data for the CPI is collected during the week and not on weekends. All people do not shop at the same time, however, so this can also skew the data.

Countries that track inflation do so because they want to understand the levels of inflation, which can change dramatically over time. Most economists agree that low levels of inflation are good, even though inflation reduces the value of goods and services people can purchase with their money over time. Furthermore, economists believe that inflation increases demand because it motivates people to make purchases instead of delaying purchasing until a time when the good or service might be more expensive because of inflation. Economists believe that an inflation rate of about 1 to 2 percent is beneficial to an economy.

Inflation rates above 3 percent are often seen as harmful, as generally people’s nominal incomes do not increase at rates that high or higher. When a person’s nominal income does not increase as much as the inflation rate, their purchasing power decreases. That means that the money will not have the same value as it did in the past. Inflation-adjusted income, which is sometimes called real income, will decrease if inflation rates outpace income increases. Therefore, high inflation rates can reduce people’s standard of living and harm the overall economy by decreasing economic demand.

At times, inflation can increase very dramatically and very quickly in a phenomenon called hyperinflation. Hyperinflation rates are much higher than average inflation rates. These rates could be 50 percent to even 1000 percent per month. This type of inflation could cause the price of common consumer goods to double once a month or even every day. Hyperinflation can make the currency it affects nearly valueless. For example, in the Weimar Republic in the 1920s after Germany’s defeat during World War I (1914–8), the country’s currency became worth so little that workers were paid in suitcases full of money. Hyperinflation is rare and usually occurs because of both a severe shock to an economy and a faulty economic policy from the government. Often, hyperinflation begins when a shock, such as a war or a supply shortage, dramatically decreases the supply of goods. This resulting cost-push inflation raises prices. Then, the government usually enacts policies that cause additional inflation, such as funding the cost of inflation by printing more money. As the value of money decreases, people rush to spend their money before it value is further reduced. An increase in demand because of this spending increases prices even further. Because of this cycle, hyperinflation is extremely difficult to slow down and reverse.

During periods of hyperinflation, people often drastically change their economic behavior. They begin using bartering systems because they no longer believe their money is an effective way to retain and measure value. Furthermore, people might be more likely to invest in real estate and other items that could retain their value better than money.

Although high inflation, and especially hyperinflation, hurts an economy, deflation is also bad for an economy. Deflation describes a general trend of decreasing prices in an economy. It is bad for the economy in part because falling prices could incentivize consumers to postpone purchases in anticipation of prices falling further in the future. Furthermore, falling prices will also cause producers to have lower profits, which may cause lower wages or even a reduction in employment.

During the twenty-first century, economists and consumer advocates also identified the trend of shrinkflation. This term refers to companies shrinking the size or quantity of their products while continuing to charge the same price as before. This results in consumers getting less value for what they spend, as they spend the same amount of money for less of a product. Some companies consider this a solution that allows them to remain financially viable amid rising inflation without raising their prices or only raising their prices a small amount. However, a number of consumer protection agencies and advocacy groups have criticized the practice as misleading, especially if companies do not clearly announce or publicize these size or quantity reductions. By the 2020s, some lawmakers in the US had begun discussing legislation to control or reduce the practice of shrinkflation.

Since low levels of inflation can help grow the size of the economy, governments aim to control inflation through their monetary policy. Normal economic factors, such as demand being larger than production, contribute to low levels of inflation. However, governments and central banks might take steps, such as increasing the money supply, to influence inflation rates.

Applications

Inflation is a crucial factor in determining an economy’s health, and large fluctuations in inflation have caused economies to fail. A famous example of inflation wreaking havoc in an economy took place during the Weimar Republic in the 1920s. Germany's loss during World War I was the initial shock to the economy, and then the government was made to repay reparations after the war ended. Germany’s currency became worthless, and the inflation rate reached 29,500 percent per month.

An example of hyperinflation occurred in 2008 in Zimbabwe. The country’s inflation rate reached a rate of about five hundred billion percent at one point. Zimbabwe’s hyperinflation was the result of many factors. The country had a weak economy overall, and then its government began printing more money to pay its debt. The country also experienced declines in demand and, therefore, economic output.

In the 2000s, Japan famously experienced a period of deflation, which played a significant role in the country having a stagnant economy. Japanese citizens responded to a weak economy by saving more money and spending less. Less spending in the economy caused a decrease in economic demand, which caused a decrease in prices.

Many countries around the world, including the United States, experienced high levels of inflation during the early 2020s alongside other economic issues associated with the COVID-19 pandemic. 2022 saw particularly high inflation in the US; in July the monthly inflation rate reached 9.1 percent, the highest level in the US since 1981. This rate slightly decreased through the remainder of 2022 but remained far higher than average. By December 2023 the annual inflation rate in the US over the previous twelve months averaged out at 3.4 percent, an improvement over the 6.5 percent rate of the previous December.

Viewpoints

Although most economists agree that low levels of inflation of about 1 to 2 percent annually help expand an economy, they often disagree about what governments should do—if anything—to try to influence the inflation rate. Furthermore, economists tend to disagree about the degree to which governments and central banks should try to influence the economy in general. Government interventions in economics increased dramatically in the twentieth and twenty-first centuries, though experts disagree about whether such interventions have been positive or negative.

Governments can intervene in economies in four ways: (1) They can pay for goods and services, such as by building infrastructure, paying for education, and funding national defense; (2) they can also move income from certain groups to other groups; (3) they can tax individuals, which will change their behavior; (4) and they can also regulate the economy, which also changes people’s economic behavior. Economists and other experts often disagree about how a government should use these powers to influence the economy to affect the inflation rate.

Economic experts believe that the government should have little or no role in affecting the economy, and they believe that negative outcomes from the free market are preferable to negative outcomes that occur because of government interference. However, other economists believe that government intervention can improve the economy. They feel that governments should intervene to guard against both deflation and rapidly rising inflation. Other experts argue that fluctuations in inflation will occur and should be regulated by the market instead of the government.

When governments and central banks consider taking steps to influence rates, they consider the source (or sources) of the inflation. If inflation is rising quickly from demand-pull inflation, the government and central bank may want to decrease demand. When high demand is driving inflation, economists often say the economy is “too hot.” These institutions will often try to reduce aggregate demand. For example, a central bank might raise interest rates to reduce demand.

Governments and central banks might take other steps to address cost-push inflation. For example, governments might create incentives to entice businesses to manufacture more products in the country. For example, experts argued that rapidly rising inflation in the United States in the early 2020s could be controlled in part by increasing the domestic supply of goods and manufacturing more goods in the United States. The United States and other countries saw rapidly increasing inflation during the early 2020s, particularly during the first half of 2022, in part because of the COVID-19 pandemic, which caused businesses to slow or temporarily shut down production and created other supply chain issues. This meant that fewer goods were produced. With fewer goods on the market, consumer prices increased significantly, which some people argued would help companies ensure a steady supply of goods, which helps prevent shortages and the inflation that accompanies them. High inflation during this period prompted the US and some other countries to raise interest rates, which remained relatively high in the US through much of 2024.

A government can also influence inflation by significantly reducing its spending. Spending money in a hot economy further drives demand and increases prices. If a government reduces its spending, it could help reduce the speed at which consumer prices increase. Governments and central banks can also use other tools and tactics to help curb inflation, such as by breaking up big corporations and taxing wealthy citizens.

About the Author

Elizabeth Mohn earned a BS in communications in 2006. She has developed social sciences content for more than a decade.

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