Inflation is the decline in the purchasing power of a given currency over time. A quantitative estimate of the rate at which purchasing power declines may be reflected in an increase in the average price level of a basket of selected goods and services in an economy over a period of time. An increase in the general level of prices, often expressed as a percentage, means that a unit of currency is effectively bought for less than in previous periods.
Inflation can be compared to deflation, which occurs when the purchasing power of money increases and prices fall.
Inflation is the rate at which the value of a currency is falling and, consequently, the general level of prices of goods and services is rising.
Inflation is sometimes classified into three types: demand-pull inflation, cost-push inflation, and implicit inflation.
The most commonly used inflation indices are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
Inflation can be viewed either positively or negatively, depending on individual perspective and rate of change.
Those with tangible assets, such as property or stock items, may prefer to see some inflation as it increases the value of their assets.
While it is easy to measure the price change of individual products over time, human needs extend beyond one or two such products. Individuals require a large and diverse set of products as well as many services to lead a comfortable life. These include utilities such as food grains, metals, fuel, electricity and transportation, and services such as healthcare, entertainment and labor.
Inflation aims to measure the overall effect of price changes for a diverse set of products and services, and allows a single price representation of the increase in the price level of goods and services in an economy over a period of time.
Important: The US Bureau of Labor Statistics (BLS) reported that the Consumer Price Index (CPI-U) for all urban consumers increased by 7.5% in the 12-month period ending January 2022, the highest since the period ending June. The biggest is the 12-month increase 1982.
As the value of a currency decreases, prices rise and it buys fewer goods and services. This loss of purchasing power affects the normal cost of living for the general public which ultimately causes a slowdown in economic growth. The general consensus among economists is that sustained inflation occurs when a country's money supply growth outweighs economic growth.
To counter this, a country's appropriate monetary authority, like the central bank, takes necessary measures to keep inflation within permissible limits and manage the money and credit supply to keep the economy running smoothly.
Theoretically, monetarism is a popular theory that explains the relationship between inflation and the money supply of an economy. For example, after the Spanish conquest of the Aztec and Inca empires, huge amounts of gold, and especially silver, flowed into the Spanish and other European economies. As the money supply increased rapidly, the value of the currency fell, causing a rapid rise in prices.
Inflation is measured in a variety of ways depending on the types of goods and services considered and is the opposite of deflation which indicates the general decline in prices for goods and services when the inflation rate falls below 0%.
Due to inflation
An increase in the money supply is the root of inflation, although it can play out through a variety of mechanisms in the economy. By devaluing (by reducing the value) of the money supply by monetary authorities either by printing more money to individuals, by legal tender currency, by bringing more (at most) new money into existence in the form of reserve account credits can be extended. Through the banking system by purchasing government bonds from banks in the secondary market.
In all such cases of increase in money supply, money loses its purchasing power. The mechanisms of how it drives inflation can be classified into three types: demand-pull inflation, cost-push inflation, and implicit inflation.
Demand-pull effect
Demand-pull inflation occurs when an increase in the supply of money and credit encourages the aggregate demand for goods and services in the economy to grow more rapidly than the economy's production capacity. This increases demand and increases prices.
With more money available to individuals, positive consumer sentiment leads to more spending, and this increased demand pulls prices higher. This creates a demand-supply gap with higher demand and less flexible supply, resulting in higher prices.
Cost-push effect
Cost-push inflation is the result of an increase in prices working through the production process inputs. When an increase in the supply of money and credit is channeled to a commodity or other asset market, and especially when it is accompanied by a negative economic shock to the supply of key goods, the cost of all types of intermediate goods increases.
These developments lead to higher costs for the finished product or service and work their way into increasing consumer prices. For example, when an expansion of the money supply creates a speculative surge in oil prices, energy costs of all kinds can rise and contribute to rising consumer prices, which are reflected in various measures of inflation.
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