What is Inflation?

Inflation

Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling.

So inflation is a sustained increase in the general price level of goods and services in an economy over a period of ‘time. When the price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy.

A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index(normally the consumer price index) over time.

The opposite of inflation is deflation. Inflation affects an economy in various ways, both positive and negative. Negative effects of inflation 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.

Inflation also has positive effects:

Fundamentally, inflation gives everyone an incentive to spend and invest, because if they don’t, their money will be worthless in the future. This increase  in spending and investment can benefit the economy. However it may also lead to sub-optimal use of resources. 

Inflation reduces the real burden of debt, both public and private. If you have a fixed-rate mortgage on your house, your salary is  likely to increase over time due to wage inflation, but your mortgage payment will stay the same. Over time, your mortgage payment will become a smaller percentage of your earnings, which means that you will have more money to spend.

Inflation keeps nominal interest rates above zero, so that central banks can reduce interest rates, when necessary, to stimulate the economy.

Inflation reduces unemployment to the extent that unemployment is caused by nominal wage rigidity. When demand for labor falls but nominal wages do not, as typically occurs during a recession, the supply and demand for labor cannot reach equilibrium, and unemployment results. By reducing the real value of a given nominal wage, inflation increases the demand for labor, and therefore reduces unemployment.

Economists generally believe that  high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. However, money supply growth does not necessarily cause inflation. Some economists maintain that under the conditions of a liquidity trap, large monetary injections are like “pushing on a string”. 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 for goods and services, or changes in available supplies such as during scarcities. 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

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