What Is Inflation?

Inflation is a sustained increase in the general price level of goods and services in an economy over time, as described by Irving Fisher in 1911.

Definition

Inflation is a sustained increase in the general price level of goods and services in an economy over time, as described by Irving Fisher in 1911.

How It Works

The inflation process begins with an increase in the money supply, which can be caused by an increase in the amount of currency in circulation or a decrease in the reserve requirements for banks, allowing them to lend more money. As more money chases a constant quantity of goods and services, prices rise. The monetary policy framework, as outlined by Milton Friedman in 1969, suggests that the money supply is a key driver of inflation. For instance, the US Federal Reserve uses open market operations to control the money supply and influence inflation, with the goal of keeping inflation around 2% annually.

The Phillips curve, developed by Alban William Phillips in 1958, describes the relationship between inflation and unemployment. As unemployment falls, inflation tends to rise, and vice versa. This relationship is not always straightforward, however, as supply shocks can cause inflation to rise even in the presence of high unemployment. The 1970s, for example, saw high inflation and high unemployment in the US, a phenomenon known as stagflation. The rational expectations model, developed by Robert Lucas in 1972, suggests that people's expectations of future inflation can influence their current behavior, making it more difficult for policymakers to control inflation.

The velocity of money, which measures how quickly money is spent and respent in the economy, also plays a role in determining the level of inflation. If the velocity of money is high, a given increase in the money supply will lead to a larger increase in prices. The quantity theory of money, which states that the general price level is proportional to the money supply, is a simple framework for understanding the relationship between money and inflation. Boeing produces ~800 aircraft annually (Boeing annual report), and an increase in the money supply could lead to higher demand for Boeing's products, driving up prices.

Key Components

• Money supply: An increase in the money supply can lead to higher inflation, as more money chases a constant quantity of goods and services. A decrease in the money supply, on the other hand, can lead to lower inflation or even deflation.
• Interest rates: Higher interest rates can reduce inflation by reducing borrowing and spending, while lower interest rates can increase inflation by stimulating borrowing and spending. The European Central Bank, for example, sets interest rates for the eurozone to influence inflation.
• Economic growth: Rapid economic growth can lead to higher inflation, as increased demand for goods and services drives up prices. The Solow growth model, developed by Robert Solow in 1956, describes the relationship between economic growth and factors such as technological progress and capital accumulation.
• Supply and demand: Imbalances between supply and demand can lead to inflation, as scarce goods and services become more expensive. The cobweb model, developed by Nicholas Kaldor in 1934, describes the dynamics of supply and demand in markets with long production lags.
• Expectations: People's expectations of future inflation can influence their current behavior, making it more difficult for policymakers to control inflation. The adaptive expectations model, developed by Irving Fisher in 1911, suggests that people's expectations of future inflation are based on their experience of past inflation.
• Global trade: Changes in global trade patterns can influence inflation, as imports and exports affect the supply and demand for goods and services. The Ricardo's comparative advantage model, developed by David Ricardo in 1817, describes the benefits of international trade based on comparative advantage.

Common Misconceptions

Myth: Inflation is always bad — Fact: Moderate inflation can be a sign of a healthy economy, as it indicates that people have the money to spend and are confident in the future (Friedman, 1969).

Myth: Deflation is always good — Fact: Deflation can be harmful, as it can lead to reduced spending and investment, and even debt deflation (Fisher, 1933).

Myth: Inflation is only caused by monetary policy — Fact: Supply shocks, such as natural disasters or global events, can also cause inflation (Lucas, 1972).

Myth: Inflation is the same as price increases — Fact: Inflation is a sustained increase in the general price level, while price increases can be one-time events or limited to specific goods and services (Fisher, 1911).

In Practice

In 2008, the US government implemented a stimulus package to combat the financial crisis, which included a significant increase in the money supply. As a result, inflation rose from 3.8% in 2008 to 4.1% in 2010 (Bureau of Labor Statistics). The increase in inflation was driven in part by higher demand for goods and services, particularly in the housing market, where prices rose by 10% in 2010 (National Association of Realtors). The Federal Reserve, led by Chairman Ben Bernanke, used quantitative easing to inject liquidity into the economy and stimulate growth, while also keeping a close eye on inflation to prevent it from getting out of control. The Fed's actions were guided by the Taylor rule, developed by John Taylor in 1993, which provides a framework for setting interest rates based on inflation and economic growth.