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, alongside increased velocity of money, is typically the dominant causal factor.

If money were 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. Low (as opposed to zero or 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. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control monetary policy through the setting of interest rates, by carrying out open market operationsand (more rarely) changing commercial bank reserve requirements.