Inflation is defined as an overall increase in the price level. Or, in other words, an overall decrease in the purchasing power of the dollar. When inflation occurs, currency buys fewer goods and services.
The most effective tool used to gauge the level of inflation is the Consumer Price Index, or CPI.
The Consumer Price Index is a basket of about 400 commonly purchased goods and services that is used to represent overall consumption. Each month, the Department of Labor checks the prices of these 400 different items in 85 areas all over the U.S.
Inflation exists when the average cost of the items is rising. If the average cost of these items remains the same, there is no inflation, even though most likely the prices went up on some of the items, while the prices went down on others. The overall percentage of increase or decrease of cost for these items from year to year is the annual inflation rate.
There are two types of inflation: demand-pull inflation and cost-push inflation.
Demand-pull inflation occurs when the demand for goods and services increases faster than the supply of goods and services. This increase in demand could come from increases in the money supply, or increases in the amount of money government spends.
Demand-pull inflation is sometimes described as too much money chasing too few goods. When demand increases, there would be a shortage of many items if prices stayed at the same level. However, prices will not stay at the same level.When there’s a shortage of something, the price on that item will rise until it hits an equilibrium. This causes a rise in the overall average of prices.
Cost-push inflation happens when there is an increase in the cost to produce goods and services. These increased production costs could be increases in the cost of raw materials, energy, or any other item used in production. There also could be increases in wages. This is sometimes referred to as wage-push inflation, or the price-wage spiral.
The government attempts to combat inflation using fiscal policy and monetary policy.
Fiscal policy is the use of the government’s taxing and spending powers to attempt to accomplish economic pulls. Fiscal policy can be used to decrease spending to reduce demand-pull inflation.
Government can reduce total spending by reducing its own spending. It could also reduce overall spending by raising taxes, which leaves consumers with less money to spend on goods and services.
Monetary policy involves the changing of interest rates and availability of loans to attempt to accomplish economic goals.
The Fed can reduce spending by raising interest rates and making loans harder to obtain, which in turn reduces demand-pull inflation.
Inflation can never be totally eliminated. Furthermore, efforts to reduce inflation tends to cause unemployment, just like efforts to reduce unemployment tends to cause inflation.
Because of this tradeoff, policymakers have to struggle with which is worse when making policy decisions.
Should they attempt to reduce inflation at the cost of higher unemployment? Should they attempt to reduce unemployment at the cost of higher inflation?
These questions are the subject of much debate among economists. And while these policies might work good in theory, it’s safe to argue that they’re not as effective as one might hope.
There are some other terms worth mentioning briefly. The first is deflation.
Deflation is defined as the general drop in the price level. Or, to put it another way, an increase in the purchasing power of the dollar.
Deflation occurs during recessions when the GDP is declining.
Because of the decline in demand, sellers must reduce their prices to attract buyers, which causes an overall price decrease, also known as deflation.
The next term worth mentioning is stagflation. Stagflation occurs when there is slow economic growth, known as stagnation, at the same time there is inflation.
So they economy is doing poorly, meaning that spending is down, which should be causing prices to drop, like in deflation, but instead prices are rising, which is usually caused by some sort of shock in a supply.
For instance, an example of stagflation was in the 1970s when oil prices rose during a recession.
The last term to discuss is hyperinflation. Hyperinflation is inflation that is extremely high or out-of-control. During hyperinflation, prices rise so fast in a country that a currency loses its value.
There is much debate as to the cause of hyperinflation, but most theories point to a very large increase in the money supply.
There have been many cases of hyperinflation throughout the last hundred years, including currently in Zimbabwe where the current inflation rate is over 10 million percent. Looking at the exchange rate between the Zimbabwe dollar and the American dollar, about nine years ago one American dollar bought a hundred Zimbabwe dollars. Now it buys a trillion times a trillion Zimbabwe dollars.