Inflation is a continual increase in prices throughout a nation’s economy. The rate of inflation is determined by changes in the price level, an average of all prices. If some prices rise and others fall, the price level may not change. Therefore, inflation occurs only if most major prices go up.
Inflation reduces the value–also called the purchasing power–of money. During an inflationary period, a certain amount of money buys less than before. For example, a worker may get a salary increase of 10 percent. If prices remain stable, the worker can buy 10 percent more goods and services. But if prices also increase 10 percent, the worker’s purchasing power has not changed. If prices rise more than 10 percent, the worker cannot buy as much as he or she previously could.
Inflation has many causes. It may result if consumers demand more goods and services than businesses can produce. Inflation may also occur if employers grant wage increases that exceed gains in productivity. The employers pass most or all of the cost of the wage increase along to consumers by charging higher prices. A government can try to control inflation by increasing taxes, raising interest rates, decreasing the money supply, reducing government spending, and setting limits on wages and prices. But the government’s task is difficult, chiefly because it may trigger a recession when it attempts to reduce inflation.
The opposite of inflation is deflation, a decrease in prices throughout a nation’s economy. Deflation tends to occur during periods of economic depression but may also happen at other times. For a discussion of the economic conditions sometimes associated with deflation.
Kinds of inflation
Mild inflation occurs when the price level increases from 2 to 4 percent a year. If businesses can pass the increases along to consumers, the economy thrives. Jobs are plentiful, and unemployment falls. If wages rise faster than prices, workers have greater purchasing power. But mild inflation usually lasts only a short time. Employers seek larger profits during periods of economic growth, and unions seek higher wages. As a result, prices rise even further–and inflation increases.
Moderate inflation results when the annual rate of inflation ranges from 5 to 9 percent. During a period of moderate inflation, prices increase more quickly than wages, and so purchasing power declines. Most people purchase more at such times because they would rather have goods and services than money that is declining in value. This increased demand for goods and services causes prices to rise even further.
Severe inflation occurs when the annual rate of inflation is 10 percent or higher. This type of inflation is also called double-digit inflation. During a period of severe inflation, prices rise much faster than wages, and so purchasing power decreases rapidly.
When inflation is severe, debtors benefit at the expense of lenders. If prices increase during the period of a loan, the debtor repays the debt with dollars less valuable than those that were borrowed. In terms of purchasing power, the lender does not get back as much money as was lent.