Wednesday, 6 August 2008

WHAT IS INFLATION

Question: What is Inflation?

Answer: To understand inflation, we first must understand what the word means. The Economics Glossary defines Inflation as:

Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole.

A similar definition of inflation can be found in Economics by Parkin and Bade:
Inflation is an upward movement in the average level of prices. Its opposite is deflation, a downward movement in the average level of prices. The boundary between inflation and deflation is price stability.

Because inflation is a rise in the general level of prices, it is intrinsically linked to money, as captured by the often heard refrain "Inflation is too many dollars chasing too few goods". To understand how this works, imagine a world that only has two commodities: Oranges picked from orange trees, and paper money printed by the government.

In a year where there is a drought and oranges are scarce, we'd expect to see the price of oranges rise, as there will be quite a few dollars chasing very few oranges. Conversely, if there's a record crop or oranges, we'd expect to see the price of oranges fall, as orange sellers will need to reduce their prices in order to clear their inventory. These scenarios are inflation and deflation, respectively, though in the real world inflation and deflation are changes in the average price of all goods and services, not just one.

We can also have inflation and deflation by changing the amount of money in the system. If the government decides to print a lot of money, then dollars will become plentiful relative to oranges, just as in our drought situation. Thus inflation is caused by the amount of dollars rising relative to the amount of oranges (goods and services), and deflation is caused by the amount of dollars falling relative to the amount of oranges. Thus, as shown by the article "Why Does Money Have Value?", inflation is caused by a combination of four factors:

The supply of money goes up.
The supply of other goods goes down.
Demand for money goes down.
Demand for other goods goes up.
Now that you know what inflation is, you may want to visit some of the other inflation resources offered at About.com:
Inflation and Deflation Resources

What is deflation and how can it be prevented? (Looks at the converse of inflation, which is deflation).

Cost-Push Inflation vs. Demand-Pull Inflation (Examines two different types of inflation)

Why Does Money Have Value? (Explains the relationship between money and goods that leads to inflation and deflation)

Why Not Just Print More Money? (Explains why high levels of inflation do not make us wealthy)

What is the Demand for Money? (In depth look at factor 3 on our list).

Why Don't Prices Decline During A Recession? (Explains why we generally do not have deflation during recessions)

Calculating and Understanding Real Interest Rates (Article explains the link between interest rates and inflation)
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