term paper on inflation

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What Causes Inflation? 

• Walter Frick

Why your money is worth less than it used to be.

What causes inflation? There is no one answer, but like so much of macroeconomics it comes down to a mix of output, money, and expectations. Supply shocks can lower an economy’s potential output, driving up prices. An increase in the money supply can stoke demand, driving up prices. And the expectation of inflation can become a self-fulfilling cycle as workers and companies demand higher wages and set higher prices.

Since the financial crisis of 2008 and the Great Recession, investors and executives have grown accustomed to a world of low interest rates and low inflation. No longer. In 2021, inflation began rising sharply in many parts of the world, and in 2022 the U.S. saw its worst inflation in decades.

• Walter Frick is a contributing editor at Harvard Business Review , where he was formerly a senior editor and deputy editor of HBR.org. He is the founder of Nonrival , a newsletter where readers make crowdsourced predictions about economics and business. He has been an executive editor at Quartz as well as a Knight Visiting Fellow at Harvard’s Nieman Foundation for Journalism and an Assembly Fellow at Harvard’s Berkman Klein Center for Internet & Society. He has also written for The Atlantic , MIT Technology Review , The Boston Globe , and the BBC, among other publications.

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What is inflation?

Inflation has been top of mind for many over the past few years. But how long will it persist? In June 2022, inflation in the United States jumped to 9.1 percent, reaching the highest level since February 1982. The inflation rate has since slowed in the United States , as well as in Europe , Japan , and the United Kingdom , particularly in the final months of 2023. But even though global inflation is higher than it was before the COVID-19 pandemic, when it hovered around 2 percent, it’s receding to historical levels . In fact, by late 2022, investors were predicting that long-term inflation would settle around a modest 2.5 percent. That’s a far cry from fears that long-term inflation would mimic trends of the 1970s and early 1980s—when inflation exceeded 10 percent.

Get to know and directly engage with senior McKinsey experts on inflation.

Ondrej Burkacky is a senior partner in McKinsey’s Munich office, Axel Karlsson is a senior partner in the Stockholm office, Fernando Perez is a senior partner in the Miami office, Emily Reasor is a senior partner in the Denver office, and Daniel Swan is a senior partner in the Stamford, Connecticut, office.

Inflation refers to a broad rise in the prices of goods and services across the economy over time, eroding purchasing power for both consumers and businesses. Economic theory and practice, observed for many years and across many countries, shows that long-lasting periods of inflation are caused in large part by what’s known as an easy monetary policy . In other words, when a country’s central bank sets the interest rate too low or increases money growth too rapidly, inflation goes up. As a result, your dollar (or whatever currency you use) will not go as far  today as it did yesterday. For example: in 1970, the average cup of coffee in the United States cost 25 cents; by 2019, it had climbed to $1.59. So for $5, you would have been able to buy about three cups of coffee in 2019, versus 20 cups in 1970. That’s inflation, and it isn’t limited to price spikes for any single item or service; it refers to increases in prices across a sector, such as retail or automotive—and, ultimately, a country’s economy.

How does inflation affect your daily life? You’ve probably seen high rates of inflation reflected in your bills—from groceries to utilities to even higher mortgage payments. Executives and corporate leaders have had to reckon with the effects of inflation too, figuring out how to protect margins while paying more for raw materials.

But inflation isn’t all bad. In a healthy economy, annual inflation is typically in the range of two percentage points, which is what economists consider a sign of pricing stability. When inflation is in this range, it can have positive effects: it can stimulate spending and thus spur demand and productivity when the economy is slowing down and needs a boost. But when inflation begins to surpass wage growth, it can be a warning sign of a struggling economy.

Introducing McKinsey Explainers : Direct answers to complex questions

Inflation may be declining in many markets, but there’s still uncertainty ahead: without a significant surge in productivity, Western economies may be headed for a period of sustained inflation or major economic reset , as Japan has experienced in the first decades of the 21st century.

What does seem to be changing are leaders’ attitudes. According to the 2023 year-end McKinsey Global Survey on economic conditions , respondents reported less fear about inflation as a risk to global and domestic economic growth . But this sentiment varies significantly by region: European respondents were most concerned about the effects of inflation, whereas respondents in North America offered brighter views.

What causes inflation?

Monetary policy is a critical driver of inflation over the long term. The current high rate of inflation is a result of increased money supply , high raw materials costs , labor mismatches , and supply disruptions —exacerbated by geopolitical conflict .

In general, there are two primary types, or causes, of short-term inflation:

• Demand-pull inflation occurs when the demand for goods and services in the economy exceeds the economy’s ability to produce them. For example, when demand for new cars recovered more quickly than anticipated from its sharp dip at the beginning of the COVID-19 pandemic, an intervening shortage  in the supply of semiconductors  made it hard for the automotive industry to keep up with this renewed demand. The subsequent shortage of new vehicles resulted in a spike in prices for new and used cars.
• Cost-push inflation occurs when the rising price of input goods and services increases the price of final goods and services. For example, commodity prices spiked sharply  during the pandemic as a result of radical shifts in demand, buying patterns, cost to serve, and perceived value across sectors and value chains. To offset inflation and minimize impact on financial performance, industrial companies were forced to increase prices for end consumers.

Learn more about McKinsey’s Growth, Marketing & Sales  Practice.

What are some periods in history with high inflation?

Economists frequently compare the current inflationary period with the post–World War II era , when price controls, supply problems, and extraordinary demand in the United States fueled double-digit inflation gains—peaking at 20 percent in 1947—before subsiding at the end of the decade. Consumption patterns today have been similarly distorted, and supply chains have been disrupted  by the pandemic.

The period from the mid-1960s through the early 1980s in the United States, sometimes called the “Great Inflation,” saw some of the country’s highest rates of inflation, with a peak of 14.8 percent in 1980. To combat this inflation, the Federal Reserve raised interest rates to nearly 20 percent. Some economists attribute this episode partially to monetary policy mistakes rather than to other causes, such as high oil prices. The Great Inflation signaled the need for public trust  in the Federal Reserve’s ability to lessen inflationary pressures.

Inflation isn’t solely a modern-day phenomenon, of course. One very early example of inflation comes from Roman times, from around 200 to 300 CE. Roman leaders were struggling to fund an army big enough to deal with attackers from multiple fronts. To help, they watered down  the silver in their coinage, causing the value of money to slowly fall—and inflation to pick up. This led merchants to raise their prices, causing widespread panic. In response, the emperor Diocletian issued what’s now known as the Edict on Maximum Prices, a series of price and wage controls designed to stop the rise of prices and wages (one helpful control was a maximum price for a male lion). But because the edict didn’t address the root cause of inflation—the impure silver coin—it didn’t fix the problem.

How is inflation measured?

Statistical agencies measure inflation first by determining the current value of a “basket” of various goods and services consumed by households, referred to as a price index. To calculate the rate of inflation over time, statisticians compare the value of the index over one period with that of another. Comparing one month with another gives a monthly rate of inflation, and comparing from year to year gives an annual rate of inflation.

In the United States, the Bureau of Labor Statistics publishes its Consumer Price Index (CPI), which measures the cost of items that urban consumers buy out of pocket. The CPI is broken down by region and is reported for the country as a whole. The Personal Consumption Expenditures (PCE) price index —published by the US Bureau of Economic Analysis—takes into account a broader range of consumer spending, including on healthcare. It is also weighted by data acquired through business surveys.

How does inflation affect consumers and companies differently?

Inflation affects consumers most directly, but businesses can also feel the impact:

• Consumers lose purchasing power when the prices of items they buy, such as food, utilities, and gasoline, increase. This can lead to household belt-tightening and growing pessimism about the economy .
• Companies lose purchasing power and risk seeing their margins decline , when prices increase for inputs used in production. These can include raw materials like coal and crude oil , intermediate products such as flour and steel, and finished machinery. In response, companies typically raise the prices of their products or services to offset inflation, meaning consumers absorb these price increases. The challenge for many companies is to strike the right balance between raising prices to cover input cost increases while simultaneously ensuring that they don’t raise prices so much that they suppress demand.

How can organizations respond to high inflation?

During periods of high inflation, companies typically pay more for materials , which decreases their margins. One way for companies to offset losses and maintain margins is by raising prices for consumers. However, if price increases are not executed thoughtfully, companies can damage customer relationships and depress sales —ultimately eroding the profits they were trying to protect.

When done successfully, recovering the cost of inflation for a given product can strengthen relationships and overall margins. There are five steps companies can take to ADAPT  (adjust, develop, accelerate, plan, and track) to inflation:

• Adjust discounting and promotions and maximize nonprice levers. This can include lengthening production schedules or adding surcharges and delivery fees for rush or low-volume orders.
• Develop the art and science of price change. Instead of making across-the-board price changes, tailor pricing actions to account for inflation exposure, customer willingness to pay, and product attributes.
• Accelerate decision making tenfold. Establish an “inflation council” that includes dedicated cross-functional, inflation-focused decision makers who can act quickly and nimbly on customer feedback.
• Plan options beyond pricing to reduce costs. Use “value engineering” to reimagine a portfolio and provide cost-reducing alternatives to price increases.
• Track execution relentlessly. Create a central supporting team to address revenue leakage and to manage performance rigorously. Traditional performance metrics can be less reliable when inflation is high .

Beyond pricing, a variety of commercial and technical levers can help companies deal with price increases in an inflationary market , but other sectors may require a more tailored response to pricing.

Learn more about our Financial Services , Industrials & Electronics , Operations , Strategy & Corporate Finance , and  Growth, Marketing & Sales Practices.

How can CEOs help protect their organizations against uncertainty during periods of high inflation?

In today’s uncertain environment, in which organizations have a much wider range of stakeholders, leaders must think about performance beyond short-term profitability. CEOs should lead with the complete business cycle and their complete slate of stakeholders in mind.

CEOs need an inflation management playbook , just as central bankers do. Here are some important areas to keep in mind while scripting it:

• Design. Leaders should motivate their organizations to raise the profile of design  to a C-suite topic. Design choices for products and services are critical for responding to price volatility, scarcity of components, and higher production and servicing costs.
• Supply chain. The most difficult task for CEOs may be convincing investors to accept supply chain resiliency as the new table stakes. Given geopolitical and economic realities, supply chain resiliency has become a crucial goal for supply chain leaders, alongside cost optimization.
• Procurement. CEOs who empower their procurement  organizations can raise the bar on value-creating contributions. Procurement leaders have told us time and again that the current market environment is the toughest they’ve experienced in decades. CEOs are beginning to recognize that purchasing leaders can be strategic partners by expanding their focus beyond cost cutting to value creation.
• Feedback. A CEO can take a lead role in playing back the feedback the organization is hearing. In today’s tight labor market, CEOs should guide their companies to take a new approach to talent, focusing on compensation, cultural factors, and psychological safety .
• Pricing. Forging new pricing relationships with customers will test CEOs in their role as the “ultimate integrator.” Repricing during inflationary times is typically unpleasant for companies and customers alike. With setting new prices, CEOs have the opportunity to forge deeper relationships with customers, by turning to promotions, personalization , and refreshed communications around value.
• Agility. CEOs can strive to achieve a focus based more on strategic action and less on firefighting. Managing the implications of inflation calls for a cross-functional, disciplined, and agile response.

A practical example: How is inflation affecting the US healthcare industry?

Consumer prices for healthcare have rarely risen faster than the rate of inflation—but that’s what’s happening today. The impact of inflation on the broader economy has caused healthcare costs to rise faster than the rate of inflation. Experts also expect continued labor shortages in healthcare—gaps of up to 450,000 registered nurses and 80,000 doctors —even as demand for services continues to rise. This drives up consumer prices and means that higher inflation could persist. McKinsey analysis as of 2022 predicted that the annual US health expenditure is likely to be $370 billion higher by 2027 because of inflation.

This climate of risk could spur healthcare leaders to address productivity, using tech levers to boost productivity while also reducing costs. In order to weather the storm, leaders will need to quickly set high aspirations, align their organizations around them, and execute with speed .

What is deflation?

If inflation is one extreme of the pricing spectrum, deflation is the other. Deflation occurs when the overall level of prices in an economy declines and the purchasing power of currency increases. It can be driven by growth in productivity and the abundance of goods and services, by a decrease in demand, or by a decline in the supply of money and credit.

Generally, moderate deflation positively affects consumers’ pocketbooks, as they can purchase more with less money. However, deflation can be a sign of a weakening economy, leading to recessions and depressions. While inflation reduces purchasing power, it also reduces the value of debt. During a period of deflation, on the other hand, debt becomes more expensive. And for consumers, investments such as stocks, corporate bonds, and real estate become riskier.

A recent period of deflation in the United States was the Great Recession, between 2007 and 2008. In December 2008, more than half of executives surveyed by McKinsey  expected deflation in their countries, and 44 percent expected to decrease the size of their workforces.

When taken to their extremes, both inflation and deflation can have significant negative effects on consumers, businesses, and investors.

For more in-depth exploration of these topics, see McKinsey’s Operations Insights  collection. Learn more about Operations consulting , and check out operations-related job opportunities  if you’re interested in working at McKinsey.

Articles referenced:

• “ Investing in productivity growth ,” March 27, 2024, Jan Mischke , Chris Bradley , Marc Canal, Olivia White , Sven Smit , and Denitsa Georgieva
• “ Economic conditions outlook during turbulent times, December 2023 ,” December 20, 2023
• “ Forward Thinking on why we ignore inflation—from ancient times to the present—at our peril with Stephen King ,” November 1, 2023
• “ Procurement 2023: Ten CPO actions to defy the toughest challenges ,” March 6, 2023, Roman Belotserkovskiy , Carolina Mazuera, Marta Mussacaleca , Marc Sommerer, and Jan Vandaele
• “ Why you can’t tread water when inflation is persistently high ,” February 2, 2023, Marc Goedhart and Rosen Kotsev
• “ Markets versus textbooks: Calculating today’s cost of equity ,” January 24, 2023, Vartika Gupta, David Kohn, Tim Koller , and Werner Rehm  
• “ Inflation-weary Americans are increasingly pessimistic about the economy ,” December 13, 2022, Gonzalo Charro, Andre Dua , Kweilin Ellingrud , Ryan Luby, and Sarah Pemberton
• “ Inflation fighter and value creator: Procurement’s best-kept secret ,” October 31, 2022, Roman Belotserkovskiy , Ezra Greenberg , Daphne Luchtenberg, and Marta Mussacaleca
• “ Prime Numbers: Rethink performance metrics when inflation is high ,” October 28, 2022, Vartika Gupta, David Kohn, Tim Koller , and Werner Rehm
• “ The gathering storm: The threat to employee healthcare benefits ,” October 20, 2022, Aditya Gupta , Akshay Kapur , Monisha Machado-Pereira , and Shubham Singhal
• “ Utility procurement: Ready to meet new market challenges ,” October 7, 2022, Roman Belotserkovskiy , Abhay Prasanna, and Anton Stetsenko
• “ The gathering storm: The transformative impact of inflation on the healthcare sector ,” September 19, 2022, Addie Fleron, Aneesh Krishna , and Shubham Singhal
• “ Pricing during inflation: Active management can preserve sustainable value ,” August 19, 2022, Niels Adler and Nicolas Magnette
• “ Navigating inflation: A new playbook for CEOs ,” April 14, 2022, Asutosh Padhi , Sven Smit , Ezra Greenberg , and Roman Belotserkovskiy
• “ How business operations can respond to price increases: A CEO guide ,” March 11, 2022, Andreas Behrendt ,  Axel Karlsson , Tarek Kasah, and  Daniel Swan
• “ Five ways to ADAPT pricing to inflation ,” February 25, 2022,  Alex Abdelnour , Eric Bykowsky, Jesse Nading,  Emily Reasor , and Ankit Sood
• “ How COVID-19 is reshaping supply chains ,” November 23, 2021,  Knut Alicke ,  Ed Barriball , and Vera Trautwein
• “ Navigating the labor mismatch in US logistics and supply chains ,” December 10, 2021,  Dilip Bhattacharjee , Felipe Bustamante, Andrew Curley, and  Fernando Perez
• “ Coping with the auto-semiconductor shortage: Strategies for success ,” May 27, 2021,  Ondrej Burkacky , Stephanie Lingemann, and Klaus Pototzky

This article was updated in April 2024; it was originally published in August 2022.

Want to know more about inflation?

Related articles.

What is supply chain?

How business operations can respond to price increases: A CEO guide

Five ways to ADAPT pricing to inflation

Economic essays on inflation

• Definition – Inflation – Inflation is a sustained rise in the cost of living and average price level.
• Causes Inflation – Inflation is caused by excess demand in the economy, a rise in costs of production, rapid growth in the money supply.

• Costs of Inflation – Inflation causes decline in value of savings, uncertainty, confusion and can lead to lower investment.

• Problems measuring inflation – why it can be hard to measure inflation with changing goods.
• Different types of inflation – cost-push inflation, demand-pull inflation, wage-price spiral,
• How to solve inflation . Policies to reduce inflation, including monetary policy, fiscal policy and supply-side policies.
• Trade off between inflation and unemployment . Is there a trade-off between the two, as Phillips Curve suggests?
• The relationship between inflation and the exchange rate – Why high inflation can lead to a depreciation in the exchange rate.
• What should the inflation target be? – Why do government typically target inflation of 2%
• Deflation – why falling prices can lead to negative economic growth.
• Monetarist Theory – Monetarist theory of inflation emphasises the role of the money supply.
• Criticisms of Monetarism – A look at whether the monetarist theory holds up to real-world scenarios.
• Money Supply   – What the money supply is.
• Can we have economic growth without inflation?
• Predicting inflation
• Link between inflation and interest rates
• Should low inflation be the primary macroeconomic objective?

See also notes on Unemployment

Economic Synopses

Inflation, part 1: what is it, exactly.

As prices rise globally at rates unseen since the late 1970s, inflation has become a broad issue in many developed economies. In the United States, consumers , market participants , and policymakers expect inflation well above the Federal Reserve's 2% target through at least 2023. 

The news is filled with a dizzying array of numbers and acronyms on the subject: 8.3% CPI , 1 6.3% PCE , 2 11% PPI . 3 What do these numbers mean? Why do they differ? What is "inflation," exactly, and how does it relate to prices consumers actually see? This essay is the first in a series explaining inflation—its definition, its measurement, and its importance. Today, we focus on our most fundamental question: What is inflation?

Price Level, Price Changes

To define inflation, we must first discuss price indexes . A price index is a measure of the average price of a collection of goods and services. How this collection (or "basket") of goods and services is constructed—what items are included and how many of each—differs depending on the prices an index is trying to capture. The most familiar indexes—the Bureau of Labor Statistics'  consumer price index (CPI) and the Bureau of Economic Analysis's personal consumption expenditures (PCE) price index —capture consumer prices in slightly different ways, which we will discuss further in Part 2 . Other indexes, such as the Bureau of Labor Statistics'  producer price index (PPI) , focus on other prices altogether, such as those faced by manufacturers.

Inflation measures the rate of change of a price index over time. This change is often expressed as a year-over-year percent change (e.g., the percent prices increased in April 2022 relative to April 2021). While price indexes measure price levels , inflation measures price changes . This distinction is important. Inflation can be constant—or even declining—while prices increase. Even if inflation declines later this year (which most forecasters expect), prices will remain high and go higher—just at a slower rate. While individual prices can fall from time to time, it is rare for the overall price level (measured by a price index) to decline; this would require negative inflation ("deflation"), something monetary policymakers try to avoid . 4  

An Analogy: Commuting to Work

Consider someone getting on and off the highway as they drive to work. The table shows the driver's speed and acceleration in five-minute intervals, with acceleration calculated as the percent change in their speed over the previous five minutes. We can think of the driver's speed as a price index and acceleration as inflation.

The example can be broken into three instructive periods: acceleration, cruising, and deceleration. 

From 7:25 to 7:30, acceleration (calculated as the per cent change in initial speed) declines, despite speed increasing. If this were about prices, we would say that inflation is "declining" or "moderating" despite the overall price level increasing.

From 7:35 to 7:40, acceleration stops, and the driver's speed remains constant. Again, if this were about prices, we would say that inflation is zero—in which case prices remain constant and don't decline.

From 7:45 to 7:50, the driver exits the highway and slows down; acceleration is negative (i.e., there is deceleration) as the vehicle speed declines. Likewise, prices only decline when inflation is negative (i.e., there is deflation). 

When it comes to driving, this last period is inevitable—people can't drive forever! But the analog—deflation—is extremely rare for price indexes, which tend to only go up. Prices also differ from driving in another important way. While traffic authorities care about drivers' speed (giving out tickets to those going too fast, regardless of how fast they accelerated to that speed), monetary policymakers focus on inflation in their mission to maintain stable prices.

Back to Inflation and Price Indexes

It may be useful to more explicitly review the relationship between prices and inflation under a variety of circumstances. The figure shows the effect on prices due to zero, constant, increasing, and decreasing inflation.

Panel A shows that if inflation were zero over two decades, prices should remain constant (at the normalized value of 100). Panel B shows that even a small amount of inflation (i.e., 2%) can have a dramatic effect on how prices grow over two decades—increasing them by nearly 50%. The growth in prices is compounded over time: This is why the change in prices is higher in the last decade (i.e., 2030 to 2040) than in the initial decade (i.e., 2020 to 2030). 

Panels C and D highlight the effects of non-constant inflation on prices. The price level either nearly doubles or increases less than 25%, depending on whether inflation itself grows to 4% or shrinks to 0% in the span of 20 years. 

These examples do not cover the case of negative inflation (deflation), which would involve price indexes declining. One can imagine extending Panel D: If inflation continued to decline into negative territory, the price level would continue to curve downward—forming a wide hump shape, as prices would first increase more and more slowly—before stopping and then shrinking more and more quickly. 

All this analysis, of course, takes a given price index for granted. In reality, the calculation of a given index involves a series of complex (and inevitably critiquable) decisions. (Why else would there be two well-publicized indexes for consumer prices [the CPI and PCE]?) In Part 2 , we will review the construction of these indexes in detail. In Part 3, we will review how the Fed views its mandate of "stable prices" according to these indexes, and how well it has historically done achieving that mandate.

1 Cox, Jeff. "Inflation Barreled Ahead at 8.3% in April from a Year Ago, Remaining Near 40-Year Highs." CNBC , May 11, 2022; https://www.cnbc.com/2022/05/11/cpi-april-2022.html .

2 Bartash, Jeffry. "U.S. Inflation Rate Slows to 6.3%, Fed-Favored PCE Gauge Shows, in a Sign that Price Pressures Could Be Peaking." Market Watch , last updated May 28, 2022; https://www.marketwatch.com/story/u-s-inflation-rate-slows-to-6-3-pce-shows-in-sign-price-pressures-could-be-near-peak-11653655258 .

3 Guilford, Gwynn. "Producer Price Gains Slowed in April But Remained Elevated." Wall Street Journal , updated May 12, 2022; https://www.wsj.com/articles/producer-price-gains-edged-downward-in-april-but-remain-elevated-11652360313 .

4 See Federal Reserve Bank of San Francisco. "What Is Deflation, What Are the Risks of Deflation, and How Can the Fed Combat Deflation?" May 2003; https://www.frbsf.org/education/publications/doctor-econ/2003/may/deflation-risks/ .

© 2022, Federal Reserve Bank of St. Louis. The views expressed are those of the author(s) and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

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Inflation: What Is It and Inflation in the USA Term Paper

Inflation is an increase in the general price level of goods, works, and services of the country’s population and businesses or an extended period. In this process, for the same amount of money after a certain time, it will be likely to buy fewer goods and services than earlier. In this case, it can be said that the purchasing power of money has decreased over the past time (Rudd, 2021). Therefore, money has depreciated; that is, it has lost some of its actual value. Inflation should be distinguished from price hikes because it is a long-term, sustained process (Mackevičius et al., 2018). Inflation does not mean an increase in all prices in the economy because the costs of individual goods and services can go up, down, or remain unchanged. It is crucial that the overall price level in the country changes.

With moderate inflation, prices rise no more than 10% a year. The value of money is preserved, contracts are signed at nominal prices. This kind of inflation is considered the best because it occurs due to the renewal of the range (Durguti et al., 2021). It allows for price adjustments due to changes in supply and demand conditions. In addition, in this form, this economic phenomenon is manageable. In October, for example, inflation will rise to 4.1% on an annualized basis throughout the euro area, compared to 3.4% in September (Eurostat, 2021). However, despite the sharp rise in inflation, the European Central Bank is not ready to cancel the stimulus measures adopted in connection with the recession caused by the pandemic (Eurostat, 2021). Higher food prices are the most visible manifestation of inflation for Europeans, which they can easily trace. It should be borne in mind that there is always the danger of moderate inflation turning into more dangerous types of inflation, so it must be kept under control.

There is a price increase from 10-20 to 50-200% per year with galloping inflation. Currency depreciation in galloping inflation is more rapid than in moderate inflation and less abrupt than in hyperinflation. The main negative feature of galloping inflation is the high risks when entering into contracts with nominal prices. That is why in case of their conclusion, it is necessary to consider the supposed growth of prices or make calculations in another, more stable currency.

From 1917 to 1927, the national income of the United States increased nearly threefold. Conveyor production was mastered, the stock market boomed, speculation grew, and real estate became more expensive. Due to the increase in production, additional money had to be emitted accordingly, and a critical circumstance to consider was that the dollar was then indexed to gold. Before the Great Depression, U.S. gold reserves did not grow as rapidly as the economy (Hetzel, 2017). This circumstance led to hidden inflation, as the government printed new money against a booming economy (Hetzel, 2017). This undermined the dollar’s security in gold, the budget deficit grew, and the Federal Reserve reduced the discount rate (Hetzel, 2017). A situation has arisen where the productivity growth in the industry has decreased. At the same time, the amount of pseudo-money has increased, which characterizes galloping inflation.

Hyperinflation causes prices to rise over 50% per month and over 100% per year. The welfare of the population deteriorates sharply, economic relations between enterprises are destroyed (St. Onge, 2017). Such inflation is uncontrollable and requires emergency measures on the part of the state (St. Onge, 2017). As a result of this process, production stops, sales of goods, products, works, and services decrease. Moreover, the actual volume of national production decreases, unemployment grows, existing enterprises close, the bankruptcy of companies occurs. In this situation, the most likely prognosis is a complete collapse of the monetary and commodity system and the transition to a natural exchange.

The first national currency collapse occurred in America during the War of Independence in 1775-1783. The second burst of hyperinflation occurred in 1861 because the Confederate States of America issued huge amounts of extra banknotes to finance the fight against the North (Inflation Data, 2019). Holders of such money were subsequently required to replace them with government bonds. During this period, the term inflation first began to be used in relation to money circulation when a considerable mass of greenbacks was issued.

Inflation can have both positive and negative effects on social and economic processes. For example, inflation has a stimulating impact on trade turnover, as the expectation of rising prices in the future encourages consumers to buy goods today. In addition, under conditions of inflationary development of the economy, weak enterprises go bankrupt. Thus, only the strongest and most efficient companies remain in the national economy. However, the problems of money emission and the depreciation of securities are also aggravated. Inflation can cause a decrease in the volume of goods produced domestically and a decrease in the value of the national currency. There are numerous examples of different types of inflation in history, and every country in the world, not just the United States, has faced this phenomenon. Knowledge of economic laws allows leaders to predict and prevent inflation in a country.

Durguti, E., Tmava, Q., Demiri-Kunoviku, F., & Krasniqi, E. (2021) Panel estimating effects of macroeconomic determinants on inflation: Evidence of Western Balkan. Cogent Economics & Finance, 9 (1), 1-13. Web.

Eurostat. (2021). Annual inflation up to 4.1% in the euro area. Web.

Hetzel, R. L. (2017. The evolution of U. S. monetary policy . Federal Reserve Bank of Richmond. Web.

Inflation Data. (2019). Confederate Inflation Rates (1861 – 1865). Web.

Mackevičius, J., Šneidere, R., & Tamulevičienė, D. (2018). The waves of enterprises bankruptcy and the factors that determine them: the case of Latvia and Lithuania. Entrepreneurship and Sustainability Issues, Entrepreneurship and Sustainability Center, 6 (1), 100-114. Web.

Rudd, J. B. (2021). Why do we think that inflation expectations matter for inflation? Finance and Economics Discussion Series, 62 , 1-25. Web.

St. Onge, P. (2017). How paper money led to the Mongol conquest: Money and the collapse of Song China. The Independent Review, 22 (2), 223–243. Web.

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IvyPanda. (2023, October 27). Inflation: What Is It and Inflation in the USA. https://ivypanda.com/essays/inflation-what-is-it-and-inflation-in-the-usa/

"Inflation: What Is It and Inflation in the USA." IvyPanda , 27 Oct. 2023, ivypanda.com/essays/inflation-what-is-it-and-inflation-in-the-usa/.

IvyPanda . (2023) 'Inflation: What Is It and Inflation in the USA'. 27 October.

IvyPanda . 2023. "Inflation: What Is It and Inflation in the USA." October 27, 2023. https://ivypanda.com/essays/inflation-what-is-it-and-inflation-in-the-usa/.

1. IvyPanda . "Inflation: What Is It and Inflation in the USA." October 27, 2023. https://ivypanda.com/essays/inflation-what-is-it-and-inflation-in-the-usa/.

Bibliography

IvyPanda . "Inflation: What Is It and Inflation in the USA." October 27, 2023. https://ivypanda.com/essays/inflation-what-is-it-and-inflation-in-the-usa/.

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What is inflation, and should we worry? An economist explains

Inflation is a concern. Hyperinflation is a disaster. A high-denomination banknote from the late 2000s. Image:  Robin Pomeroy

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Stay up to date:, global economic imbalances.

• Inflation was low for decades in much of the developed world before COVID.
• A surge in demand, some problems of supply and soaring energy costs have caused a big jump in inflation rates.
• Is this a blip, or is inflation back to stay, and what can be done?
• UBS Chief Economist Paul Donovan talks to the Radio Davos podcast.

As the world emerges from COVID, economies are revving back to life - but so is something that many parts of the world have not seen much of for decades - inflation.

So what is inflation and why has it suddenly reared up around the world?

UBS Chief Economist Paul Donovan , author of The Truth About Inflation , spoke to Radio Davos.

Have you read?

Why do oil prices matter to the global economy an expert explains, what is the impact of inflation on low-income households, 7 chief economists on how to solve the pandemic’s labour market paradox, what is inflation, and should we worry an interview with paul donovan.

Robin Pomeroy: Inflation is something everyone has been talking about and you even wrote a book about it called The Truth About Inflation , which is exactly what we want to get to in this interview: What is inflation? What is true, what is false about it? Why is inflation for you, as an economist and as an individual, such an important issue?

We have this idea that there is a single inflation number which affects us all. And that just isn't true.

Paul Donovan: It's important because I think it's it's very often misunderstood. We have this idea that there is a single inflation number which affects us all. And that just isn't true. The inflation experienced by older people tends to be higher. The inflation experienced by lower income people tends to be higher because of what they buy. Older people buy healthcare, lower income people are buying food, energy and housing in disproportionate amounts. And that gives them a higher inflation rate. So really, if you want to avoid inflation, you need to be young and rich.

Investors also, I think, get very confused about aspects of inflation. So consumer price inflation, which is the number most people look at, actually is not a very good guide to corporate pricing power because companies tend not to sell to consumers - companies sell to other companies. So it's a different measure - producer price inflation - that gives us a better indication of pricing power. Costs are driven by wage inflation. So this idea that there's a single nice statistic that tells us everything we need to know about price changes just isn't true, and we need to really understand the detail of what's going on to properly be able to assess the economic consequences of inflation moving up or inflation moving down.

Do we believe the inflation rate?

Robin Pomeroy: Individuals, we as people, sometimes find it hard to accept the official inflation rate because of biases we may have. Could you explain that a little bit?

Paul Donovan: People never believe the official inflation statistics, and they tend to believe that inflation is higher than it actually is. Why is that? Well, it's two behavioural economic concepts which are actually very well understood. So the first is loss aversion, and this is the fact that we are genetically programmed to remember and react to bad news more than good news. We run away from the sabre tooth tiger three times as fast as we run towards our next meal. So because of loss aversion, which is this sort of ancient behavioural trait, people remember price increases and they forget about the price cuts. And so you end up with this sort of bias that you're ignoring the fact that your flat screen TV fell in price last year, and you're remembering the fact that the price of your Snickers bar has gone up over the course of the last year.

Because of loss aversion, which is this ancient behavioural trait, people remember price increases and they forget about the price cuts.

But then we have this second behavioural trait, which is frequency bias, and this is a really big problem. People remember the price of something they buy frequently - that means food and fuel. The result is you get a very distorted view of what's driving inflation. So, for example, if I come into my office and I see that the price of a Snickers bar in a vending machine here has gone from 50 pence to 60 pence, I know I'm going to get colleagues coming up to me all the time and saying, 'inflation's out of control, we've got 20% inflation'. Now, with the best will in the world, my colleagues can only consume so many chocolate bars in a 24-hour period - it's not a major part of their overall budget. But every single time they go to the vending machine, they're reminded the price has gone up by 20% and that sticks in the mind. And so what we then have is this combination that we are focused on high-frequency purchases, and we tend to remember the price increases not the price declines. And that can give us a very distorted view of what's going on with average prices in the economy.

What's happening with inflation now?

Robin Pomeroy: So what is happening with inflation now globally? Everyone's talking about a resurgence in inflation. It seems that in many parts of the world there's not been inflation that's been above a point that we would consider problematic in many parts of the world, but now perhaps we are at a point where that's the case. Could you tell us - is that true what I'm saying, that there has been this historical period? And what is happening now?

Is this really inflation? That's that's where economists start to disagree.

Paul Donovan: In developed economies, by and large, we have had a 20-25 year period of pretty low inflation. Now there's been the odd spike, but generally speaking, prices have come in sort of around a 1.5-3-3.5% range of increase every year on an average index. And that, of course, is perfectly fine.

What we're now seeing is inflation rates come in quite a way above that. So in the United States, the latest inflation number for headline CPI - consumer price inflation - is 7% year over year, which is a very high number. Now is this really inflation? Well, that's that's where economists start to disagree a little bit. Because inflation is a general increase in prices, lots of prices rising by a large amount, all at the same time. And that's important because if lots and lots of prices are rising, that's telling you that there's an imbalance in the overall economy and that's something that policymakers need to address. But if you've got one or two prices rising a lot and other prices behaving more or less normally, then that's telling you that there's a problem in one or two markets, but not in the economy at large. We have got slightly stronger inflation for most of the economy and one or two price increases that are really quite extraordinary. And that's a pattern that we're seeing pretty much globally. Energy is behind a lot of the headline numbers. The used car market, the new car market, has also had some distortions because there have been problems with supply there over the last year. This is what's really pushing up the the headline inflation rate.

Inflation - the policy makers

Robin Pomeroy: At a recent conversation at the Davos Agenda , we had senior economists and central bankers talking about inflation. The head of the IMF, the head of the Bank of Japan, the head of the European Central Bank. I'd like to play you a clip from Christine Lagarde, the governor of the European Central Bank, with her view on where inflation is at right now.

Christine Lagarde (speaking at the Davos Agenda 2022 ): We have to ask ourselves, where is it [inflation] coming from? Is it likely to last? And we are trying to figure out how long it will last, because that is going to be critical in really composing the policy response that will be needed. And what do we see under the numbers? Well, we see 50% energy prices. It is not just the recovery, it is also geopolitical factors that are critically important at the moment, unfortunately. It is also some idiosyncratic factors. It is some weather-related factors. And the rest, essentially, taking out a few base effects that will eventually clear out in the next month, actually, we see a lot of this super-strong recovery that has outpaced supply, which was constrained. And as a result of that, you all, we all, talk about the bottlenecks, the congestion of ports, the lack of truck drivers and what have you. So then you ask yourself: these two big factors, are they going to be with us for the long term? Are they going to affect this inflation number and make it sustainable? And will that dictate our monetary policy response?

We are not seeing this sustainable movement that would lead to inflation spiralling out of control. On the contrary, we assume — and again, lesson of humility here, there is a lot of uncertainty about it — but we assume for the moment that energy prices will stabilise in the course of '22, that those bottlenecks and those congested ports and drivers missing in action, and all the rest of it, will also stabilise in the course of '22, and that gradually those inflation numbers will decline.

Robin Pomeroy: Christine Lagarde, governor of the European Central Bank, seemingly cautiously optimistic that inflation will start to come back under control because the things she mentioned are transitory problems there. Do you agree with her forecast?

Paul Donovan: Broadly, I would agree with President Lagarde that inflation is going to come down because the increase in the oil price is slowing, and that means the contribution of the oil price to inflation is slowing. And other factors, I think, are also going to be coming down. Demand, which has been quite extraordinary, is going to normalise as we go through this year.

We're hearing a lot from policymakers about supply chain problems and supply chain bottlenecks. This is politics - it's not economics. Because when we look at what's happened with global supply, global supply simply surged last year. Global manufacturing output: all time record high. Global volume of trade: up 11% on the World Trade Organisation's numbers. The volume of shipping through the Suez Canal: all-time record high, even with ships going sideways , they still get an all-time record high volume of shipping! So we're seeing supply chains work wonderfully throughout 2021. This idea that supply chains are crumbling ruins around the world is complete nonsense.

You've got to go back to the end of wartime rationing to see so strong a surge in demand for durable goods.

But what we had last year was a simply extraordinary level of demand. In the United States, demand for durable goods surged in the strongest increase we have seen since 1946. You've got to go back to the end of wartime rationing to see so strong a surge in demand for durable goods. And why was that? Well, that was because, during the pandemic, people saved money and once they were released from the restrictions around COVID and were able to go out and spend the money, they went out and spent the money. So you've had this extraordinary, extraordinary surge in demand, which has overwhelmed a valiant effort by supply to meet that demand. So here we have a bit of an imbalance in the economy. Demand is a lot stronger than supply, and that has pushed up some prices of goods. But of course, that surge in demand cannot last, and we're already starting to see it fade in the US and possibly also in the UK. Because once the savings are spent, you have to go back to normal levels of demand. And that seems to be where we're moving to. And as we normalise demand, we're going to normalise inflation rates with a little bit of a lag because prices take a little while to adjust, but normalising inflation seems to me very, very likely this year.

Robin Pomeroy: So we should all take a deep breath and kind of ride this wave. I guess the question is with inflation is: will it spiral? Let me play this little clip from someone else on that panel at the Davos Agenda week. This is Brazilian Economy Minister Paulo Guedes.

Paulo Guedes (speaking at the Davos Agenda 2022 ) : I don't think inflation will be transitory at all. I think these supply adverse shocks will fade away gradually, but there's no arbitrage anymore to be exploited by the Western side. So I think the central banks are sleeping at the driver wheel. They should be aware. And I think inflation will be a problem, a real problem, very soon for the Western world.

Inflation - what causes a spiral?

Robin Pomeroy: So that was Paulo Guedes, the economy minister of Brazil, taking the other opinion, saying that things will spiral out of control. What are the risk factors that do push inflation to spiral upwards? What are the policy levers available and whether they might or might not be useful this time around?

Labour costs in a developed economy are about 70% of inflation.

Paul Donovan: So the simple answer is labour costs. Now, labour costs in a developed economy are about 70% of inflation. We all focus on things like commodity prices. Commodities really aren't that important to inflation - about 15% is down to commodities. Labour costs are the big one. And it's important to recognise here that we're not talking about wages. So wages is how much you take home. But actually what a company is interested in when it's setting prices is, 'how much do I have to spend on labour entirely to produce a unit of output?' The wage rate going up is not all we've got to consider. We've also got to consider how hard are people working, because if people are working harder, then they should be paid more money, something I repeatedly remind my bosses of. If you've got people who are working harder, they're producing more output - paying them more money isn't necessarily inflationary. So the US restaurant sector is a really good example of this. If we look at the data for December, restaurant sales in the United States were over 19% higher than they were in January of 2020. But you've achieved that increase in restaurant sales with 2.3% fewer staff. So in that situation, of course, what's happening is staff are working harder or in some restaurants staff have been replaced by computers. The only thing the restaurant employee does is actually prepare the food for you. So this automation means that you can use fewer people to achieve more output, and so therefore you can afford to pay those people a little bit more. So the way that economists look at this is through something called unit labour costs. Now the problem with unit labour costs is this is data that's revised very, very often, and it's not a very stable statistic, to be perfectly honest. But that's really what we're looking at. If we start to see wages increasing more rapidly than output is increasing, that would be something that would start to be problematic because then those wage costs would be passed on in higher prices and then workers may respond with increased wage demands.

I think it's very unlikely to happen. It happened in the 1970s in a very, very different world. The US president, President Nixon, was setting wages and prices personally, it was a state control. The price of hamburger in the United States was personally set by President Nixon in the Oval Office. Quite remarkable. And that whole collapse of that pricing structure led to an inflation bout. The unionised nature of wage bargaining also led to increased inflation pressure. We're nowhere near any of that now.

Inflation, wages and productivity

Robin Pomeroy: You're talking about this word 'productivity' there aren't you? That's the term economists use. So 'it's OK to increase wages if productivity increases'. I just wonder, I mean, in a hamburger restaurant that might apply, but what about lots of areas where the output is quite difficult to measure? What about the millions of people who work in schools and in hospitals? How do you measure the productivity of a teacher or of a nurse? You know, a nurse who's worked her fingers to the bone, or his, through the pandemic, who deserves a pay rise, who's got to deal with these inflationary pressures. There will be pressure, won't there, to increase wages for millions of people around the world, very often low paid people who have tough jobs. But it's very hard to measure, I would have thought, productivity increases for them, isn't it?

Paul Donovan: It is. There are ways that you can try and do this and you have to come up with, you know: 'What is the value of healthcare?', 'What is the value of education?' It's controversial. The UK, for example, measures the value of education based on the number of students that are taught, whereas France measures the value of education based on how much they pay their teachers. There are more and more sophisticated ways of measuring output, which is helpful and which does allow us to see a little bit more about what's going on in terms of productivity and the value of what people are producing in the economy. But we've got to recognise that the pandemic has accelerated an awful lot of structural change, and data is scrambling to keep up with this. But things like working from home change productivity, change efficiency. The increase of self-employment, we've seen a massive increase in self-employment in many, many developed economies in the aftermath of the pandemic. That's not necessarily being captured in the data, but it's still output and productivity and income. So it's becoming a lot more complicated as we go through this structural upheaval in the economy.

The inflation policy levers

Robin Pomeroy: So let's talk a bit about the policies now. We've quoted central bankers who are in charge of setting interest rates. Could you just take us back to the basics and say what is it that policymakers are looking out for and what is it they can do, at least in theory, to control inflation?

There's a limit to what central bankers can do. There's some prices that they've got to sit there and say: 'You know what? Sit it out for 12 months and this is going to stop being a problem'.

Paul Donovan: We have fiscal policy, we have monetary policy, and inflation is generally put down to the monetary policy makers. That's not always entirely practical. So if we look at some of the current inflation, there's nothing Fed Chair Powell can do to change global oil prices. He is not a used car sales person. There's nothing he can do to change the price of a 2001 Honda Civic. So there's a limit to what central bankers can do. There's some prices that they've really got to sit there and say, 'You know what? Sit it out for 12 months and this is going to stop being a problem'. And that's effectively what central bankers are having to do. But there are other prices that they can influence, and they can influence to some extent wage growth, indirectly, they can influence some other cyclical prices by influencing the cost of credit in the economy. And by raising the cost of credit - raising interest rates - what of course you are doing is limiting the ability of people to demand goods and therefore you bring supply and demand into balance, and that helps reduce inflation pressures. You may also give people an incentive to save money rather than spend money if you've raised the interest rate. But we have to recognise the limitations. We've just got to burn through this demand and then after that see where we are. And so that's what I think is is happening. Central banks know that inflation is going to be coming down this year because the technical factors are going to fade. So what they are looking to do is not to sort of squeeze inflation out of the system - they're not looking to create a recession. What they're looking to do is have interest rates that are a level that allow growth after this demand surge to settle back into a more normal pattern. And that's quite a less aggressive policy than when you're trying to actually push down on inflation. Central banks are saying, 'Look, inflation's coming down, and once it's down, we want to keep it there'. That's a slightly different approach that they're going to be taking.

Hyperinflation

Robin Pomeroy: Let's just go back to inflation as this kind of bogeyman that some people fear. And you've got countries, haven't you, that have this collective memory of something far worse than that - of hyperinflation? We know that the Germans, even people who aren't old enough to remember it, there's still this kind of societal memory of hyperinflation there. Could you remind us what hyperinflation is and how bad inflation can get and why we should be so scared of it in those circumstances.

In a hyperinflation episode people can lose everything.

Paul Donovan: There isn't really a formal definition of what hyperinflation is. I would say that once you're talking about a 50% inflation rate, you're getting pretty close to a hyperinflation scenario. And it's where prices are changing constantly. That becomes socially disruptive. You're changing social status of people. You're changing the relative value of jobs, of positions in society, of incomes. Normally, a hyperinflation episode involves a huge transfer of wealth from savers to borrowers. Borrowers benefit, savers suffer. And that's what people remember. Again, it's that loss aversion. In a hyperinflation episode people can lose everything - they lose their social status, they lose their income. And that's why hyperinflation episodes tend to be remembered for multi-generations. So Germany had two hyperinflation episodes: 1923 and then immediately after the Second World War. Singapore is another interesting society where there's a very strong fear of inflation coming, not from Singapore's hyperinflation episode, but from the hyperinflation of nationalist China after the war and then a lot of emigres from nationalist China went and settled in Singapore and they took with them the memory of the very, very destructive power of a very, very high inflation rate. So hyperinflation tends to cause considerable concern.

If you've got an economist running a central bank, you will not have hyperinflation.

It's something which happens deliberately, to be perfectly honest. If you've got an economist running a central bank, you will not have hyperinflation because hyperinflation is essentially caused by printing too much money. In 1923, the Reichsbank 's President Havenstein in Germany, who wasn't an economist, he was a lawyer, responded to the German economic situation just simply printing more and more money. And this famous occasion where he gave a speech saying, 'Don't worry, we've ordered more printing presses. We're going to be able to print even more money and it will all be fine. And that will get rid of the inflation.' Complete misunderstanding of what was going on, to the extent that by the end of the hyperinflation episode, the central bank was printing money where they only printed one side of the banknote, the other side was blank paper because there wasn't enough time to print both sides of the banknote before the money devalued and lost all sense of value.

We've seen that more recently in places like Zimbabwe, the worst hyperinflation episode ever was in Czechoslovakia after the Second World War. So we've had all of these these episodes. It's caused by a complete failure to observe the laws of economics. As long as you observe the laws of economics, you maintain some semblance of balance between money supply and money demand.

Robin Pomeroy: That's a reassuring note, perhaps on which to end it. Paul Donovan, thanks very much for explaining inflation to us. We're going to keep a close eye on it. Thanks for joining us on Radio Davos.

Paul Donovan: Thanks so much for your time.

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The Long-term Effects of Inflation on Inflation Expectations

We study the long-term effects of inflation surges on inflation expectations. German households living in areas with higher local inflation during the hyperinflation of the 1920s expect higher inflation today, after partialling out determinants of historical inflation and current inflation expectations . Our evidence points towards transmission of inflation experiences from parents to children and through collective memory. Differential historical inflation also modulates the updating of expectations to current inflation, the response to economic policies affecting inflation, and financial decisions. We obtain similar results for Polish households residing in formerly German areas. Overall, our findings are consistent with inflationary shocks having a long-lasting impact on attitudes towards inflation.

Financial support from the Swiss National Science Foundation (grant number 207668) and the sponsors association of the Swiss Institute of Banking and Finance of the University of St. Gallen is gratefully acknowledged. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.

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Essay on Inflation: Types, Causes and Effects

Essay on Inflation!

Essay on the Meaning of Inflation:

Inflation and unemployment are the two most talked-about words in the contemporary society. These two are the big problems that plague all the economies. Almost everyone is sure that he knows what inflation exactly is, but it remains a source of great deal of confusion because it is difficult to define it unambiguously.

Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget may be financed by additional money creation. But the situation of monetary expansion or budget deficit may not cause price level to rise. Hence the difficulty of defining ‘inflation’ .

Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the price of only one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in the general level or average of prices’ . In other words, inflation is a state of rising price level, but not rise in the price level. It is not high prices but rising prices that constitute inflation.

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It is an increase in the overall price level. A small rise in prices or a sudden rise in prices is not inflation since these may reflect the short term workings of the market. It is to be pointed out here that inflation is a state of disequilibrium when there occurs a sustained rise in price level.

It is inflation if the prices of most goods go up. However, it is difficult to detect whether there is an upward trend in prices and whether this trend is sustained. That is why inflation is difficult to define in an unambiguous sense.

Let’s measure inflation rate. Suppose, in December 2007, the consumer price index was 193.6 and, in December 2008 it was 223.8. Thus the inflation rate during the last one year was 223.8 – 193.6/193.6 × 100 = 15.6%.

As inflation is a state of rising prices, deflation may be defined as a state of falling prices but not fall in prices. Deflation is, thus, the opposite of inflation, i.e., rise in the value or purchasing power of money. Disinflation is a slowing down of the rate of inflation.

Essay on the Types of Inflation :

As the nature of inflation is not uniform in an economy for all the time, it is wise to distinguish between different types of inflation. Such analysis is useful to study the distributional and other effects of inflation as well as to recommend anti-inflationary policies.

Inflation may be caused by a variety of factors. Its intensity or pace may be different at different times. It may also be classified in accordance with the reactions of the government toward inflation.

Thus, one may observe different types of inflation in the contemporary society:

(a) According to Causes:

i. Currency Inflation:

This type of inflation is caused by the printing of currency notes.

ii. Credit Inflation:

Being profit-making institutions, commercial banks sanction more loans and advances to the public than what the economy needs. Such credit expansion leads to a rise in price level.

iii. Deficit-Induced Inflation:

The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the government may ask the central bank to print additional money. Since pumping of additional money is required to meet the budget deficit, any price rise may be called deficit-induced inflation.

iv. Demand-Pull Inflation:

An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull inflation (henceforth DPI). But why does aggregate demand rise? Classical economists attribute this rise in aggregate demand to money supply.

If the supply of money in an economy exceeds the available goods and services, DPI appears. It has been described by Coulborn as a situation of “too much money chasing too few goods” .

Note that, in this region, price level begins to rise. Ultimately, the economy reaches full employment situation, i.e., Range 3, where output does not rise but price level is pulled upward. This is demand-pull inflation. The essence of this type of inflation is “too much spending chasing too few goods.”

v. Cost-Push Inflation:

Inflation in an economy may arise from the overall increase in the cost of production. This type of inflation is known as cost-push inflation (henceforth CPI). Cost of production may rise due to increase in the price of raw materials, wages, etc. Often trade unions are blamed for wage rise since wage rate is not market-determined. Higher wage means higher cost of production.

Prices of commodities are thereby increased. A wage-price spiral comes into operation. But, at the same time, firms are to be blamed also for the price rise since they simply raise prices to expand their profit margins. Thus we have two important variants of CPI: wage-push inflation and profit-push inflation. Anyway, CPI stems from the leftward shift of the aggregate supply curve.

The price level thus determined is OP 1 . As aggregate demand curve shifts to AD 2 , price level rises to OP 2 . Thus, an increase in aggregate demand at the full employment stage leads to an increase in price level only, rather than the level of output. However, how much price level will rise following an increase in aggregate demand depends on the slope of the AS curve.

Causes of Demand-Pull Inflation :

DPI originates in the monetary sector. Monetarists’ argument that “only money matters” is based on the assumption that at or near full employment, excessive money supply will increase aggregate demand and will thus cause inflation.

An increase in nominal money supply shifts aggregate demand curve rightward. This enables people to hold excess cash balances. Spending of excess cash balances by them causes price level to rise. Price level will continue to rise until aggregate demand equals aggregate supply.

Keynesians argue that inflation originates in the non-monetary sector or the real sector. Aggregate demand may rise if there is an increase in consumption expenditure following a tax cut. There may be an autonomous increase in business investment or government expenditure. Governmental expenditure is inflationary if the needed money is procured by the government by printing additional money.

In brief, an increase in aggregate demand i.e., increase in (C + I + G + X – M) causes price level to rise. However, aggregate demand may rise following an increase in money supply generated by the printing of additional money (classical argument) which drives prices upward. Thus, money plays a vital role. That is why Milton Friedman believes that inflation is always and everywhere a monetary phenomenon.

There are other reasons that may push aggregate demand and, hence, price level upwards. For instance, growth of population stimulates aggregate demand. Higher export earnings increase the purchasing power of the exporting countries.

Additional purchasing power means additional aggregate demand. Purchasing power and, hence, aggregate demand, may also go up if government repays public debt. Again, there is a tendency on the part of the holders of black money to spend on conspicuous consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused by a variety of factors.

Cost-Push Inflation Theory :

In addition to aggregate demand, aggregate supply also generates inflationary process. As inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is usually associated with the non-monetary factors. CPI arises due to the increase in cost of production. Cost of production may rise due to a rise in the cost of raw materials or increase in wages.

Such increases in costs are passed on to consumers by firms by raising the prices of the products. Rising wages lead to rising costs. Rising costs lead to rising prices. And rising prices, again, prompt trade unions to demand higher wages. Thus, an inflationary wage-price spiral starts.

This causes aggregate supply curve to shift leftward. This can be demonstrated graphically (Fig. 11.4) where AS 1 is the initial aggregate supply curve. Below the full employment stage this AS curve is positive sloping and at full employment stage it becomes perfectly inelastic. Intersection point (E 1 ) of AD 1 and AS 1 curves determines the price level.

Now, there is a leftward shift of aggregate supply curve to AS 2 . With no change in aggregate demand, this causes price level to rise to OP 2 and output to fall to OY 2 .

With the reduction in output, employment in the economy declines or unemployment rises. Further shift in the AS curve to AS 2 results in higher price level (OP 3 ) and a lower volume of aggregate output (OY 3 ). Thus, CPI may arise even below the full employment (Y f ) stage.

Causes of CPI :

It is the cost factors that pull the prices upward. One of the important causes of price rise is the rise in price of raw materials. For instance, by an administrative order the government may hike the price of petrol or diesel or freight rate. Firms buy these inputs now at a higher price. This leads to an upward pressure on cost of production.

Not only this, CPI is often imported from outside the economy. Increase in the price of petrol by OPEC compels the government to increase the price of petrol and diesel. These two important raw materials are needed by every sector, especially the transport sector. As a result, transport costs go up resulting in higher general price level.

Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions demand higher money wages as a compensation against inflationary price rise. If increase in money wages exceeds labour productivity, aggregate supply will shift upward and leftward. Firms often exercise power by pushing up prices independently of consumer demand to expand their profit margins.

Fiscal policy changes, such as an increase in tax rates leads to an upward pressure in cost of production. For instance, an overall increase in excise tax of mass consumption goods is definitely inflationary. That is why government is then accused of causing inflation.

Finally, production setbacks may result in decreases in output. Natural disaster, exhaustion of natural resources, work stoppages, electric power cuts, etc., may cause aggregate output to decline.

In the midst of this output reduction, artificial scarcity of any goods by traders and hoarders just simply ignite the situation.

Inefficiency, corruption, mismanagement of the economy may also be the other reasons. Thus, inflation is caused by the interplay of various factors. A particular factor cannot be held responsible for inflationary price rise.

Essay on the Effects of Inflation :

People’s desires are inconsistent. When they act as buyers they want prices of goods and services to remain stable but as sellers they expect the prices of goods and services should go up. Such a happy outcome may arise for some individuals; “but, when this happens, others will be getting the worst of both worlds.” Since inflation reduces purchasing power it is bad.

The old people are in the habit of recalling the days when the price of say, meat per kilogram cost just 10 rupees. Today it is Rs. 250 per kilogram. This is true for all other commodities. When they enjoyed a better living standard. Imagine today, how worse we are! But meanwhile, wages and salaries of people have risen to a great height, compared to the ‘good old days’. This goes unusually untold.

When price level goes up, there is both a gainer and a loser. To evaluate the consequence of inflation, one must identify the nature of inflation which may be anticipated and unanticipated. If inflation is anticipated, people can adjust with the new situation and costs of inflation to the society will be smaller.

In reality, people cannot predict accurately future events or people often make mistakes in predicting the course of inflation. In other words, inflation may be unanticipated when people fail to adjust completely. This creates various problems.

One can study the effects of unanticipated inflation under two broad headings:

(i) Effect on distribution of income and wealth

(ii) Effect on economic growth.

(a) Effects of Inflation on Income and Wealth Distribution :

During inflation, usually people experience rise in incomes. But some people gain during inflation at the expense of others. Some individuals gain because their money incomes rise more rapidly than the prices and some lose because prices rise more rapidly than their incomes during inflation. Thus, it redistributes income and wealth.

Though no conclusive evidence can be cited, it can be asserted that following categories of people are affected by inflation differently:

i. Creditors and Debtors:

Borrowers gain and lenders lose during inflation because debts are fixed in rupee terms. When debts are repaid their real value declines by the price level increase and, hence, creditors lose. An individual may be interested in buying a house by taking a loan of Rs. 7 lakh from an institution for 7 years.

The borrower now welcomes inflation since he will have to pay less in real terms than when it was borrowed. Lender, in the process, loses since the rate of interest payable remains unaltered as per agreement. Because of inflation, the borrower is given ‘dear’ rupees, but pays back ‘cheap’ rupees.

However, if in an inflation-ridden economy creditors chronically loose, it is wise not to advance loans or to shut down business. Never does it happen. Rather, the loan- giving institution makes adequate safeguard against the erosion of real value.

ii. Bond and Debenture-Holders:

In an economy, there are some people who live on interest income—they suffer most.

Bondholders earn fixed interest income:

These people suffer a reduction in real income when prices rise. In other words, the value of one’s savings decline if the interest rate falls short of inflation rate. Similarly, beneficiaries from life insurance programmes are also hit badly by inflation since real value of savings deteriorate.

iii. Investors:

People who put their money in shares during inflation are expected to gain since the possibility of earning business profit brightens. Higher profit induces owners of firms to distribute profit among investors or shareholders.

iv. Salaried People and Wage-Earners:

Anyone earning a fixed income is damaged by inflation. Sometimes, unionized worker succeeds in raising wage rates of white-collar workers as a compensation against price rise. But wage rate changes with a long time lag. In other words, wage rate increases always lag behind price increases.

Naturally, inflation results in a reduction in real purchasing power of fixed income earners. On the other hand, people earning flexible incomes may gain during inflation. The nominal incomes of such people outstrip the general price rise. As a result, real incomes of this income group increase.

v. Profit-Earners, Speculators and Black Marketeers:

It is argued that profit-earners gain from inflation. Profit tends to rise during inflation. Seeing inflation, businessmen raise the prices of their products. This results in a bigger profit. Profit margin, however, may not be high when the rate of inflation climbs to a high level.

However, speculators dealing in business in essential commodities usually stand to gain by inflation. Black marketeers are also benefited by inflation.

Thus, there occurs a redistribution of income and wealth. It is said that rich becomes richer and poor becomes poorer during inflation. However, no such hard and fast generalizations can be made. It is clear that someone wins and someone loses from inflation.

These effects of inflation may persist if inflation is unanticipated. However, the redistributive burdens of inflation on income and wealth are most likely to be minimal if inflation is anticipated by the people.

With anticipated inflation, people can build up their strategies to cope with inflation. If the annual rate of inflation in an economy is anticipated correctly people will try to protect them against losses resulting from inflation.

Workers will demand 10 p.c. wage increase if inflation is expected to rise by 10 p.c. Similarly, a percentage of inflation premium will be demanded by creditors from debtors. Business firms will also fix prices of their products in accordance with the anticipated price rise. Now if the entire society “learns to live with inflation” , the redistributive effect of inflation will be minimal.

However, it is difficult to anticipate properly every episode of inflation. Further, even if it is anticipated it cannot be perfect. In addition, adjustment with the new expected inflationary conditions may not be possible for all categories of people. Thus, adverse redistributive effects are likely to occur.

Finally, anticipated inflation may also be costly to the society. If people’s expectation regarding future price rise become stronger they will hold less liquid money. Mere holding of cash balances during inflation is unwise since its real value declines. That is why people use their money balances in buying real estate, gold, jewellery, etc.

Such investment is referred to as unproductive investment. Thus, during inflation of anticipated variety, there occurs a diversion of resources from priority to non-priority or unproductive sectors.

b. Effect on Production and Economic Growth :

Inflation may or may not result in higher output. Below the full employment stage, inflation has a favourable effect on production. In general, profit is a rising function of the price level. An inflationary situation gives an incentive to businessmen to raise prices of their products so as to earn higher doses of profit.

Rising price and rising profit encourage firms to make larger investments. As a result, the multiplier effect of investment will come into operation resulting in higher national output. However, such a favourable effect of inflation will be temporary if wages and production costs rise very rapidly.

Further, inflationary situation may be associated with the fall in output, particularly if inflation is of the cost-push variety. Thus, there is no strict relationship between prices and output. An increase in aggregate demand will increase both prices and output, but a supply shock will raise prices and lower output.

Inflation may also lower down further production levels. It is commonly assumed that if inflationary tendencies nurtured by experienced inflation persist in future, people will now save less and consume more. Rising saving propensities will result in lower further outputs.

One may also argue that inflation creates an air of uncertainty in the minds of business community, particularly when the rate of inflation fluctuates. In the midst of rising inflationary trend, firms cannot accurately estimate their costs and revenues. Under the circumstance, business firms may be deterred in investing. This will adversely affect the growth performance of the economy.

However, slight dose of inflation is necessary for economic growth. Mild inflation has an encouraging effect on national output. But it is difficult to make the price rise of a creeping variety. High rate of inflation acts as a disincentive to long run economic growth. The way the hyperinflation affects economic growth is summed up here.

We know that hyperinflation discourages savings. A fall in savings means a lower rate of capital formation. A low rate of capital formation hinders economic growth. Further, during excessive price rise, there occurs an increase in unproductive investment in real estate, gold, jewellery, etc.

Above all, speculative businesses flourish during inflation resulting in artificial scarcities and, hence, further rise in prices. Again, following hyperinflation, export earnings decline resulting in a wide imbalance in the balance of payments account.

Often, galloping inflation results in a ‘flight’ of capital to foreign countries since people lose confidence and faith over the monetary arrangements of the country, thereby resulting in a scarcity of resources. Finally, real value of tax revenue also declines under the impact of hyperinflation. Government then experiences a shortfall in investible resources.

Thus, economists and policy makers are unanimous regarding the dangers of high price rise. But the consequence of hyperinflation is disastrous. In the past, some of the world economies (e.g., Germany after the First World War (1914-1918), Latin American countries in the 1980s) had been greatly ravaged by hyperinflation.

The German Inflation of 1920s was also Catastrophic:

During 1922, the German price level went up 5,470 per cent, in 1923, the situation worsened; the German price level rose 1,300,000,000 times. By October of 1923, the postage of the lightest letter sent from Germany to the United States was 200,000 marks.

Butter cost 1.5 million marks per pound, meat 2 million marks, a loaf of bread 200,000 marks, and an egg 60,000 marks Prices increased so rapidly that waiters changed the prices on the menu several times during the course of a lunch!! Sometimes, customers had to pay double the price listed on the menu when they observed it first!!!

During October 2008, Zimbabwe, under the President-ship of Robert G. Mugabe, experienced 231,000,000 p.c. (2.31 million p.c.) as against 1.2 million p.c. price rise in September 2008—a record after 1923. It is an unbelievable rate. In May 2008, the cost of price of a toilet paper itself and not the costs of the roll of the toilet paper came to 417 Zimbabwean dollars.

Anyway, people are harassed ultimately by the high rate of inflation. That is why it is said that ‘inflation is our public enemy number one’. Rising inflation rate is a sign of failure on the part of the government.

Related Articles:

• Essay on the Causes of Inflation (473 Words)
• Cost-Push Inflation and Demand-Pull or Mixed Inflation
• Demand Pull Inflation and Cost Push Inflation | Money
• Essay on Inflation: Meaning, Measurement and Causes

Inflation: What It Is, How It Can Be Controlled, and Extreme Examples

What you need to know about the purchasing power of money and how it changes

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What Is Inflation?

Understanding inflation, types of price indexes.

• Pros and Cons

Controlling Inflation

• Inflation, Deflation, and Disinflation

Hedging Against Inflation

The bottom line.

Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.

Inflation is a measure of how quickly prices are increasing over time. In other words, inflation measures how quickly money loses its purchasing power .

The inflation rate is calculated as the average price increase of a basket of selected goods and services over one year. High inflation means that prices are increasing quickly, with low inflation meaning that prices are increasing more slowly. Inflation can be contrasted with deflation, which occurs when prices decline and purchasing power increases.

Key Takeaways

• Inflation measures how quickly the prices of goods and services are rising.
• Inflation is sometimes classified into three types: demand-pull inflation, cost-push inflation, and built-in inflation.
• The most commonly used inflation indexes are the Consumer Price Index and the Wholesale Price Index.
• Inflation can be viewed positively or negatively depending on the individual viewpoint and rate of change.
• Those with tangible assets, like property or stocked commodities, may like to see some inflation as that raises the value of their assets.

While it is easy to measure the price changes of individual products over time, human needs extend beyond just one or two products. Individuals need a big and diversified set of products as well as a host of services for living a comfortable life. They include commodities like food grains, metal, fuel, utilities like electricity and transportation, and services like healthcare , entertainment, and labor.

Inflation aims to measure the overall impact of price changes for a diversified set of products and services. It allows for a single value representation of the increase in the price level of goods and services in an economy over a specified time.

Prices rise, which means that one unit of money buys fewer goods and services. This loss of purchasing power impacts the cost of living for the common public which ultimately leads to a deceleration in economic growth. The consensus view among economists is that sustained inflation occurs when a nation's money supply growth outpaces economic growth.

The increase in the Consumer Price Index For All Urban Consumers (CPI-U) over the 12 months ending March 2024 on an unadjusted basis. Prices rose 0.4% on a seasonally adjusted basis in March 2024 from the previous month.

To combat this, the monetary authority (in most cases, the central bank ) takes the necessary steps to manage the money supply and credit to keep inflation within permissible limits and keep the economy running smoothly.

Theoretically, monetarism is a popular theory that explains the relationship between inflation and the money supply of an economy. For example, following the Spanish conquest of the Aztec and Inca empires, massive amounts of gold and silver flowed into the Spanish and other European economies. Since the money supply rapidly increased, the value of money fell, contributing to rapidly rising prices.

Inflation is measured in a variety of ways depending on the types of goods and services. It is the opposite of deflation , which indicates a general decline in prices when the inflation rate falls below 0%. Keep in mind that deflation shouldn't be confused with disinflation , which is a related term referring to a slowing down in the (positive) rate of inflation.

Investopedia / Julie Bang

Causes of Inflation

An increase in the supply of money is the root of inflation, though this can play out through different mechanisms in the economy. A country's money supply can be increased by the monetary authorities by:

• Printing and giving away more money to citizens
• Legally devaluing (reducing the value of) the legal tender currency
• Loaning new money into existence as reserve account credits through the banking system by purchasing government bonds from banks on the secondary market (the most common method)
• Supply bottlenecks and shortages of key goods, causing other prices to rise.

In all of these cases, the money ends up losing its purchasing power. The mechanisms of how this drives inflation can be classified into three types: demand-pull inflation, cost-push inflation, and built-in inflation.

Demand-Pull Effect

Demand-pull inflation occurs when an increase in the supply of money and credit stimulates the overall demand for goods and services to increase more rapidly than the economy's production capacity. This increases demand and leads to price rises.

When people have more money, it leads to positive consumer sentiment. This, in turn, leads to higher spending, which pulls prices higher. It creates a demand-supply gap with higher demand and less flexible supply, which results in higher prices.

Melissa Ling {Copyright} Investopedia, 2019

Cost-Push Effect

Cost-push inflation is a result of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channeled into a commodity or other asset markets, costs for all kinds of intermediate goods rise. This is especially evident when there's a negative economic shock to the supply of key commodities.

These developments lead to higher costs for the finished product or service and work their way into rising consumer prices. For instance, when the money supply is expanded, it creates a speculative boom in oil prices . This means that the cost of energy can rise and contribute to rising consumer prices, which is reflected in various measures of inflation.

Built-in Inflation

Built-in inflation is related to adaptive expectations or the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, people may expect a continuous rise in the future at a similar rate.

As such, workers may demand more costs or wages to maintain their standard of living. Their increased wages result in a higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.

Depending upon the selected set of goods and services used, multiple types of baskets of goods are calculated and tracked as price indexes. The most commonly used price indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI) .

The Consumer Price Index (CPI)

The CPI is a measure that examines the weighted average of prices of a basket of goods and services that are of primary consumer needs. They include transportation, food, and medical care.

CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. The prices in consideration are the retail prices of each item, as available for purchase by the individual citizens.

Changes in the CPI are used to assess price changes associated with the cost of living , making it one of the most frequently used statistics for identifying periods of inflation or deflation. In the U.S., the Bureau of Labor Statistics (BLS) reports the CPI on a monthly basis and has calculated it as far back as 1913.

The CPI-U, which was introduced in 1978, represents the buying habits of approximately 88% of the non-institutional population of the United States.

The Wholesale Price Index (WPI)

The WPI is another popular measure of inflation. It measures and tracks the changes in the price of goods in the stages before the retail level.

While WPI items vary from one country to another, they mostly include items at the producer or wholesale level. For example, it includes cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing.

Although many countries and organizations use WPI, many other countries, including the U.S., use a similar variant called the producer price index (PPI) .

The Producer Price Index (PPI)

The PPI is a family of indexes that measures the average change in selling prices received by domestic producers of intermediate goods and services over time. The PPI measures price changes from the perspective of the seller and differs from the CPI which measures price changes from the perspective of the buyer.

In all variants, the rise in the price of one component (say oil) may cancel out the price decline in another (say wheat) to a certain extent. Overall, each index represents the average weighted price change for the given constituents which may apply at the overall economy, sector , or commodity level.

The Formula for Measuring Inflation

The above-mentioned variants of price indexes can be used to calculate the value of inflation between two particular months (or years). While a lot of ready-made inflation calculators are already available on various financial portals and websites, it is always better to be aware of the underlying methodology to ensure accuracy with a clear understanding of the calculations. Mathematically,

Percent Inflation Rate = (Final CPI Index Value ÷ Initial CPI Value) x 100

Say you wish to know how the purchasing power of $10,000 changed between January 1975 and January 2024. One can find price index data on various portals in a tabular form. From that table, pick up the corresponding CPI figures for the given two months. For September 1975, it was 52.1 (initial CPI value) and for January 2024, it was 308.417 (final CPI value).

Plugging in the formula yields:

Percent Inflation Rate = (308.417 ÷ 52.1) x 100 = (5.9197) x 100 = 591.97%

Since you wish to know how much $10,000 from January 1975 would worth be in January 2024, multiply the inflation rate by the amount to get the changed dollar value:

Change in Dollar Value = 5.9197 x $10,000 = $59,197

This means that $10,000 in January 1975 will be worth $59,197 today. Essentially, if you purchased a basket of goods and services (as included in the CPI definition) worth $10,000 in 1975, the same basket would cost you $59,197 in January 2024.

Advantages and Disadvantages of Inflation

Inflation can be construed as either a good or a bad thing, depending upon which side one takes, and how rapidly the change occurs.

Individuals with tangible assets (like property or stocked commodities) priced in their home currency may like to see some inflation as that raises the price of their assets, which they can sell at a higher rate.

Inflation often leads to speculation by businesses in risky projects and by individuals who invest in company stocks because they expect better returns than inflation.

An optimum level of inflation is often promoted to encourage spending to a certain extent instead of saving. If the purchasing power of money falls over time, there may be a greater incentive to spend now instead of saving and spending later. It may increase spending, which may boost economic activities in a country. A balanced approach is thought to keep the inflation value in an optimum and desirable range.

Disadvantages

Buyers of such assets may not be happy with inflation, as they will be required to shell out more money. People who hold assets valued in their home currency, such as cash or bonds, may not like inflation, as it erodes the real value of their holdings.

As such, investors looking to protect their portfolios from inflation should consider inflation-hedged asset classes, such as gold, commodities, and real estate investment trusts (REITs). Inflation-indexed bonds are another popular option for investors to profit from inflation .

High and variable rates of inflation can impose major costs on an economy. Businesses, workers, and consumers must all account for the effects of generally rising prices in their buying, selling, and planning decisions.

This introduces an additional source of uncertainty into the economy, because they may guess wrong about the rate of future inflation. Time and resources expended on researching, estimating, and adjusting economic behavior are expected to rise to the general level of prices. That's opposed to real economic fundamentals, which inevitably represent a cost to the economy as a whole.

Even a low, stable, and easily predictable rate of inflation, which some consider otherwise optimal, may lead to serious problems in the economy. That's because of how, where, and when the new money enters the economy.

Whenever new money and credit enter the economy, it is always in the hands of specific individuals or business firms. The process of price level adjustments to the new money supply proceeds as they then spend the new money and it circulates from hand to hand and account to account through the economy.

Inflation does drive up some prices first and drives up other prices later. This sequential change in purchasing power and prices (known as the Cantillon effect) means that the process of inflation not only increases the general price level over time. But it also distorts relative prices , wages, and rates of return along the way.

Economists, in general, understand that distortions of relative prices away from their economic equilibrium are not good for the economy, and Austrian economists even believe this process to be a major driver of cycles of recession in the economy.

Leads to higher resale value of assets

Optimum levels of inflation encourage spending

Buyers have to pay more for products and services

Impose higher prices on the economy

Drives some prices up first and others later

A country’s financial regulator shoulders the important responsibility of keeping inflation in check. It is done by implementing measures through monetary policy , which refers to the actions of a central bank or other committees that determine the size and rate of growth of the money supply.

In the U.S., the Fed's monetary policy goals include moderate long-term interest rates, price stability, and maximum employment. Each of these goals is intended to promote a stable financial environment. The Federal Reserve clearly communicates long-term inflation goals in order to keep a steady long-term rate of inflation , which is thought to be beneficial to the economy.

Price stability or a relatively constant level of inflation allows businesses to plan for the future since they know what to expect. The Fed believes that this will promote maximum employment, which is determined by non-monetary factors that fluctuate over time and are therefore subject to change.

For this reason, the Fed doesn't set a specific goal for maximum employment, and it is largely determined by employers' assessments. Maximum employment does not mean zero unemployment, as at any given time there is a certain level of volatility as people vacate and start new jobs.

Hyperinflation is often described as a period of inflation of 50% or more per month.

Monetary authorities also take exceptional measures in extreme conditions of the economy. For instance, following the 2008 financial crisis, the U.S. Fed kept the interest rates near zero and pursued a bond-buying program called quantitative easing (QE) .

Some critics of the program alleged it would cause a spike in inflation in the U.S. dollar, but inflation peaked in 2007 and declined steadily over the next eight years. There are many complex reasons why QE didn't lead to inflation or hyperinflation , though the simplest explanation is that the recession itself was a very prominent deflationary environment, and quantitative easing supported its effects.

Consequently, U.S. policymakers have attempted to keep inflation steady at around 2% per year. The European Central Bank (ECB) has also pursued aggressive quantitative easing to counter deflation in the eurozone, and some places have experienced negative interest rates . That's due to fears that deflation could take hold in the eurozone and lead to economic stagnation.

Moreover, countries that experience higher rates of growth can absorb higher rates of inflation. India's target is around 4% (with an upper tolerance of 6% and a lower tolerance of 2%), while Brazil aims for 3.25% (with an upper tolerance of 4.75% and a lower tolerance of 1.75%).

Meaning of Inflation, Deflation, and Disinflation

While a high inflation rate means that prices are increasing, a low inflation rate does not mean that prices are falling. Counterintuitively, when the inflation rate falls, prices are still increasing, but at a slower rate than before. When the inflation rate falls (but remains positive) this is known as disinflation .

Conversely, if the inflation rate becomes negative, that means that prices are falling. This is known as deflation , which can have negative effects on an economy. Because buying power increases over time, consumers have less incentive to spend money in the short term, resulting in falling economic activity.

Stocks are considered to be the best hedge against inflation , as the rise in stock prices is inclusive of the effects of inflation. Since additions to the money supply in virtually all modern economies occur as bank credit injections through the financial system, much of the immediate effect on prices happens in financial assets that are priced in their home currency, such as stocks.

Special financial instruments exist that one can use to safeguard investments against inflation . They include Treasury Inflation-Protected Securities (TIPS) , low-risk treasury security that is indexed to inflation where the principal amount invested is increased by the percentage of inflation.

One can also opt for a TIPS mutual fund or TIPS-based exchange-traded fund (ETF). To get access to stocks, ETFs, and other funds that can help avoid the dangers of inflation, you'll likely need a brokerage account. Choosing a stockbroker can be a tedious process due to the variety among them.

Gold is also considered to be a hedge against inflation, although this doesn't always appear to be the case looking backward.

Examples of Inflation

Since all world currencies are fiat money , the money supply could increase rapidly for political reasons, resulting in rapid price level increases. The most famous example is the hyperinflation that struck the German Weimar Republic in the early 1920s.

The nations that were victorious in World War I demanded reparations from Germany, which could not be paid in German paper currency, as this was of suspect value due to government borrowing. Germany attempted to print paper notes, buy foreign currency with them, and use that to pay their debts.

This policy led to the rapid devaluation of the German mark along with the hyperinflation that accompanied the development. German consumers responded to the cycle by trying to spend their money as fast as possible, understanding that it would be worth less and less the longer they waited. More money flooded the economy, and its value plummeted to the point where people would paper their walls with practically worthless bills. Similar situations occurred in Peru in 1990 and in Zimbabwe between 2007 and 2008.

What Causes Inflation?

There are three main causes of inflation: demand-pull inflation, cost-push inflation, and built-in inflation.

• Demand-pull inflation refers to situations where there are not enough products or services being produced to keep up with demand, causing their prices to increase.
• Cost-push inflation, on the other hand, occurs when the cost of producing products and services rises, forcing businesses to raise their prices.
• Built-in inflation (which is sometimes referred to as a wage-price spiral) occurs when workers demand higher wages to keep up with rising living costs. This in turn causes businesses to raise their prices in order to offset their rising wage costs, leading to a self-reinforcing loop of wage and price increases.

Is Inflation Good or Bad?

Too much inflation is generally considered bad for an economy, while too little inflation is also considered harmful. Many economists advocate for a middle ground of low to moderate inflation, of around 2% per year.

Generally speaking, higher inflation harms savers because it erodes the purchasing power of the money they have saved; however, it can benefit borrowers because the inflation-adjusted value of their outstanding debts shrinks over time.

What Are the Effects of Inflation?

Inflation can affect the economy in several ways. For example, if inflation causes a nation’s currency to decline, this can benefit exporters by making their goods more affordable when priced in the currency of foreign nations.

On the other hand, this could harm importers by making foreign-made goods more expensive. Higher inflation can also encourage spending, as consumers will aim to purchase goods quickly before their prices rise further. Savers, on the other hand, could see the real value of their savings erode, limiting their ability to spend or invest in the future.

Why Is Inflation So High Right Now?

In 2022, inflation rates around the world rose to their highest levels since the early 1980s. While there is no single reason for this rapid rise in global prices, a series of events worked together to boost inflation to such high levels.

The COVID-19 pandemic led to lockdowns and other restrictions that greatly disrupted global supply chains, from factory closures to bottlenecks at maritime ports. Governments also issued stimulus checks and increased unemployment benefits to counter the financial impact on individuals and small businesses. When vaccines became widespread and the economy bounced back, demand (fueled in part by stimulus money and low interest rates) quickly outpaced supply, which still struggled to get back to pre-COVID levels.

Russia's unprovoked invasion of Ukraine in early 2022 led to economic sanctions and trade restrictions on Russia, limiting the world's supply of oil and gas since Russia is a large producer of fossil fuels. Food prices also rose as Ukraine's large grain harvests could not be exported. As fuel and food prices rose, it led to similar increases down the value chains. The Fed raised interest rates to combat the high inflation, which significantly came down in 2023, though it remains above pre-pandemic levels .

Inflation is a rise in prices, which results in the decline of purchasing power over time. Inflation is natural and the U.S. government targets an annual inflation rate of 2%; however, inflation can be dangerous when it increases too much, too fast.

Inflation makes items more expensive, especially if wages do not rise by the same levels of inflation. Additionally, inflation erodes the value of some assets, especially cash. Governments and central banks seek to control inflation through monetary policy.

U.S. Bureau of Labor Statistics. " CONSUMER PRICE INDEX ," Page 1.

Edo, Anthony and Melitz, Jacques. " The Primary Cause of European Inflation in 1500-1700: Precious Metals or Population? The English Evidence ." CEPII Working Paper , October 2019, pp. 13-14. Download PDF.

U.S. Bureau of Labor Statistics. " Consumer Price Index: Overview ."

U.S. Bureau of Labor Statistics. " Chapter 17. The Consumer Price Index (Updated 2-14-2018) ," Page 2.

U.S. Bureau of Labor Statistics. " Consumer Price Index Chronology ."

U.S. Bureau of Labor Statistics. " Producer Price Index Frequently Asked Questions (FAQs) ," Select "4. How does the Producer Price Index differ from the Consumer Price Index?"

U.S. Bureau of Labor Statistics. " Producer Price Index Frequently Asked Questions (FAQs) ," Select "3. When did the Wholesale Price Index become the Producer Price Index?"

U.S. Bureau of Labor Statistics. " Producer Price Indexes ."

U.S. Bureau of Labor Statistics. " Consumer Price Index Historical Tables for U.S. City Average ."

U.S. Bureau of Labor Statistics. " Historical CPI-U ," Page 3.

Adam Smith Institute. " The Cantillion Effect ."

Foundation for Economic Education. " The Current Economic Crisis and the Austrian Theory of the Business Cycle ."

Board of Governors of the Federal Reserve System. " Review of Monetary Policy Strategy, Tools, and Communication ."

Board of Governors of the Federal Reserve System. " What is the Lowest Level of Unemployment that the U.S. Economy Can Sustain? "

Fischer, Stanley and et al. " Modern Hyper- and High Inflations ." Journal of Economic Literature , vol. 40, no. 3, September 2002, pp. 837.

Federal Reserve History. " The Great Recession and its Aftermath ."

Federal Reserve Bank of New York. " Liberty Street Economics: Ten Years Later—Did QE Work? "

Congressional Budget Office. " How the Federal Reserve’s Quantitative Easing Affects the Federal Budget ."

Board of Governors of the Federal Reserve System. " FAQs: Why Does the Federal Reserve Aim for Inflation of 2 Percent Over the Longer Run? "

European Central Bank. " How Quantitative Easing Works ."

Reserve Bank of India. " Monetary Policy ," Select "The Monetary Policy Framework."

Central Bank of Brazil. " Inflation Targeting Track Record ."

TreasuryDirect. " Treasury Inflation-Protected Securities (TIPS) ."

University of Illinois, Urbana-Champaign. " 1920s Hyperinflation in Germany and Bank Notes ."

Rossini, Renzo (Editors Alejandro M. Werner and Alejandro Santos). " Staying the Course of Economic Success: Chapter 2. Peru’s Recent Economic History: From Stagnation, Disarray, and Mismanagement to Growth, Stability, and Quality Policies ." International Monetary Fund, September 2015.

Kramarenko, Vitaliy and et al. " Zimbabwe: Challenges and Policy Options after Hyperinflation ." International Monetary Fund , June 2010, no. 6.

The World Bank. " Inflation, Consumer Prices (Annual %) ."

Federal Reserve Bank of St. Louis, FRED. " Consumer Price Index for All Urban Consumers: All Items in U.S. City Average ."

Board of Governors of the Federal Reserve System. " Open Market Operations ."

• Inflation: What It Is, How It Can Be Controlled, and Extreme Examples 1 of 41
• 10 Common Effects of Inflation 2 of 41
• How to Profit From Inflation 3 of 41
• When Is Inflation Good for the Economy? 4 of 41
• History of the Cost of Living 5 of 41
• Why Are P/E Ratios Higher When Inflation Is Low? 6 of 41
• What Causes Inflation? How It's Measured and How to Protect Against It 7 of 41
• Understand the Different Types of Inflation 8 of 41
• Wage Push Inflation: Definition, Causes, and Examples 9 of 41
• Cost-Push Inflation: When It Occurs, Definition, and Causes 10 of 41
• Cost-Push Inflation vs. Demand-Pull Inflation: What's the Difference? 11 of 41
• Inflation vs. Stagflation: What's the Difference? 12 of 41
• What Is the Relationship Between Inflation and Interest Rates? 13 of 41
• Inflation's Impact on Stock Returns 14 of 41
• How Does Inflation Affect Fixed-Income Investments? 15 of 41
• How Inflation Affects Your Cost of Living 16 of 41
• How Inflation Impacts Your Savings 17 of 41
• How Inflation Impacts Your Retirement Income 18 of 41
• What Impact Does Inflation Have on a Dollar's Value Over Time? 19 of 41
• Inflation and Economic Recovery 20 of 41
• What Is Hyperinflation? Causes, Effects, Examples, and How to Prepare 21 of 41
• Why Didn't Quantitative Easing Lead to Hyperinflation? 22 of 41
• Worst Cases of Hyperinflation in History 23 of 41
• How the Great Inflation of the 1970s Happened 24 of 41
• What Is Stagflation, What Causes It, and Why Is It Bad? 25 of 41
• Understanding Purchasing Power and the Consumer Price Index 26 of 41
• Consumer Price Index (CPI): What It Is and How It's Used 27 of 41
• Why Is the Consumer Price Index Controversial? 28 of 41
• Core Inflation: What It Is and Why It's Important 29 of 41
• What Is Headline Inflation (Reported in Consumer Price Index)? 30 of 41
• What Is the GDP Price Deflator and Its Formula? 31 of 41
• Indexation Explained: Meaning and Examples 32 of 41
• Inflation Accounting: Definition, Methods, Pros & Cons 33 of 41
• Inflation-Adjusted Return: Definition, Formula, and Example 34 of 41
• What Is Inflation Targeting, and How Does It Work? 35 of 41
• Real Economic Growth Rate: Definition, Calculation, and Uses 36 of 41
• Real Gross Domestic Product (Real GDP): How to Calculate It, vs. Nominal 37 of 41
• Real Income, Inflation, and the Real Wages Formula 38 of 41
• Real Interest Rate: Definition, Formula, and Example 39 of 41
• Real Rate of Return: Definition, How It's Used, and Example 40 of 41
• Wage-Price Spiral: What It Is and How It’s Controlled 41 of 41

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The Great Inflation

The Great Inflation was the defining macroeconomic event of the second half of the twentieth century. Over the nearly two decades it lasted, the global monetary system established during World War II was abandoned, there were four economic recessions, two severe energy shortages, and the unprecedented peacetime implementation of wage and price controls. It was, according to one prominent economist, “the greatest failure of American macroeconomic policy in the postwar period” (Siegel 1994).

But that failure also brought a transformative change in macroeconomic theory and, ultimately, the rules that today guide the monetary policies of the Federal Reserve and other central banks around the world. If the Great Inflation was a consequence of a great failure of American macroeconomic policy, its conquest should be counted as a triumph.

Forensics of the Great Inflation

In 1964, inflation measured a little more than 1 percent per year. It had been in this vicinity over the preceding six years. Inflation began ratcheting upward in the mid-1960s and reached more than 14 percent in 1980. It eventually declined to average only 3.5 percent in the latter half of the 1980s.

While economists debate the relative importance of the factors that motivated and perpetuated inflation for more than a decade, there is little debate about its source. The origins of the Great Inflation were policies that allowed for an excessive growth in the supply of money—Federal Reserve policies.

To understand this episode of especially bad policy, and monetary policy in particular, it will be useful to tell the story in three distinct but related parts. This is a forensic investigation of sorts, examining the motive, means, and opportunity for the Great Inflation to occur.

The Motive: The Phillips Curve and the Pursuit of Full Employment

The first part of the story, the motive underlying the Great Inflation, dates back to the immediate aftermath of the Great Depression , an earlier and equally transformative period for macroeconomic theory and policy. At the conclusion of World War II, Congress turned its attention to policies it hoped would promote greater economic stability. Most notable among the laws that emerged was the  Employment Act of 1946 . Among other things, the act declared it a responsibility of the federal government “to promote maximum employment, production, and purchasing power” and provided for greater coordination between fiscal and monetary policies. 1  This act is the seminal basis for the Federal Reserve’s current  dual mandate  to “maintain long run growth of the monetary and credit aggregates…so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates” (Steelman 2011).

The orthodoxy guiding policy in the post-WWII era was Keynesian stabilization policy, motivated in large part by the painful memory of the unprecedented high unemployment in the United States and around the world during the 1930s. The focal point of these policies was the management of aggregate spending (demand) by way of the spending and taxation policies of the fiscal authority and the monetary policies of the central bank. The idea that monetary policy can and should be used to manage aggregate spending and stabilize economic activity is still a generally accepted tenet that guides the policies of the Federal Reserve and other central banks today. But one critical and erroneous assumption to the implementation of stabilization policy of the 1960s and 1970s was that there existed a stable, exploitable relationship between unemployment and inflation. Specifically, it was generally believed that permanently lower rates of unemployment could be “bought” with modestly higher rates of inflation.

The idea that the “Phillips curve” represented a longer-term trade-off between unemployment, which was very damaging to economic well-being, and inflation, which was sometimes thought of as more of an inconvenience, was an attractive assumption for policymakers who hoped to forcefully pursue the dictates of the Employment Act. 2   But the stability of the Phillips curve was a fateful assumption, one that economists Edmund Phelps (1967) and Milton Friedman (1968) warned against. Said Phelps “[I]f the statical ‘optimum’ is chosen, it is reasonable to suppose that the participants in product and labour markets will learn to expect inflation…and that, as a consequence of their rational, anticipatory behaviour, the Phillips Curve will gradually shift upward...” (Phelps 1967; Friedman 1968). In other words, the trade-off between lower unemployment and more inflation that policymakers may have wanted to pursue would likely be a false bargain,  requiring ever higher inflation to maintain .

The Means: The Collapse of Bretton Woods

Chasing the Phillips curve in pursuit of lower unemployment could not have occurred if the policies of the Federal Reserve were well-anchored. And in the 1960s, the US dollar was anchored—albeit very tenuously—to gold through the Bretton Woods agreement. So the story of the Great Inflation is in part also about the collapse of the Bretton Woods system and the separation of the US dollar from its last link to gold.

During World War II , the world’s industrial nations agreed to a  global monetary system  that they hoped would bring greater economic stability and peace by promoting global trade. That system, hashed out by forty-four nations in Bretton Woods, New Hampshire, during July 1944, provided for a fixed rate of exchange between the currencies of the world and the US dollar, and the US dollar was linked to gold. 3

But the  Bretton Woods system  had a number of flaws in its implementation, chief among them the attempt to maintain fixed parity between global currencies that was incompatible with their domestic economic goals. Many nations, it turned out, were pursing monetary policies that promised to march up the Phillips curve for a more favorable unemployment-inflation nexus.

As the world’s reserve currency, the US dollar had an additional problem. As global trade grew, so too did the demand for U.S. dollar reserves. For a time, the demand for US dollars was satisfied by an increasing balance of payments shortfall, and foreign central banks accumulated more and more dollar reserves. Eventually, the supply of dollar reserves held abroad exceeded the US stock of gold, implying that the United States could not maintain complete convertibility at the existing price of gold—a fact that would not go unnoticed by foreign governments and currency speculators.

As inflation drifted higher during the latter half of the 1960s, US dollars were increasingly converted to gold,  and in the summer of 1971, President Nixon halted the exchange of dollars for gold by foreign central banks . Over the next two years, there was an attempt to salvage the global monetary system through the short-lived  Smithsonian Agreement , but the new arrangement fared no better than Bretton Woods and it quickly broke down. The postwar global monetary system was finished.

With the last link to gold severed, most of the world’s currencies, including the US dollar, were now completely unanchored. Except during periods of global crisis, this was the first time in history that most of the monies of the industrialized world were on an irredeemable paper money standard.

The Opportunity: Fiscal Imbalances, Energy Shortages, and Bad Data

The late 1960s and the early 1970s were a turbulent time for the US economy. President Johnson’s Great Society legislation brought about major spending programs across a broad array of social initiatives at a time when the US fiscal situation was already being strained by the Vietnam War. These growing fiscal imbalances complicated monetary policy.

In order to avoid monetary policy actions that might interfere with the funding plans of the Treasury, the Federal Reserve followed a practice of conducting “even-keel” policies. In practical terms, this meant the central bank would not implement a change in policy and would hold interest rates steady during the period between the announcement of a Treasury issue and its sale to the market. Under ordinary conditions, Treasury issues were infrequent and the Fed’s even-keel policies didn’t significantly interfere with the implementation of monetary policy. But as debt issues became more prevalent, the Federal Reserve’s adherence to the even-keel principle increasingly constrained the conduct of monetary policy (Meltzer 2005).

A more disruptive force was the repeated energy crises that increased oil costs and sapped U.S. growth. The first crisis was an Arab oil embargo that began in October 1973  and lasted about five months. During this period, crude oil prices quadrupled to a plateau that held until the Iranian revolution brought a  second energy crisis in 1979 . The second crisis tripled the cost of oil.

In the 1970s, economists and policymakers began to commonly categorize the rise in aggregate prices as different inflation types. “Demand-pull” inflation was the direct influence of macroeconomic policy, and monetary policy in particular. It resulted from policies that produced a level of spending in excess of what the economy could produce without pushing the economy beyond its ordinary productive capacity and pulling more expensive resources into play. But inflation could also be pushed higher from supply disruptions, notably originating in food and energy markets (Gordon 1975). 4   This “cost-push” inflation also got passed through the chain of production into higher retail prices.

From the perspective of the central bank, the inflation being caused by the rising price of oil was largely beyond the control of monetary policy. But the rise in unemployment that was occurring in response to the jump in oil prices was not.

Motivated by a mandate to create full employment with little or no anchor for the management of reserves, the Federal Reserve accommodated large and rising fiscal imbalances and leaned against the headwinds produced by energy costs. These policies accelerated the expansion of the money supply and raised overall prices without reducing unemployment.

Bad data (or at least a bad understanding of the data) also handicapped policymakers. Looking back at the information policymakers had in hand during the period leading up to and during the Great Inflation, economist Athanasios Orphanides has shown that the real-time estimate of potential output was significantly overstated, and the estimate of the rate of unemployment consistent with full employment was significantly understated. In other words, policymakers were also likely underestimating the inflationary effects of their policies. In fact, the policy path they were on simply wasn’t feasible without accelerating inflation (Orphanides 1997; Orphanides 2002).

And to make matters worse yet, the Phillips curve, the stability of which was an important guide to the policy decisions of the Federal Reserve, began to move.

From High Inflation to Inflation Targeting—The Conquest of US Inflation

Phelps and Friedman were right. The stable trade-off between inflation and unemployment proved unstable. The ability of policymakers to control any “real” variable was ephemeral. This truth included the rate of unemployment, which oscillated around its “natural” rate. The trade-off that policymakers hoped to exploit did not exist.

As businesses and households came to appreciate, indeed anticipate, rising prices, any trade-off between inflation and unemployment became a less favorable exchange until, in time, both inflation and unemployment became unacceptably high. This, then, became the era of “stagflation.” In 1964, when this story began, inflation was 1 percent and unemployment was 5 percent. Ten years later, inflation would be over 12 percent and unemployment was above 7 percent. By the summer of 1980, inflation was near 14.5 percent, and unemployment was over 7.5 percent.

Federal Reserve officials were not blind to the inflation that was occurring and were well aware of the dual mandate that required monetary policy to be calibrated so that it delivered full employment and price stability. Indeed, the Employment Act of 1946 was re-codified in 1978 by the  Full Employment and Balanced Growth Act , more commonly known as the Humphrey-Hawkins Act after the bill’s authors. Humphrey-Hawkins explicitly charged the Federal Reserve to pursue full employment and price stability, required that the central bank establish targets for the growth of various monetary aggregates, and provide a semiannual Monetary Policy Report to Congress. 5    Nevertheless, the employment half of the mandate appears to have had the upper hand when full employment and inflation came into conflict. As Fed Chairman  Arthur Burns  would later claim, full employment was the first priority in the minds of the public and the government, if not also at the Federal Reserve (Meltzer 2005). But there was also a clear sense that addressing the inflation problem head-on would have been too costly to the economy and jobs.

There had been a few earlier attempts to control inflation without the costly side effect of higher unemployment. The  Nixon administration introduced wage and price controls  over three phases between 1971 and 1974. Those controls only temporarily slowed the rise in prices while exacerbating shortages, particularly for food and energy. The Ford administration fared no better in its efforts. After declaring inflation “enemy number one,” the president in 1974 introduced the Whip Inflation Now (WIN) program, which consisted of voluntary measures to encourage more thrift. It was a failure.

By the late 1970s, the public had come to expect an inflationary bias to monetary policy. And they were increasingly unhappy with inflation. Survey after survey showed a deteriorating public confidence over the economy and government policy in the latter half of the 1970s. And often, inflation was identified as a special evil. Interest rates appeared to be on a secular rise since 1965 and spiked sharply higher still as the 1970s came to a close. During this time, business investment slowed, productivity faltered, and the nation’s trade balance with the rest of the world worsened. And inflation was widely viewed as either a significant contributing factor to the economic malaise or its primary basis.

But once in the position of having unacceptably high inflation and high unemployment, policymakers faced an unhappy dilemma. Fighting high unemployment would almost certainly drive inflation higher still, while fighting inflation would just as certainly cause unemployment to spike even higher.

In 1979,  Paul Volcker , formerly the president of the Federal Reserve Bank of New York, became chairman of the Federal Reserve Board. When he took office in August, year-over-year inflation was running above 11 percent, and national joblessness was just a shade under 6 percent. By this time, it was generally accepted that reducing inflation required greater control over the growth rate of reserves specifically, and broad money more generally. The Federal Open Market Committee (FOMC) had already begun establishing targets for the monetary aggregates as required by the Humphrey-Hawkins Act. But it was clear that sentiment was shifting with the new chairman and that stronger measures to control the growth of the money supply were required. In  October 1979 , the FOMC announced its intention to target reserve growth rather than the fed funds rate as its policy instrument.

Fighting inflation was now seen as necessary to achieve both objectives of the dual mandate, even if it temporarily caused a disruption to economic activity and, for a time, a higher rate of joblessness. In early 1980, Volcker said, “[M]y basic philosophy is over time we have no choice but to deal with the inflationary situation because over time inflation and the unemployment rate go together.… Isn’t that the lesson of the 1970s?” (Meltzer 2009, 1034).

Over time, greater control of reserve and money growth, while less than perfect, produced a desired slowing in inflation. This tighter reserve management was augmented by the introduction of credit controls in early 1980 and with the  Monetary Control Act . Over the course of 1980, interest rates spiked, fell briefly, and then spiked again. Lending activity fell, unemployment rose, and the economy entered a brief recession between January and July. Inflation fell but was still high even as the economy recovered in the second half of 1980.

But the Volcker Fed continued to press the fight against high inflation with a combination of higher interest rates and even slower reserve growth.  The economy entered recession again in July 1981, and this proved to be more severe and protracted, lasting until November 1982 . Unemployment peaked at nearly 11 percent, but inflation continued to move lower and by recession’s end, year-over-year inflation was back under 5 percent. In time, as the Fed’s commitment to low inflation gained credibility, unemployment retreated and the economy entered a period of sustained growth and stability. The Great Inflation was over.

By this time, macroeconomic theory had undergone a transformation, in large part informed by the economic lessons of the era. The important role public expectations play in the interplay between economic policy and economic performance became de rigueur in macroeconomic models. The importance of time-consistent policy choices—policies that do not sacrifice longer-term prosperity for short-term gains—and policy credibility became widely appreciated as necessary for good macroeconomic results.

Today central banks understand that a commitment to price stability is essential for good monetary policy and most, including the Federal Reserve, have adopted specific numerical objectives for inflation. To the extent they are credible, these numerical inflation targets have reintroduced an anchor to monetary policy. And in so doing, they have enhanced the transparency of monetary policy decisions and reduced uncertainty, now also understood to be necessary antecedents to the achievement of long-term growth and maximum employment.

• 1  The act also created the president’s Council of Economic Advisers.
• 2  The Phillips curve is a negative, statistical relationship between inflation (or nominal wage growth) and the rate of unemployment. It is named after British economist A.W. Phillips, who is often credited with the revelation of the relations. Phillips, A.W. "The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861–1957." Economica 25, no. 100 (1958): 283–99. http://www.jstor.org/stable/2550759 .
• 3  Dollars were convertible for gold by foreign governments and central banks. For domestic purposes, the US dollar was separated from gold in 1934 and has remained unconvertible since.
• 4  The concept of core inflation—the measurement of aggregate prices excluding food and energy goods—has its origin about this time.
• 5  The Humphrey-Hawkins Act expired in 2000; the Federal Reserve continues to provide its Monetary Policy Report to Congress on a semiannual basis.

Bibliography

Friedman, Milton. “The Role of Monetary Policy.” American Economic Review 58, no. 1 (March 1968): 1–17.

Gordon, Robert J. “Alternative Responses of Policy to External Supply Shocks.” Brookings Papers on Economic Activity 6, no. 1 (1975): 183–206.

Meltzer, Allan H., “ Origins of the Great Inflation ,” Federal Reserve Bank of St. Louis Review 87, no. 2, part 2 (March/April 2005): 145-75.

Meltzer, Allan H. A History of the Federal Reserve, Volume 2, Book 2, 1970-1986 . Chicago: University of Chicago Press, 2009.

Orphanides, Athanasios, “ Monetary Policy Rules Based on Real-Time Data ,” Finance and Economics Discussion Series 1998-03, Federal Reserve Board, Washington, DC, December 1997.

Orphanides, Athanasios, “ Monetary Policy Rules and the Great Inflation ,” Finance and Economics Discussion Series 2002-08, Federal Reserve Board, Washington, DC, January 2002.

Phelps, E.S. “ Phillips Curves, Expectations of Inflation and Optimal Unemployment Over Time .” Economica 34, no. 135 (August 1967): 254–81.

Phillips, A.W. " The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom 1861–1957 ." Economica 25, no. 100 (1958): 283–99.

Siegel, Jeremy J. Stocks for the Long Run: A Guide to Selecting Markets for Long-Term Growth , 2nd ed. New York: McGraw-Hill, 1994.

Steelman, Aaron. “ The Federal Reserve’s ‘Dual Mandate’: The Evolution of an Idea .” Federal Reserve Bank of Richmond Economic Brief no. 11-12 (December 2011).

Written as of November 22, 2013. See disclaimer .

Essays in this Time Period

• Launch of the Bretton Woods System
• Community Reinvestment Act of 1977
• Federal Reserve Reform Act of 1977
• Volcker's Announcement of Anti-Inflation Measures
• Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins)
• Garn-St Germain Depository Institutions Act of 1982
• Nixon Ends Convertibility of U.S. Dollars to Gold and Announces Wage/Price Controls
• Depository Institutions Deregulation and Monetary Control Act of 1980
• Oil Shock of 1973–74
• Oil Shock of 1978–79
• Recession of 1981–82
• Savings and Loan Crisis
• The Smithsonian Agreement

Related People

Arthur F. Burns Chairman

Board of Governors

1970 – 1978

Paul A. Volcker Chairman

1979 – 1987

Related Links

• FRASER: Origins of the Great Inflation

Federal Reserve History

Home — Essay Samples — Economics — Political Economy — Inflation

Essays on Inflation

Inflation essay topics and outline examples, essay title 1: understanding inflation: causes, effects, and economic policy responses.

Thesis Statement: This essay provides a comprehensive analysis of inflation, exploring its root causes, the economic and societal effects it generates, and the various policy measures employed by governments and central banks to manage and mitigate inflationary pressures.

• Introduction
• Defining Inflation: Concept and Measurement
• Causes of Inflation: Demand-Pull, Cost-Push, and Monetary Factors
• Effects of Inflation on Individuals, Businesses, and the Economy
• Inflationary Policies: Central Bank Actions and Government Interventions
• Case Studies: Historical Inflationary Periods and Their Consequences
• Challenges in Inflation Management: Balancing Growth and Price Stability

Essay Title 2: Inflation and Its Impact on Consumer Purchasing Power: A Closer Look at the Cost of Living

Thesis Statement: This essay focuses on the effects of inflation on consumer purchasing power, analyzing how rising prices affect the cost of living, household budgets, and the strategies individuals employ to cope with inflation-induced challenges.

• Inflation's Impact on Prices: Understanding the Cost of Living Index
• Consumer Behavior and Inflation: Adjustments in Spending Patterns
• Income Inequality and Inflation: Examining Disparities in Financial Resilience
• Financial Planning Strategies: Savings, Investments, and Inflation Hedges
• Government Interventions: Indexation, Wage Controls, and Social Programs
• The Global Perspective: Inflation in Different Economies and Regions

Essay Title 3: Hyperinflation and Economic Crises: Case Studies and Lessons from History

Thesis Statement: This essay explores hyperinflation as an extreme form of inflation, examines historical case studies of hyperinflationary crises, and draws lessons on the devastating economic and social consequences that result from unchecked inflationary pressures.

• Defining Hyperinflation: Thresholds and Characteristics
• Case Study 1: Weimar Republic (Germany) and the Hyperinflation of 1923
• Case Study 2: Zimbabwe's Hyperinflationary Collapse in the Late 2000s
• Impact on Society: Currency Devaluation, Poverty, and Social Unrest
• Responses and Recovery: Stabilizing Currencies and Rebuilding Economies
• Preventative Measures: Policies to Avoid Hyperinflationary Crises

The Impact of Inflation Reduction Act on The International Economic Stage

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The Oscillating Tides of The American Economy

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Methods to Control Inflation

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Main Factors of Inflation in Singapore

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• Unemployment
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• American Dream
• Real Estate
• Supply and Demand
• Minimum Wage

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College Term Paper

🖋 best way to write a great college term paper, term paper on inflation.

Inflation Term Paper:

Inflation is the unregulated increase of prices caused by the instability of a national currency. That means one can buy little amount of goods for big sum of money. moreover, the process of inflation is continuous, so one will have to pay more and more money for the same products. Inflation can occur when the economical situation of the country is weak, when the country produces very few resources and goods which can compete with the goods of other countries.

No wonder that the developing countries often experience the problem of inflation, because their economics is far from the one of the highly-developed states. The only way out and the most common one is to change the country’s currency. The stability of the nation’s currency depends on the gold standard. The gold standard is the most valid system of currency. The system is very simple: the more gold a country possesses, the more stable currency it will have and inflation will never be a threat to it. The connection between inflation and unemployment is very high. The higher rate of inflation is, the bigger percent of people is unemployed.

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The topic of inflation (especially in such countries as India or Bangladesh for example) is extremely important for every person in the world, no matter whether one is an economist or not, everybody will feel the impact of inflation on his financial condition.

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When a student has to complete a term paper on the topic, he usually feels disappointed, because the problem is really complicated and needs profound research and much time to understand it. One has to read carefully in order to realize the nature and the reasons of inflation. Good books, articles in periodicals, scientific publications, encyclopedias will be useful for every student to understand the topic well. Free example term papers on inflation and unemployment will be of a good help when one has problems with proper paper writing.

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Related Term Papers:

• Term Paper on Unemployment in Pakistan
• Term Paper on Economics
• Term Paper on Global Financial Crisis
• Inflation Unemplyment Growth

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Stubborn Inflation Could Prod Fed to Keep Rates High for Longer

Hopes for substantial cuts in interest rates are fading as inflation shows more staying power than expected.

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By Jeanna Smialek and Ben Casselman

Reporting from Washington and New York

Investors are giving up on dreams of imminent rate cuts as inflation remains stubborn, a problem that could prod Federal Reserve policymakers to keep borrowing costs high for a longer period.

The latest reading of the Fed’s most closely watched inflation measure, released on Friday, showed that price increases remain notably faster than the Fed’s 2 percent goal.

The Personal Consumption Expenditures index rose 2.7 percent in March from a year earlier, up from 2.5 percent in February. And after stripping out volatile food and fuel prices for a clearer reading of price trends, inflation remained steady at 2.8 percent on an annual basis.

The report was just the latest sign that, after months of steady improvement in 2023, progress on cooling inflation is stalling out in 2024. And that unexpected roadblock has caused policymakers, economists and investors to question how soon and how much the Fed might be able to cut borrowing costs. Jerome H. Powell, the Fed chair, signaled last week that central bankers were not seeing the progress that they were hoping to witness before lowering rates.

The Fed meets next week in Washington to discuss its next rate move. While it is widely expected to leave interest rates unchanged in its May 1 decision, investors will watch a news conference with Mr. Powell closely for hints about how long rates are likely to stay on hold. If inflation continues to remain sticky in the months to come, it could prod officials to keep interest rates at their current relatively high level for an extended time as they try to tap the brakes on the economy and snuff out price increases more fully.

“There’s a much greater uncertainty about the disinflationary path,” said Matthew Luzzetti, chief U.S. economist at Deutsche Bank, noting that “you’re continuing to see an economy that’s chugging along quite well.”

Policymakers raised interest rates to 5.33 percent between March 2022 and last summer, and have held them steady since. They think that is high enough to eventually weigh on the economy — in economics parlance, it is “restrictive.”

But some economists have begun to question just how restrictive the Fed’s current rate setting is, because growth has remained solid and hiring rapid even after months of relatively high rates.

Data released Friday showed that momentum continued in March: Consumer spending rose 0.8 percent for the second consecutive month, ahead of forecasters’ expectations. That spending is being supported by a strong market that is pushing up wages: Americans’ after-tax income in March significantly outpaced price increases for the first time since December.

Separate data from a University of Michigan survey on Friday showed that consumers had become slightly more pessimistic in April about the outlook for both the economy as a whole and inflation in particular.

Stock indexes rose on Friday morning, in part because Wall Street had been bracing for a slightly worse inflation report after data released on Thursday suggested that price gains might have been hotter in March than the Personal Consumption Expenditure figures showed.

Friday’s figures “could be viewed with a sigh of relief,” Omair Sharif, founder of Inflation Insights, wrote in a note following the report.

Even so, investors see a greater chance of a long period of high rates — which tend to dent stock prices — than they did a month or even just a week ago. Investors are now betting that the Fed might make its first move in September or later, based on market pricing . A small but growing share think that the central bank may not manage to cut rates at all this year.

Given the economy’s momentum, some economists are even wondering if Fed officials could begin to contemplate raising rates again.

Fed governor Michelle Bowman has already said that while it was not her “base line outlook,” she saw “the risk that at a future meeting we may need to increase the policy rate further.”

While markets are likely to fixate on whether rates might increase again, it is more likely that the Fed will simply hold them at a high level for longer, said Blerina Uruci, chief U.S. economist at T. Rowe Price.

It would likely take an outright acceleration in inflation to prod the Fed to lift borrowing costs again, she said, rather than just the stalled progress seen in recent months.

“I don’t think we’re at the point where we need to talk about increasing interest rates this year,” Ms. Uruci said. “But we’re certainly at the point where we need to talk about fewer cuts.”

Many economists think that inflation is still likely to slow further, in part because cooler new rent prices are still slowly feeding into official inflation data. But the process is taking longer than many had expected, and with the economy so solid, the risk that inflation could remain firm has grown.

Plus, economists have regularly found their predictions for inflation upended by economic surprises in recent years: It was not expected to climb as quickly as it did in 2021 and 2022, and then it fell slightly faster than many had anticipated late last year. Now, its flatlining has been a surprise.

“After the past several years, you have to be humble,” Mr. Luzzetti said.

Higher interest rates are meant to rein in inflation by making consumers and businesses more reluctant to spend. That appears to have happened to some degree: High mortgage rates led to a sharp slowdown in the housing market, and businesses have pulled back on capital investments and posted fewer job openings.

But the economy as a whole has proved remarkably resilient to the effects of high borrowing costs. Consumers have been particularly undeterred, opting to draw down savings and rack up credit card debt even as they have complained about high prices. Americans saved just 3.2 percent of their after-tax income in March, the lowest rate since 2022.

At Portland Gear, a clothing retailer in Portland, Ore., sales keep setting records as customers snap up $79 sweatshirts and $36 baseball caps, said Marcus Harvey, the company’s founder.

“Consumers might say that things are getting expensive, but their buying habits aren’t really saying that,” he said.

As a result, Mr. Harvey is continuing to invest, despite the pinch of high interest rates. The company recently opened a flagship store in downtown Portland and is opening a location in the city’s airport.

“It is what it is: For the next five years, rates are going to be high,” Mr. Harvey said. “You just can’t do anything about it. Business goes on. Life goes on.”

Jeanna Smialek covers the Federal Reserve and the economy for The Times from Washington. More about Jeanna Smialek

Ben Casselman writes about economics with a particular focus on stories involving data. He has covered the economy for nearly 20 years, and his recent work has focused on how trends in labor, politics, technology and demographics have shaped the way we live and work. More about Ben Casselman

Why experts say inflation is relatively low but voters feel differently

A lot goes into planning a personal budget – and the price of food and how it fluctuates with inflation can be a big part of that.

According to the U.S. Department of Agriculture, food prices rose by 25 percent from 2019 to 2023 . And a report from Purdue University found that a majority of consumers expect food prices to keep rising in the coming year .

Are food prices as bad as consumers think?

All Things Considered host Ailsa Chang spoke with Joseph Balagtas, a professor of agricultural economics at Purdue University and the lead author of that report.

This interview has been lightly edited for length and clarity.

Ailsa Chang: The majority of consumers are predicting rising food prices. And, yeah, we definitely saw a hike in food prices during and after the pandemic. But what is actually happening right now with food and grocery prices? Are things as bad as some consumers fear?

Joseph Balagtas: So the Bureau of Labor Statistics just two weeks ago released its latest inflation data from the Consumer Price Index [CPI]. Food prices in March were 2.2 percent higher than they were in March 2023. So a 2.2 percent increase in food prices over the past year.

Chang: And how bad is that?

Balagtas: That is relatively low. Low relative to the food price inflation that we've seen over the past two years. Food price inflation peaked in the summer of 2022 at about 10 or 11 percent per year, and has been coming down regularly, has been under three percent in 2024 and is at its lowest point – 2.2 percent – that we've seen since [the] end of 2021.

Chang: Yeah. And it being 2024 now, an election year, your report also looked at how people's political leanings affect their view of inflation. I'm so curious what you saw there.

Balagtas: Yeah. So we asked people in our monthly survey to tell us how food prices have changed over the past year. And it gives us a measure of perceived inflation that we could compare to the CPI. And interestingly, for the last eight months, consumers have been reporting price inflation in the range of six and seven percent, well above what food price inflation has been, according to the CPI.

Chang: And how did that pessimism break down according to political affiliation?

Balagtas: It's not only a political issue. Both Democrats and Republicans tell us if inflation is higher over the last year than what we're seeing in the CPI. But Republicans are reporting an inflation that's ... one percentage point and a half higher than Democrats. So Republicans are telling us 7.3 percent higher, Democrats 5.7 percent higher.

Chang: Okay. Regardless, though, both sides are overstating food inflation. Why do you think that is? Why do you think consumers across the board seem to be overestimating how much food prices are going up?

Balagtas: It could be that consumers – they're not measuring prices relative to exactly a year ago, which is what the Bureau of Labor Statistics does when it reports 2.2 percent inflation. So they might be looking at a longer time horizon. They might be thinking back to a time, you know, "remember when egg prices were such-and-such". We don't necessarily live in one month and 12 month increments like the CPI is reported.

Chang: And how much do you sense food prices drive the way voters actually vote?

Balagtas: Yeah, well, so I think the economy in general affects presidential elections. I think good economic conditions help the incumbent, bad economic conditions harm the incumbent. You know, we haven't seen food price inflation like this in an election year in some time. And so I'm not quite sure how to predict how that would be. But I think if price inflation in general were to increase again over the coming six months, I think that'd be bad for the incumbent.

Chang: And as we get closer and closer to November, do you expect food prices specifically to be a major thing that all the candidates will be talking about?

Balagtas: I'd say that most of the drivers of higher food prices have gone away. The one that's lingered is high labor costs. And so we see sustained higher prices or faster inflation in items that are labor intensive, including restaurant meals and packaged foods. So we're going to see higher food prices in some items. I don't think – and I certainly don't hope – that we return to the fast food price inflation that we saw last year or the year before.

The radio version of this piece was produced by Elena Burnett and edited by William Troop.

Copyright 2024 NPR. To see more, visit https://www.npr.org.