What is inflation?

Most people probably know that inflation means that prices rise. But not all price increases are inflation. Some goods increase in price because they become more difficult to get hold of. For instance, the oil price may rise as oil reserves diminish. Such price increases are usually called relative price increases and are thus not inflation. For inflation to exist there should be an increase in the general price level, that is, all prices in the economy shall increase. 

 

The fact that the oil price rises may be due to oil becoming an increasingly scarce resource, but it can also be part of a general price upswing and may in this case be part of an inflation process. One can thus say that a consequence of inflation is that the price of individual goods and services rises. But one cannot look at the way an individual price changes to determine whether it is inflation or a change in relative prices.

 

One usually also makes a distinction between one-off increases in the general price level and inflation. If the Government raises VAT, prices will rise. But what happens to the general price level? If the only thing to occur is that the Government raises VAT, the general price level will rise from one level to another, and then remain still. An increase in the VAT rate thus gives rise to a one-off increase in the general price level. But the increase in VAT does not lead to prices continuing to rise. One therefore does not usually call the effects of such an increase in VAT inflation. To be inflation, the rate of increase in the general price level must change.

How does inflation arise?

Inflation can arise in a number of ways. One way is if a central bank supplies too much money. Then prices will rise and the value of the money will be undermined. The famous economist and winner of the Sveriges Riksbank Prize in Economic Sciences in memory of Alfred Nobel Milton Friedman said that “Inflation is always and everywhere a monetary phenomenon”. The most well-known examples of periods of high inflation, so-called hyperinflation, were also characterised by a drop in the value of money due to central banks printing excessive quantities of banknotes. 

 

Another way that inflation can arise is if people want to buy more goods and services than the companies can produce. Yet another is if the costs of producing the goods and services increase. This may be because wages have risen, for instance. The companies may then need to raise their prices as compensation for rising production costs. But inflation can also arise if companies and households believe that everything will become more expensive. Employees demand higher wages to be able to buy as much in the future. Employers may more readily agree to raise wages. They see an opportunity to raise their prices. Expectations of higher inflation may thus be self-fulfilling. 

 

You can read more about Milton Friedman’s work among the other winners of the Sveriges Riksbank Prize in Economic Sciences in memory of Alfred Nobel. You can read more about the meaning of the word inflation in the article.

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