What is inflation?
Inflation is an increase in the general price level that means you can buy fewer goods and services for the same amount of money. Money thus declines in value. For example, this means that the price of the same basket of goods from a shop rises over time.
If prices of some individual goods or services rise, this is not inflation. Prices of individual goods and services can rise because, for instance, it is more difficult to get hold of them. For instance, the price of oil 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, prices in general should rise. And if one is to call it inflation, the price increase should be lasting. If, for instance, the government raises VAT, this has a one-off effect on the general price level, but does not lead to prices continuing to rise.
How does inflation arise?
There are many reasons why inflation arises.
- If a central bank supplies too much money, prices rise and the value of money is undermined. The most well-known examples of periods of very 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.
- Large demand – people want to buy more goods and services than the companies are able to produce.
- If the costs of producing goods and services increase, companies may need to raise their prices in compensation for rising production costs. This may be because wages have risen or because oil has become more expensive.
- Expectations – if companies and households believe that prices will increase, the employees can demand higher wages in compensation, which companies may in turn compensate for by raising their prices. This means that by expecting inflation, one has created inflation. This may lead to the economy getting into an upward spiral of rising wages and prices that may be difficult to halt.