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. The price of the same basket of goods in the shops rises over time meaning that the value of money falls.
If prices of some individual products rise, this is not inflation in the real sense. The price of a particular product may increase if it is currently in high demand or if the production or distribution of the product is disturbed, leading to a fall in supply. Such price increases are usually called relative price changes, which is to say that some individual prices rise relative to others. This is not inflation. For inflation to be present, the general price level should rise.
A consumer price index is often used as a measure of the general price level. This measures the price of an average basket of a variety of goods and services purchased by Swedish consumers. Statistics Sweden calculates the consumer price index each month, along with a number of different variations of this measure. These measures are certainly affected by changes in the price of a few individual products, that is to say by changes in relative prices, but what inflation really means is a broader price increase in the consumer basket.
See also: How is inflation measured?
How does inflation arise?
Inflation may arise if demand in the economy is strong, such as in an economic upswing. Households then demand many goods and services, and it is easier for companies to raise prices. The price of the basket measured by Statistics Sweden will then rise.
Inflation may also arise if companies’ costs increase, for example for wages and energy or other factors used in production. Companies may then raise their prices in step with the cost increases. What starts with an increase in energy prices, for example – which is actually a relative price change – can spread to other prices. The result is that the overall price level rises, that is, that there is inflation.
One important factor is the level of inflation households and companies expect to see in the future. For example, if they expect inflation to be high, they will adjust their prices and wage demands accordingly. This, in turn, makes price and wage increases high, leading households and companies to continue to expect high inflation, and so on. The Riksbank may then need to raise its policy rate strongly in order to reduce activity in the economy and break the inflation spiral. If households and companies instead expect inflation to be 2 per cent in the future, which is the Riksbank’s inflation target, this will help the Riksbank to maintain the target.
The Riksbank’s main tool for holding inflation at 2 per cent is the policy rate. Using the policy rate allows the Riksbank to influence demand in the economy and inflation expectations.
See also: How monetary policy affects inflation