Inflation is a 'persistent (or sustained) increase in the average level of prices'.
This results in fall in the currency's purchasing power. In other words consumers can buy fewer goods and services with each unit of their currency. It is important not to confuse inflation with an increase in the price of a particular good or service - it is the overall level of all prices that is important.
Alternatively, if there is a persistent fall in the average level of prices in an economy, this is referred to as 'deflation'. Japan has had a history of struggling with deflation, particularly in the 1990s, and has recently experienced it again.
Changes in inflation are usually measured through the calculation of a Consumer Price Index (CPI) or Retail Price Index (RPI). The CPI measures the movements in prices of a typical 'basket' of goods and services consumed by the 'average' consumer. The changes are weighted to take account of how much income people spend on certain items. When the price of a basket increases, then this means that the average price level has risen. The US Bureau of Labor Statistics publishes a range of information on the US economy including inflation and the weights attached to goods in the average US basket.
Causes of inflation
Inflation has several potential causes, though quite often it is the result of a combination of the following factors.
- Demand led or demand-pull inflation. This is when demand within an economy is greater than the ability of the economy to supply. As such we normally forecast that prices will rise to ration the amount available. High levels of employment, high levels of consumer income and easy access to relatively cheap credit facilities often cause this type of inflation. A simple analogy is an auction; if there are lots of bidders for a particular product - its price will rise.
- Cost inflation (also called cost-push inflation) is caused by increasing costs of manufacturing inputs, such as raw materials, energy and wages forcing companies to increase prices (elasticity permitting) to maintain their profit margins.
- Changes in money supply - this 'monetarist' interpretation of inflation centres on the supply (amount) of money increasing faster than output. In simple terms it is caused by 'too much money chasing too few goods'. This can be made worse if the supply of money increases. This might happen as the result of government printing more money or banks increasing access to credit, such as the process of 'Quantitative Easing'.
- One other possible cause in the mind of some economists is that of expectations. If consumers think that prices will rise in the near future, they buy now before the price rise and so actually cause inflationary pressure as demand increases.
One of the most extreme examples of inflation out of control was that experienced in Zimbabwe. The BBC has produced an excellent question and answer article on hyperinflation in Zimbabwe explaining the underlying factors. By December 2008, inflation in Zimbabwe was estimated at 6.5 quindecillion novemdecillion percent (65 followed by 107 zeros). In April 2009, Zimbabwe abandoned printing of the Zimbabwean dollar, and the South African rand and US dollar became the standard currencies for exchange.
Problems associated with inflation
For some economists, inflation is the root of all economic problems. High inflation may certainly affect business in various negative ways:
- It will impact on sales and cause them to fall as prices increase.
- The national economy will lose part of its international competitiveness and this will reduce earnings from exports - this will particularly affect firms who export a large proportion of their output.
- The increase in prices will put pressure on employees to seek compensatory wage claims.
- Business will feel less secure regarding future planning, such as investment in new factories or machinery.
- The value of investments is destroyed over time.
- It can be economically disastrous for lenders.
- Government control of the economy to restrain inflation, such as increases in interest rates or increases in taxation can restrain economic development of the country and damage business performance.
- High levels of inflation tend to lead to economic stagnation.
When inflation is low:
- Interest rates will be low and that means low costs of borrowing.
- Export prices should be competitive.
- Business is operating against a less uncertain background and can therefore plan with more consistency.
- Costs are lower as prices seldom change.
- Firms have to be competitive, as they can't pass on prices rises as easily as they can when prices are rising.
To allow inflation comparisons between EU countries, the method of calculating the CPI has been standardised. This is referred to as the Harmonised Index of Consumer Prices (HICP).
The HICP differs from the US CPI by excluding owner-occupied housing from its scope. However, the Bureau of Labor Statistics, the producer of the US CPI, has recently calculated an experimental index designed for direct comparison with the HICP.
An interactive diagram of annual percentage changes in inflation rates in the Euro area (1996 - 2009) can be seen here or can be opened in the window below.