Inflation is the increase in the general level of prices of goods and services in an economy. It is normally expressed as a percentage and is usually determined by comparing the prices of a given basket of goods and services in a given period of time to the prices of the same basket in a different period of time. In this article, we will define what inflation is, how it is measured, and what consequences it brings to the economy.
The main source of inflation is an increase in the supply of money relative to the demand for goods and services. When there is more money in the society than there are goods and services to buy, people will have to pay more money for the goods and services that they require, thus increasing the prices. Inflation can also be ascribed to other factors like increase in the cost of production or supply shortage of goods and services.
Inflation is usually determined by the country’s central bank or by a statistical agency using a specific basket of goods and services that are typical of the economy. This basket is referred to as the consumer price index (CPI) and includes things like food, clothes, shelter, and transportation. The CPI is used to work out the change in the price of the basket over time, which is called the inflation rate.
The effects of inflation on the economy can be positive or negative depending on the level and rate of inflation. Moderate and predictable inflation is generally regarded as being beneficial to the economy because it helps individuals and firms to know what to expect in the future and how to use their resources wisely. However, high and volatile inflation can be negative and can pose a threat to the stability of the economy. High inflation also erodes the value of money, because people need more money to purchase the same goods and services.
There are several ways through which governments and central banks attempt to control inflation. A usual practice is to vary interest rates which can affect the amount of money in circulation. When interest rates are high, then people will not access credit facilities and this will decrease the supply of money in the economy and thus control inflation. On the other hand, when interest rates are low, then people will want to borrow money and this will increase the supply of money in the economy and may lead to higher inflation.
Another way which governments and central banks can control inflation is through the use of monetary policy. This is the application of tools such as setting inflation targets, controlling the amount of money in the system or changing the exchange rate. For instance, a central bank may set an inflation target and then employ monetary policy measures in an effort to achieve that target.
There are other factors that can lead to change in inflation rate in the economy. One of these is the level of economic activity which is the actual level of production and consumption of goods and services in the economy. When the economic growth is positive and there is a high demand for goods and services then it leads to increase in prices and may cause inflation. On the other hand, when the economy is contracting and there is low aggregate demand then this may lead to a decline in prices and possibly deflation.
Inflation can also be stimulated by factors outside the domestic economy such as the level of global demand or the exchange rate. For instance, if there is an increase in the demand for a country’s export goods then it will increase the prices and may lead to inflation. For instance, changes in the exchange rate between a country’s currencyand other currencies will affect the price of imported goods and services and may also affect inflation.
In conclusion, inflation is the increase in the price of goods and services in the economy with reference to a specific time frame. It is usually brought about by the increase in the supply of money compared to the demand for goods and services and is measured by the consumer price index (CPI). Inflation considered moderate and constant is generally regarded as beneficial to the economy, but high and volatile inflation may lead to uncertainties and undermine the stability of the economy. Governments and central banks employ tools like interest rates and monetary policy to fight inflation and there are many factors that can cause inflation in the economy such as economic activity and other factors including demand and exchange rates.