Inflation is a term you hear frequently in economics, and for good reason. It has been a major factor in economic instability throughout history. Central bankers are often judged by their success in controlling it, and politicians rise and fall based on their promises and failures to manage inflation. In fact, it was once declared “Public Enemy No. 1” in the United States. So, what exactly is inflation, and why is it considered so important?
Inflation is defined as the rate at which the general level of prices for goods and services is rising, and consequently, the purchasing power of currency is falling. It’s usually measured over a year, indicating how much more expensive things have become compared to the previous year. While inflation is typically discussed broadly, like the overall price increase in a country, it can also be measured for specific items, such as the rising cost of food or services like haircuts. Regardless of the scope, inflation essentially tells us the percentage increase in the cost of a particular set of goods or services over a period of time.
Measuring Inflation: How Do We Know Prices Are Rising?
To understand the impact of inflation on everyday life, we need to measure the cost of living for consumers. This cost is determined by the prices of numerous goods and services and how much of our budget we spend on each. To track this, government agencies conduct regular household surveys. These surveys identify a representative “basket” of commonly purchased items. This basket includes everything from groceries and gasoline to housing and healthcare. By monitoring the cost of this basket over time, we can gauge how the average consumer’s expenses are changing. In the United States, for example, housing costs, including rent and mortgages, make up the largest portion of this consumer basket.
The Consumer Price Index (CPI) is calculated based on the cost of this basket in relation to a base year. The CPI represents the cost of the basket at a specific time compared to its cost in a base year. Consumer price inflation is then the percentage change in the CPI over a period, typically a year, and is the most widely recognized measure of inflation. For instance, if the CPI was 100 in the base year and is currently 110, it indicates a 10 percent inflation rate over that period.
Core inflation provides a deeper look at the persistent inflation trends. It excludes prices that are heavily influenced by government policies or are highly volatile, such as food and energy prices. These items are often subject to seasonal fluctuations or temporary supply disruptions. Policymakers pay close attention to core inflation as it gives a clearer picture of underlying inflationary pressures in the economy.
To measure inflation across the entire economy, not just for consumers, a broader index like the GDP deflator is used. The GDP deflator measures the average price change for all goods and services produced in an economy.
While the CPI basket is generally kept consistent to allow for accurate comparisons over time, it is periodically updated to reflect shifts in consumer spending habits. This might involve including new technology products or removing items that are no longer commonly purchased. The GDP deflator, on the other hand, changes its composition annually, making it more current than the CPI basket because it reflects the actual goods and services produced each year. However, it’s important to note that the GDP deflator includes non-consumer items like government military spending, making it less suitable for measuring the cost of living specifically.
The Double-Edged Sword: Is Inflation Always Bad?
When inflation rises, and household nominal income (the actual money earned) doesn’t keep pace with price increases, people become worse off. This is because their purchasing power, or real income (income adjusted for inflation), decreases. Real income is a key indicator of the standard of living; when real incomes rise, the standard of living generally improves, and vice versa.
Prices don’t all rise uniformly during inflation. Some, like globally traded commodities, fluctuate daily, while others, such as wages set by contracts, adjust more slowly – economists call this “sticky” prices. This uneven price increase pattern in inflationary times inevitably reduces the purchasing power of some consumers. This erosion of real income is considered the primary negative consequence of inflation.
Inflation also distorts the value of money over time, especially for those dealing with fixed interest rates. Consider pensioners receiving a fixed 5 percent annual pension increase. If inflation exceeds 5 percent, their purchasing power declines. Conversely, a borrower with a fixed 5 percent mortgage benefits from 5 percent inflation because the real interest rate (the nominal interest rate minus inflation) becomes zero. Debt repayment becomes easier as inflation rises, assuming the borrower’s income keeps up. However, the lender’s real income suffers in this scenario. If inflation isn’t accurately factored into nominal interest rates, there will be winners and losers in terms of purchasing power.
Many countries have experienced the harsh realities of high inflation, and in extreme cases, hyperinflation, defined as inflation exceeding 1,000 percent annually. Zimbabwe in 2008 faced one of history’s worst hyperinflations, with annual inflation reaching an estimated 500 billion percent at its peak. Such extreme inflation is devastating, forcing countries to implement drastic and often painful measures to regain control, sometimes even abandoning their national currency, as Zimbabwe did.
However, while high inflation is detrimental, deflation, or falling prices, is also undesirable. When prices are falling, consumers tend to postpone purchases, anticipating even lower prices in the future. This leads to decreased economic activity, reduced income for businesses, and slower economic growth. Japan’s prolonged period of near-zero economic growth is often attributed to deflation. Preventing deflation was a key concern during the global financial crisis of 2007. Central banks like the US Federal Reserve maintained low interest rates and implemented other monetary policies to ensure sufficient liquidity in financial systems.
Most economists today agree that low, stable, and, crucially, predictable inflation is beneficial for a healthy economy. When inflation is low and predictable, it’s easier to incorporate it into contracts and interest rates, minimizing its disruptive effects. Furthermore, a slight expectation of future price increases can incentivize consumers to make purchases sooner, which stimulates economic activity. Many central banks now prioritize maintaining low and stable inflation as their primary policy objective, a strategy known as inflation targeting.
What Causes Inflation? Understanding the Drivers
Sustained periods of high inflation are often linked to loose monetary policy. If the money supply grows faster than the economy’s output, the value of currency decreases; in other words, purchasing power declines, and prices rise. This relationship is described by the quantity theory of money, one of the oldest principles in economics.
Supply shocks and demand shocks can also trigger inflation. Supply shocks, such as natural disasters or spikes in oil prices, disrupt production or increase costs. This can lead to “cost-push” inflation, where price increases are driven by supply-side disruptions. The global food and fuel inflation of 2008 is a prime example, where soaring food and fuel prices spread globally through trade.
Conversely, demand shocks, like a stock market boom or expansionary policies (e.g., interest rate cuts or increased government spending), can temporarily boost demand and economic growth. However, if demand outstrips the economy’s production capacity, it creates pressure on resources, resulting in “demand-pull” inflation. Policymakers face the challenge of balancing demand stimulation and growth without over-stimulating the economy and triggering inflation.
Expectations play a crucial role in shaping inflation. If people and businesses anticipate higher prices in the future, they factor these expectations into wage negotiations and price contracts (like automatic rent increases). This behavior becomes self-fulfilling; when contracts are executed and wages or prices rise as agreed, it contributes to actual inflation. When expectations are based on recent inflation trends, inflation tends to persist over time, creating inflation inertia.
How Policymakers Combat Inflation: Tools and Strategies
The appropriate disinflationary policies (measures to reduce inflation) depend on the underlying causes of inflation. If the economy is overheating due to excessive demand, central banks committed to price stability can implement contractionary policies. These policies aim to curb aggregate demand, typically by raising interest rates, making borrowing more expensive and cooling down economic activity.
Some central banks have attempted to control inflation by fixing the exchange rate, pegging their currency’s value to another currency. This effectively links their monetary policy to that of the country whose currency they are pegged to. However, this approach may be ineffective when inflation is driven by global factors rather than domestic ones. For instance, during the global inflation surge of 2008, driven by high food and fuel prices, many countries allowed global prices to pass through to their domestic economies. In some cases, governments may directly intervene by setting prices (administrative price-setting) to prevent price increases from being passed on, though this can lead to large government subsidies to compensate producers.
Increasingly, central banks are leveraging their ability to influence inflation expectations as a tool to manage inflation. Policymakers communicate their commitment to temporarily slowing economic activity to curb inflation, aiming to shape expectations and reduce the inflationary component built into contracts. The more credible a central bank is, the greater its influence on inflation expectations.
Ceyda Oner is a Deputy Division Chief in the IMF’s Finance Department.
Disclaimer: Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.
