QandAs: Finance

What Is Inflation?

Answer:
In economic terms, inflation is the rise in the prices of goods and services in the given economy over a period of time.

As the prices rise, each unit of the country’s currency will buy fewer goods and services.

Another way to think of inflation is that it is an erosion of the power of money. It is a loss of real value of the currency of the nation. The main measure of inflation is the inflation rate, which is the annualized percentage change in the general price index over time.

Inflation will have both negative and positive effects on the overall economy. Negative effects of inflation include the following: a loss in the stability of the real value of money and other monetary items over time; uncertainty about future inflation can discourage saving and investing; and high inflation rates can lead to shortages of goods as people begin hoarding over concerns over future price hikes. Positive effects can include an easing of a recession, as well as providing debt relief by reducing the real level of debt.

High rates of inflation and hyperinflation are usually caused by the money supply growing too quickly. Low or mild inflation can be caused by several factors, such as variations in the real demand for goods and services, changes in supplies during scarcities, or growth in the money supply. The consensus view among economists is that long sustained periods of inflation are caused by the country’s money supply growing at a faster rate than the rate of economic growth.

A low steady rate of inflation is preferred by most economists. Low inflation can reduce the severity of a recession by allowing the labor market to adjust more quickly during a downturn, as well as reduce the risk that a liquidity trap will prevent monetary policy from stabilizing the economy. Monetary authorities usually have the responsibility of keeping the inflation rate low. In most countries, the monetary authorities are the central banks. They control the size of the money supply by setting interest rates, by operating in the open market, and by setting bank reserve regulations.

Originally, inflation referred to the debasement of the currency. In that past, when gold was used as a currency, the government would collect those gold coins, melt them down and mix them with other materials, and then reissue them at the same face value. They could then issue more coins, increasing the money supply. However, this would lower the relative value of each coin, causing prices to rise.