Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods. Inflation aims to measure the overall impact of price changes for a diversified set of products and services, and allows for a single value representation of the increase in the price level of goods and services in an economy over a period of time. As a currency loses value, prices rise and it buys fewer goods and services. This loss of purchasing power impacts the general cost of living for the common public which ultimately leads to a deceleration in economic growth. The consensus view among economists is that sustained inflation occurs when a nation's money supply growth outpaces economic growth.
Causes of Inflation
Demand-pull inflation - Demand-pull inflation happens when the demand for certain goods and services is greater than the economy's ability to meet those demands. When this demand outpaces supply, there's an upward pressure on prices causing inflation.
Cost-push inflation - Cost-push inflation is the increase of prices when the cost of wages and materials goes up. These costs are often passed down to consumers in the form of higher prices for those goods and services.
Increased money supply - Increased money supply is defined as the total amount of money in circulation, which includes cash, coins, and balances and bank accounts according to the Federal Reserve.
Devaluation - Devaluation is downward adjustment in a country's exchange rate, resulting in lower values for a country's currency.
Rising wages - Some believe that an increase in wages could result in cost-push inflation due to the higher cost to businesses, while others believe that higher wages across the board (not just concentrated in certain sectors) will also increase demand enough to offset a spike in prices.
Methods to Control Inflation
Monetary policy – Higher interest rates reduce demand in the economy, leading to lower economic growth and lower inflation.
Control of money supply – Monetarists argue there is a close link between the money supply and inflation, therefore controlling money supply can control inflation.
Supply-side policies – policies to increase the competitiveness and efficiency of the economy, putting downward pressure on long-term costs.
Fiscal policy – a higher rate of income tax could reduce spending, demand and inflationary pressures.
Wage controls – trying to control wages could, in theory, help to reduce inflationary pressures. However, apart from the 1970s, it has been rarely used.
Inflation can impose a real cost on society in terms of the efficiency with which the exchange mechanism works, by distorting the incentives to save, invest, and work, and by providing incorrect signals that needlessly alter production and work effort. Because of this, policymakers should be concerned with the ongoing rate of inflation and any tendency for it to accelerate. An additional reason for concern arises because efforts to reduce the rate of inflation have often been associated with economic downturns.