Inflation is the overall increase in price of goods/services over time.
Unless the volume of production and trade grows at the same rate as the money supply, there will be inflation.
Inflation is a concept, not a number. To say that "inflation is at 5% this year" is a misnomer. Rather, what this person means to say is that the Consumer Price Index (as defined by the government) has gotten 5% more expensive this year. Not everything in the economy is part of this CPI.
An analysis of inflation is incomplete until we have assessed how much the absolute increase in price we will be impacted with.
- ex. if the CPI rose 5% this year, and gasoline specifically rose 33%, you have then ask the question: "how much do I spend on gas anyway?". Maybe your overall gas expense rises from $1000/year to $1330/year, which may be considered immaterial.
The rationale that "if inflation is 5% this year then our money is worth 5% less" is a bit misguided, and is based on this oversimplification of an index like the CPI. Inflation rising by 5% only means that your money is worth 5% less for those goods in the index, and somewhat disproportionally too.
- Often, there is great disproportion in price changes of some members of the CPI. For instance, maybe transportation prices rise 9.1%, but housing only rises by 3.9%.
- ques: is saying "housing prices rose by 5%" the same as saying housing market rose by 5%?
It is the combination of Fiscal Policy and Monetary Policy that the central bank uses to influence inflation.
There are different schools of thought as to the causes of inflation. Most can be divided into two broad areas: quality theories of inflation and quantity theories of inflation.
- The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods they desire as a buyer.
- The quantity theory of inflation rests on the quantity equation of money that relates the money supply, its velocity, and the nominal value of exchanges.
- widely accepted as an accurate model of inflation in the long run.
In the long run, the inflation rate is essentially dependent on the growth rate of the money supply relative to the growth of the economy. On the other hand, in the short and medium term, inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates.
caused by increases in aggregate demand due to increased private and government spending This occurs when the demand for certain goods/services is greater than the economy's ability to meet those demands.
- ex. There were virtually no public concerts in 2020 due to Covid, increasing demand for concerts when they reopened again in 2021.
caused by a drop in aggregate supply (potential output) This occurs when the cost of wages and materials goes up.
- ex. the cost of mobile phone circuitry rises, pushing the price of iPhones up
- ex. when the cost of lumber rises, there is a commensurate rise in housing prices.
Changes in Money Supply
The central bank can issue bonds (ie. increase the money in circulation, causing inflation), or buy back bonds
- If the money supply increases faster than the rate of production, this could result in demand-pull inflation (since there will be too many dollars chasing too few products).
The devaluation of a currency makes a country's exports less expensive, encouraging foreign nations to buy more of the devalued goods.
- Devaluation also makes foreign products for the devaluing country more expensive which encourages citizens of the devaluing country to buy domestic products over foreign imports.