Inflation

A sustained increase in the general price level. Because inflation is an indicator of the general upward movement of prices, it is normally measured by an index of prices, the most popular and influential being the consumer price index (CPI)—a normal rather than luxurious basket of goods and services consumed by typical urban consumers.

There is no consensus on the reasons for inflation, but some economists argue that it is a monetary phenomenon; meaning that it is the result of a rapid increase in the money supply (growth) relative to the production of output. In a simplistic monetary expression, inflation may be defined as “too much money chasing too few goods.”

Economists, more often than not, distinguish between two types of inflation: (1) demand pull and (2) cost push. Demand-pull inflation occurs when the general price level increases because total spending exceeds an economy's capacity to produce. Cost-push inflation occurs not because total spending exceeds an economy's capacity to produce but because the cost of production is so high that it puts an upward pressure on the general price level. This form of inflation is largely attributable to resource or input cost. Resource cost may generate supply shocks in the form of escalating oil prices, as was the case in the 1970s, or prices of other raw materials.

Inflation bids up the cost of borrowing money. Monetary authorities raise the interest rate to check perceived excessive spending in order to stabilize prices, but creditors also revise their expectations of inflation upward and therefore increase interest rates to offset the inflation premium. Additionally, as real income (purchasing power) falls, owners of assets convert their assets into cash to neutralize price increases. Bond prices fall, and interest rates increases.

[Page 256]Fixed-income receivers, savers, and creditors are normally hurt by inflation when adjustments are not made to compensate for escalating prices.