DEFINITION: Inflation denotes an increase in the amount of money (nominal price) that must on average be paid for goods. It’s not inflation if Walmart raises the cost of some particular item, thereby increasing its nominal price. It is inflation if all stores taken together increase prices on all goods. The opposite of inflation is deflation.
Inflation occurs when the money supply increases more rapidly than the supply of goods and services offered within an extended market system—nowadays, usually a nation state. In that case, the nominal price of available goods and services will increase (“inflate”) over time until the gap is closed. This means that the purchasing power of each unit of currency decreases.
Inflation and deflation therefore occur when a disequilibrium exists within an extended market system between the aggregate supply of goods and services and the aggregate money supply available to purchase those goods and services.
Note that an increase in nominal prices implies a decrease in the purchasing power of each unit of currency. In other words, when prices go up, your money does not go as far and thus holds less real value.
USAGE: Inflation may appear to be a relatively simple phenomenon. However, the causes of inflation can take different forms and may be quite complex.
In any extended market system, prices are always fluctuating, depending on various factors affecting supply and demand in a random way. When such factors are no longer random, but begin to act in concert in the manner described above, then inflation will likely result.
Throughout recorded history, inflation has been noticed and its causes discussed. One of the forms in which inflation was most often encountered before the modern period was through adulteration of the coinage.
That is, the value of the coins in circulation in ancient and medieval societies was tied to specified weights of some precious metal (usually gold or silver). In that case, adding some other metal (i.e., creating an alloy) during the minting process was tantamount to spreading a given weight of precious metal over more coins.
This, of course, reduced the amount of the precious metal—which, remember, was considered to be the real store of value—in each coin. Eventually, this practice caused prices to rise and the purchasing power of each debased coin to fall.
Another premodern historical example of inflation occurred in Spain during the sixteenth century, as silver and gold began to pour into the country from the newly conquered “Indies” (Central and South America). The Spanish Scholastic thinkers Juan de Mariana and Martín de Azpilcueta (see the article on the Salamanca School) gave the correct explanation for this phenomenon.
Under the circumstances of a growing economy, prices will increase over time unless the money supply keeps pace with that growth in productive output. In modern industrial democracies, it is the central bank’s job to add to the money supply (“print money”) to achieve the goal of maintaining a rough equilibrium between the natural growth in the productive output of the economy and the money supply.
Even so, inflation may occur. When it does, it may be for either (or both) of two distinct reasons.
First, external factors in the cost of production or the transportation of goods may lead producers to increase their prices. This is known as “cost-push” inflation.
Second, if central governments print too much money, usually to meet obligations incurred for political reasons, then there will be “too much currency chasing too few goods and services,” causing the price of the latter to increase until the gap between the supply and the demand is closed. This is called “demand-pull” inflation.
Inflation has been called the “unfairest tax” because rising prices for essential commodities naturally hit the poorest segment of the population the hardest.