What Is Inflation?

Maybe your grandparents told you that bread or bus tickets used to cost much less. This is inflation: prices go up over time, so your money buys less than before.

A small amount of inflation is normal. In many countries, the central bank tries to keep it around two percent per year. That means prices rise slowly and in a way people can plan for.

Why do prices rise? Sometimes people want to buy more than shops can sell, so sellers raise prices. Sometimes the things companies need — oil, materials, workers — become more expensive, so they charge more. And if there is much more money in the economy but the same amount of goods, each unit of money is worth less.

Inflation is hard for people whose money does not grow: savers, and people on a fixed income. It can be easier for people who owe money, because they pay back with money that is worth less. When inflation gets very high and fast, it becomes dangerous, and people lose trust in the money itself.

Inflation is simply the rate at which the general level of prices rises, which is the same as saying the rate at which the purchasing power of money falls. A currency that loses two percent of its value a year will buy roughly a third less in twenty years.

Economists generally distinguish a few drivers. Demand-pull inflation occurs when spending outpaces the economy's capacity to produce, and sellers respond by raising prices. Cost-push inflation comes from the supply side: a jump in the price of energy, raw materials or labour feeds through into the price of finished goods. And there is a monetary dimension — if the quantity of money in circulation grows much faster than the quantity of goods and services, more money ends up chasing the same output.

Most central banks now target a low, positive rate, commonly around two percent. The reasoning is that mild inflation lubricates the economy — it makes it easier to adjust wages and prices, and it keeps the economy a safe distance from deflation, which can be more damaging because falling prices encourage people to delay spending.

The effects are uneven. Inflation erodes the value of cash savings and fixed pensions, while it quietly reduces the real burden of debts with fixed interest. Rapid or unpredictable inflation is worse than a steady rate, because it makes planning impossible and, in extreme cases, undermines confidence in the currency altogether.

Inflation is among the most consequential numbers in economic life and among the most widely misunderstood. Formally it is the rate of change of a price index; experientially it is the sensation that money is slipping through your fingers, that a wage rise has been quietly cancelled, that the future is harder to plan for.

The textbook taxonomy identifies demand-pull inflation, arising when aggregate demand exceeds productive capacity; cost-push inflation, transmitted from the supply side via energy, commodities or wages; and a monetary component, in which an expansion of the money supply outpacing real output dilutes the value of each unit. In practice these mechanisms interact, and disentangling them in real time — which matters, because the appropriate policy response differs — is a large part of what makes central banking difficult.

The near-universal adoption of an explicit inflation target, typically around two percent, reflects a hard-won consensus. A small positive rate is thought to grease the wheels of price and wage adjustment, provide a buffer against the deflationary trap in which expectations of falling prices become self-fulfilling, and give monetary policy room to cut interest rates in a downturn. Whether two is the right number, rather than a convention that has acquired the status of natural law, is periodically reopened.

What is not in dispute is that inflation redistributes. It transfers real wealth from creditors to debtors, from holders of cash to holders of assets, from those with fixed incomes to those whose incomes reprice quickly. High and volatile inflation compounds the harm by destroying the informational value of prices and, at the extreme, the social agreement that money represents. That is why central banks treat expectations — what people believe inflation will be — as something close to the whole game.