Definition of Inflation in Economics

Written by becky salmela haase
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Definition of Inflation in Economics
Inflation affects the prices of goods and services. (graph bars image by Tomislav from Fotolia.com)

Inflation is a core economic principle that affects the prices of goods and services. At times, radical changes in inflation has wreaked havoc on economies around the world, and governments try to maintain inflation at certain levels. While inflation has enormous influence over everyone around the world, economists are unable to pinpoint the precises causes or events that lead to high or low inflation. Inflation generally has a bad connotation, but economists view it as a sign an economy is growing.

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Inflation 101

In the simplest terms, inflation is the continued increase in the prices for goods and services as measured by annual percentages. Rising inflation means that every dollar buys a smaller percentage of goods and services. If inflation is at 2 per cent, for example, an item priced at 60p today will require 60p in one year.

Definition of Inflation in Economics
When inflation exists, more money is needed to purchase the same goods over time. (carrots with price image by Jo Ann Koch from Fotolia.com)

Purchasing Power

This change in the amount needed to buy a good or service is referred to as purchasing power. When inflation exists, the value of a dollar is changing. To measure its value, economists observe the amount of tangible goods a currency can buy, or purchasing power. Inflation affects purchasing power by increasing or decreasing the costs of goods.

Definition of Inflation in Economics
Inflation has a direct effect on consumers' purchasing power. (penny graph image by RT from Fotolia.com)

Causes of Inflation

Economists more or less fall into two theory camps when discussing the causes of inflation: demand-pull and cost-push.

Demand-pull inflation theorists describe inflation as the rising price levels because of an imbalance between the demand and supply of goods. Rising inflation means that there are too few goods and too many dollars available. Prices rise because consumers are willing to pay more for the goods because they are able, having an excess of dollars. In general, this happens when an economy grows.

The cost-push inflation theory points again to the supply of goods in the economy. In this theory, however, prices rise because it costs more to produce the goods than before, resulting in fewer goods available but no change in demand.

Definition of Inflation in Economics
Economists debate if too much money or high-cost production causes inflation. (catenaccio image by Satan from Fotolia.com)

Inflation's Winners & Losers

Inflation isn't necessarily a negative thing, and economists link inflation with growth. Economists generally assume that inflation will increase over time, in which case steps can be taken to hedge against inflation. Governments can raise and lower interest rates. Workers can negotiate incremental wage increases because provided that wages increase at the same level as inflation, consumers maintain their purchasing power. Consumers on fixed incomes, however, such as retirees, may not maintain their purchasing power over time. National exports can fall if inflation is higher in the United States. than in other countries, which makes U.S. products more expensive.

Definition of Inflation in Economics
Inflation generally will rise over time. (dispute for the money image by ktsdesign from Fotolia.com)

Inflation in the 1970s

Moderate, expected inflation is easily absorbed over time, but there have been times when it has spiked quickly. In the 1970s, a period of stagnation swept the United States. Stagnation is the combination of high inflation coupled with an economic slowdown. During the 1970s, prices increased quickly and dramatically because of high oil prices. Both companies and consumers were unable to cope with the quick changes and the economy stalled.

Definition of Inflation in Economics
The 1970s saw the unfortunate combination of rising inflation and a slow economy. (how much? image by Photoeyes from Fotolia.com)

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