economics essay on inflation

What is inflation?

Inflation has been top of mind for many over the past few years. But how long will it persist? In June 2022, inflation in the United States jumped to 9.1 percent, reaching the highest level since February 1982. The inflation rate has since slowed in the United States , as well as in Europe , Japan , and the United Kingdom , particularly in the final months of 2023. But even though global inflation is higher than it was before the COVID-19 pandemic, when it hovered around 2 percent, it’s receding to historical levels . In fact, by late 2022, investors were predicting that long-term inflation would settle around a modest 2.5 percent. That’s a far cry from fears that long-term inflation would mimic trends of the 1970s and early 1980s—when inflation exceeded 10 percent.

Get to know and directly engage with senior McKinsey experts on inflation.

Ondrej Burkacky is a senior partner in McKinsey’s Munich office, Axel Karlsson is a senior partner in the Stockholm office, Fernando Perez is a senior partner in the Miami office, Emily Reasor is a senior partner in the Denver office, and Daniel Swan is a senior partner in the Stamford, Connecticut, office.

Inflation refers to a broad rise in the prices of goods and services across the economy over time, eroding purchasing power for both consumers and businesses. Economic theory and practice, observed for many years and across many countries, shows that long-lasting periods of inflation are caused in large part by what’s known as an easy monetary policy . In other words, when a country’s central bank sets the interest rate too low or increases money growth too rapidly, inflation goes up. As a result, your dollar (or whatever currency you use) will not go as far  today as it did yesterday. For example: in 1970, the average cup of coffee in the United States cost 25 cents; by 2019, it had climbed to $1.59. So for $5, you would have been able to buy about three cups of coffee in 2019, versus 20 cups in 1970. That’s inflation, and it isn’t limited to price spikes for any single item or service; it refers to increases in prices across a sector, such as retail or automotive—and, ultimately, a country’s economy.

How does inflation affect your daily life? You’ve probably seen high rates of inflation reflected in your bills—from groceries to utilities to even higher mortgage payments. Executives and corporate leaders have had to reckon with the effects of inflation too, figuring out how to protect margins while paying more for raw materials.

But inflation isn’t all bad. In a healthy economy, annual inflation is typically in the range of two percentage points, which is what economists consider a sign of pricing stability. When inflation is in this range, it can have positive effects: it can stimulate spending and thus spur demand and productivity when the economy is slowing down and needs a boost. But when inflation begins to surpass wage growth, it can be a warning sign of a struggling economy.

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Inflation may be declining in many markets, but there’s still uncertainty ahead: without a significant surge in productivity, Western economies may be headed for a period of sustained inflation or major economic reset , as Japan has experienced in the first decades of the 21st century.

What does seem to be changing are leaders’ attitudes. According to the 2023 year-end McKinsey Global Survey on economic conditions , respondents reported less fear about inflation as a risk to global and domestic economic growth . But this sentiment varies significantly by region: European respondents were most concerned about the effects of inflation, whereas respondents in North America offered brighter views.

What causes inflation?

Monetary policy is a critical driver of inflation over the long term. The current high rate of inflation is a result of increased money supply , high raw materials costs , labor mismatches , and supply disruptions —exacerbated by geopolitical conflict .

In general, there are two primary types, or causes, of short-term inflation:

• Demand-pull inflation occurs when the demand for goods and services in the economy exceeds the economy’s ability to produce them. For example, when demand for new cars recovered more quickly than anticipated from its sharp dip at the beginning of the COVID-19 pandemic, an intervening shortage  in the supply of semiconductors  made it hard for the automotive industry to keep up with this renewed demand. The subsequent shortage of new vehicles resulted in a spike in prices for new and used cars.
• Cost-push inflation occurs when the rising price of input goods and services increases the price of final goods and services. For example, commodity prices spiked sharply  during the pandemic as a result of radical shifts in demand, buying patterns, cost to serve, and perceived value across sectors and value chains. To offset inflation and minimize impact on financial performance, industrial companies were forced to increase prices for end consumers.

Learn more about McKinsey’s Growth, Marketing & Sales  Practice.

What are some periods in history with high inflation?

Economists frequently compare the current inflationary period with the post–World War II era , when price controls, supply problems, and extraordinary demand in the United States fueled double-digit inflation gains—peaking at 20 percent in 1947—before subsiding at the end of the decade. Consumption patterns today have been similarly distorted, and supply chains have been disrupted  by the pandemic.

The period from the mid-1960s through the early 1980s in the United States, sometimes called the “Great Inflation,” saw some of the country’s highest rates of inflation, with a peak of 14.8 percent in 1980. To combat this inflation, the Federal Reserve raised interest rates to nearly 20 percent. Some economists attribute this episode partially to monetary policy mistakes rather than to other causes, such as high oil prices. The Great Inflation signaled the need for public trust  in the Federal Reserve’s ability to lessen inflationary pressures.

Inflation isn’t solely a modern-day phenomenon, of course. One very early example of inflation comes from Roman times, from around 200 to 300 CE. Roman leaders were struggling to fund an army big enough to deal with attackers from multiple fronts. To help, they watered down  the silver in their coinage, causing the value of money to slowly fall—and inflation to pick up. This led merchants to raise their prices, causing widespread panic. In response, the emperor Diocletian issued what’s now known as the Edict on Maximum Prices, a series of price and wage controls designed to stop the rise of prices and wages (one helpful control was a maximum price for a male lion). But because the edict didn’t address the root cause of inflation—the impure silver coin—it didn’t fix the problem.

How is inflation measured?

Statistical agencies measure inflation first by determining the current value of a “basket” of various goods and services consumed by households, referred to as a price index. To calculate the rate of inflation over time, statisticians compare the value of the index over one period with that of another. Comparing one month with another gives a monthly rate of inflation, and comparing from year to year gives an annual rate of inflation.

In the United States, the Bureau of Labor Statistics publishes its Consumer Price Index (CPI), which measures the cost of items that urban consumers buy out of pocket. The CPI is broken down by region and is reported for the country as a whole. The Personal Consumption Expenditures (PCE) price index —published by the US Bureau of Economic Analysis—takes into account a broader range of consumer spending, including on healthcare. It is also weighted by data acquired through business surveys.

How does inflation affect consumers and companies differently?

Inflation affects consumers most directly, but businesses can also feel the impact:

• Consumers lose purchasing power when the prices of items they buy, such as food, utilities, and gasoline, increase. This can lead to household belt-tightening and growing pessimism about the economy .
• Companies lose purchasing power and risk seeing their margins decline , when prices increase for inputs used in production. These can include raw materials like coal and crude oil , intermediate products such as flour and steel, and finished machinery. In response, companies typically raise the prices of their products or services to offset inflation, meaning consumers absorb these price increases. The challenge for many companies is to strike the right balance between raising prices to cover input cost increases while simultaneously ensuring that they don’t raise prices so much that they suppress demand.

How can organizations respond to high inflation?

During periods of high inflation, companies typically pay more for materials , which decreases their margins. One way for companies to offset losses and maintain margins is by raising prices for consumers. However, if price increases are not executed thoughtfully, companies can damage customer relationships and depress sales —ultimately eroding the profits they were trying to protect.

When done successfully, recovering the cost of inflation for a given product can strengthen relationships and overall margins. There are five steps companies can take to ADAPT  (adjust, develop, accelerate, plan, and track) to inflation:

• Adjust discounting and promotions and maximize nonprice levers. This can include lengthening production schedules or adding surcharges and delivery fees for rush or low-volume orders.
• Develop the art and science of price change. Instead of making across-the-board price changes, tailor pricing actions to account for inflation exposure, customer willingness to pay, and product attributes.
• Accelerate decision making tenfold. Establish an “inflation council” that includes dedicated cross-functional, inflation-focused decision makers who can act quickly and nimbly on customer feedback.
• Plan options beyond pricing to reduce costs. Use “value engineering” to reimagine a portfolio and provide cost-reducing alternatives to price increases.
• Track execution relentlessly. Create a central supporting team to address revenue leakage and to manage performance rigorously. Traditional performance metrics can be less reliable when inflation is high .

Beyond pricing, a variety of commercial and technical levers can help companies deal with price increases in an inflationary market , but other sectors may require a more tailored response to pricing.

Learn more about our Financial Services , Industrials & Electronics , Operations , Strategy & Corporate Finance , and  Growth, Marketing & Sales Practices.

How can CEOs help protect their organizations against uncertainty during periods of high inflation?

In today’s uncertain environment, in which organizations have a much wider range of stakeholders, leaders must think about performance beyond short-term profitability. CEOs should lead with the complete business cycle and their complete slate of stakeholders in mind.

CEOs need an inflation management playbook , just as central bankers do. Here are some important areas to keep in mind while scripting it:

• Design. Leaders should motivate their organizations to raise the profile of design  to a C-suite topic. Design choices for products and services are critical for responding to price volatility, scarcity of components, and higher production and servicing costs.
• Supply chain. The most difficult task for CEOs may be convincing investors to accept supply chain resiliency as the new table stakes. Given geopolitical and economic realities, supply chain resiliency has become a crucial goal for supply chain leaders, alongside cost optimization.
• Procurement. CEOs who empower their procurement  organizations can raise the bar on value-creating contributions. Procurement leaders have told us time and again that the current market environment is the toughest they’ve experienced in decades. CEOs are beginning to recognize that purchasing leaders can be strategic partners by expanding their focus beyond cost cutting to value creation.
• Feedback. A CEO can take a lead role in playing back the feedback the organization is hearing. In today’s tight labor market, CEOs should guide their companies to take a new approach to talent, focusing on compensation, cultural factors, and psychological safety .
• Pricing. Forging new pricing relationships with customers will test CEOs in their role as the “ultimate integrator.” Repricing during inflationary times is typically unpleasant for companies and customers alike. With setting new prices, CEOs have the opportunity to forge deeper relationships with customers, by turning to promotions, personalization , and refreshed communications around value.
• Agility. CEOs can strive to achieve a focus based more on strategic action and less on firefighting. Managing the implications of inflation calls for a cross-functional, disciplined, and agile response.

A practical example: How is inflation affecting the US healthcare industry?

Consumer prices for healthcare have rarely risen faster than the rate of inflation—but that’s what’s happening today. The impact of inflation on the broader economy has caused healthcare costs to rise faster than the rate of inflation. Experts also expect continued labor shortages in healthcare—gaps of up to 450,000 registered nurses and 80,000 doctors —even as demand for services continues to rise. This drives up consumer prices and means that higher inflation could persist. McKinsey analysis as of 2022 predicted that the annual US health expenditure is likely to be $370 billion higher by 2027 because of inflation.

This climate of risk could spur healthcare leaders to address productivity, using tech levers to boost productivity while also reducing costs. In order to weather the storm, leaders will need to quickly set high aspirations, align their organizations around them, and execute with speed .

What is deflation?

If inflation is one extreme of the pricing spectrum, deflation is the other. Deflation occurs when the overall level of prices in an economy declines and the purchasing power of currency increases. It can be driven by growth in productivity and the abundance of goods and services, by a decrease in demand, or by a decline in the supply of money and credit.

Generally, moderate deflation positively affects consumers’ pocketbooks, as they can purchase more with less money. However, deflation can be a sign of a weakening economy, leading to recessions and depressions. While inflation reduces purchasing power, it also reduces the value of debt. During a period of deflation, on the other hand, debt becomes more expensive. And for consumers, investments such as stocks, corporate bonds, and real estate become riskier.

A recent period of deflation in the United States was the Great Recession, between 2007 and 2008. In December 2008, more than half of executives surveyed by McKinsey  expected deflation in their countries, and 44 percent expected to decrease the size of their workforces.

When taken to their extremes, both inflation and deflation can have significant negative effects on consumers, businesses, and investors.

For more in-depth exploration of these topics, see McKinsey’s Operations Insights  collection. Learn more about Operations consulting , and check out operations-related job opportunities  if you’re interested in working at McKinsey.

Articles referenced:

• “ Investing in productivity growth ,” March 27, 2024, Jan Mischke , Chris Bradley , Marc Canal, Olivia White , Sven Smit , and Denitsa Georgieva
• “ Economic conditions outlook during turbulent times, December 2023 ,” December 20, 2023
• “ Forward Thinking on why we ignore inflation—from ancient times to the present—at our peril with Stephen King ,” November 1, 2023
• “ Procurement 2023: Ten CPO actions to defy the toughest challenges ,” March 6, 2023, Roman Belotserkovskiy , Carolina Mazuera, Marta Mussacaleca , Marc Sommerer, and Jan Vandaele
• “ Why you can’t tread water when inflation is persistently high ,” February 2, 2023, Marc Goedhart and Rosen Kotsev
• “ Markets versus textbooks: Calculating today’s cost of equity ,” January 24, 2023, Vartika Gupta, David Kohn, Tim Koller , and Werner Rehm  
• “ Inflation-weary Americans are increasingly pessimistic about the economy ,” December 13, 2022, Gonzalo Charro, Andre Dua , Kweilin Ellingrud , Ryan Luby, and Sarah Pemberton
• “ Inflation fighter and value creator: Procurement’s best-kept secret ,” October 31, 2022, Roman Belotserkovskiy , Ezra Greenberg , Daphne Luchtenberg, and Marta Mussacaleca
• “ Prime Numbers: Rethink performance metrics when inflation is high ,” October 28, 2022, Vartika Gupta, David Kohn, Tim Koller , and Werner Rehm
• “ The gathering storm: The threat to employee healthcare benefits ,” October 20, 2022, Aditya Gupta , Akshay Kapur , Monisha Machado-Pereira , and Shubham Singhal
• “ Utility procurement: Ready to meet new market challenges ,” October 7, 2022, Roman Belotserkovskiy , Abhay Prasanna, and Anton Stetsenko
• “ The gathering storm: The transformative impact of inflation on the healthcare sector ,” September 19, 2022, Addie Fleron, Aneesh Krishna , and Shubham Singhal
• “ Pricing during inflation: Active management can preserve sustainable value ,” August 19, 2022, Niels Adler and Nicolas Magnette
• “ Navigating inflation: A new playbook for CEOs ,” April 14, 2022, Asutosh Padhi , Sven Smit , Ezra Greenberg , and Roman Belotserkovskiy
• “ How business operations can respond to price increases: A CEO guide ,” March 11, 2022, Andreas Behrendt ,  Axel Karlsson , Tarek Kasah, and  Daniel Swan
• “ Five ways to ADAPT pricing to inflation ,” February 25, 2022,  Alex Abdelnour , Eric Bykowsky, Jesse Nading,  Emily Reasor , and Ankit Sood
• “ How COVID-19 is reshaping supply chains ,” November 23, 2021,  Knut Alicke ,  Ed Barriball , and Vera Trautwein
• “ Navigating the labor mismatch in US logistics and supply chains ,” December 10, 2021,  Dilip Bhattacharjee , Felipe Bustamante, Andrew Curley, and  Fernando Perez
• “ Coping with the auto-semiconductor shortage: Strategies for success ,” May 27, 2021,  Ondrej Burkacky , Stephanie Lingemann, and Klaus Pototzky

This article was updated in April 2024; it was originally published in August 2022.

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What Causes Inflation? 

• Walter Frick

Why your money is worth less than it used to be.

What causes inflation? There is no one answer, but like so much of macroeconomics it comes down to a mix of output, money, and expectations. Supply shocks can lower an economy’s potential output, driving up prices. An increase in the money supply can stoke demand, driving up prices. And the expectation of inflation can become a self-fulfilling cycle as workers and companies demand higher wages and set higher prices.

Since the financial crisis of 2008 and the Great Recession, investors and executives have grown accustomed to a world of low interest rates and low inflation. No longer. In 2021, inflation began rising sharply in many parts of the world, and in 2022 the U.S. saw its worst inflation in decades.

• Walter Frick is a contributing editor at Harvard Business Review , where he was formerly a senior editor and deputy editor of HBR.org. He is the founder of Nonrival , a newsletter where readers make crowdsourced predictions about economics and business. He has been an executive editor at Quartz as well as a Knight Visiting Fellow at Harvard’s Nieman Foundation for Journalism and an Assembly Fellow at Harvard’s Berkman Klein Center for Internet & Society. He has also written for The Atlantic , MIT Technology Review , The Boston Globe , and the BBC, among other publications.

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Understanding US inflation during the COVID-19 era

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Laurence ball , laurence ball professor of economics - johns hopkins university daniel leigh , and daniel leigh division chief, world economic studies division - imf research department prachi mishra prachi mishra chief of the systemic issues division, research department - international monetary fund.

September 7, 2022

The paper summarized here is part of the Fall 2022 edition of the Brookings Papers on Economic Activity (BPEA) , the leading conference series and journal in economics for timely, cutting-edge research about real-world policy issues. The conference draft of this paper was presented at the Fall 2022 BPEA conference . The final version was published in the Fall 2022 issue by Johns Hopkins University Press.

See the Fall 2022 BPEA event page to watch conference recordings and read conference drafts of all the papers from this edition.  Submit a proposal to present at a future BPEA conference  here .

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The Federal Reserve likely will need to push unemployment far higher than its 4.1 percent projection if it is to succeed in bringing inflation down to its 2 percent target by the end of 2024, suggests a paper discussed at the Brookings Papers on Economic Activity (BPEA) conference on September 8.

The paper, Understanding US Inflation During the COVID-19 Era , analyzes why the pandemic-related surge in inflation has persisted and runs simulations under different assumptions to look at where inflation might be heading.

According to the authors—Laurence Ball of Johns Hopkins University and Daniel Leigh and Prachi Mishra of the International Monetary Fund—it is unlikely, but not impossible, for the Fed to achieve the soft landing (substantially lower inflation with only modestly higher unemployment) that it projected in June.

The median Fed policymaker projected 4.1 percent unemployment at the end of 2024, up only modestly from 3.7 percent in July. The median projection for inflation, as measured by the Commerce Department’s personal consumption expenditures (PCE) price index, was 2.2 percent at the end of 2024, down from a four-decade high of 6.8 percent in June. The PCE Index eased modestly in July (prices were up 6.3 percent from a year earlier). The Labor Department’s more widely known consumer price index (CPI) also hit a 40-year high in June (9.1 percent) before easing slightly to 8.5 percent in July.

“If either the labor market doesn’t behave, or expectations don’t behave, the small increase in unemployment the Fed projects won’t be enough.”

So far this year the Fed has raised its short-term interest rate target by 2.25 percentage points, from near zero, and projected in June that to tame inflation it would need to raise the target by only an additional percentage point this year and a half percentage point next year.

Fed policymakers, as well as most economists (including the paper’s authors), had expected that the upturn in inflation that began in March 2021 would prove transitory. The paper cited three reasons why those expectations proved to be wrong: first, unforeseeable events such as Russia’s invasion of Ukraine and the persistence of pandemic supply-chain disruptions; second, failure to account for the pass-through of specific price shocks (such as to energy and auto prices) into the core, or underlying, rate of inflation; and, third a focus on the unemployment rate (which has only recently fallen back to pre-pandemic levels) as an indicator of labor market tightness rather than the very high ratio of job vacancies to unemployed workers (V/U).

The very high V/U ratio in 2021 and this year can explain three-quarters of the rise in monthly core CPI inflation as measured by a Federal Reserve Bank of Cleveland index that strips out the effects of unusually large price changes in certain industries, according to the paper. Some of the consumer demand that fueled the economy, as well as the labor market tightness, in turn, can be explained by the Biden administration’s $1.9 trillion American Rescue Plan enacted in March 2021. Without it, the authors estimate that annualized monthly core inflation would have been 3.7 percent in July rather than 6.5 percent.

According to the paper, whether the Fed can achieve its objectives depends on whether it is possible to slow demand in such a way that vacancies decrease but unemployment doesn’t rise (returning the V/U ratio to its pre-pandemic norm) and on whether consumers and businesses start to expect that high inflation will continue for the longer term, and thus plan for it. Under optimistic assumptions for both the V/U ratio and long-term inflation expectations (and assuming the Fed’s 4.1 percent unemployment projection proves correct), the paper projects the Fed will bring core inflation down close to its target by the end of 2024. However, under the most pessimistic assumptions for both the V/U ratio and inflation expectations, core inflation rises to about 8.8 percent if unemployment moves up only to 4.1 percent.

“If you make quite-optimistic assumptions, we might get something close to what the Fed expects,” Ball said in an interview with The Brookings Institution. “But if either the labor market doesn’t behave, or expectations don’t behave, the small increase in unemployment the Fed projects won’t be enough. Either inflation will stay substantially higher, or we will have higher unemployment and a substantial economic slowdown.”

Ball, Laurence, Daniel Leigh, and Prachi Mishra. 2022. “Understanding US Inflation during the COVID-19 Era.” Brookings Papers on Economic Activity , Fall. 1-54.

Furman, Jason. 2022. “Comment on ‘Understanding US Inflation during the COVID-19 Era’.” Brookings Papers on Economic Activity , Fall. 55-65.

Şahin, Ayşegül. 2022. “Comment on ‘Understanding US Inflation during the COVID-19 Era’.” Brookings Papers on Economic Activity , Fall. 65-76.

Discussants

Daniel Leigh and Prachi Mishra are employees of the International Monetary Fund, which conducts a review of all externally published pieces. The authors did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. The authors are not currently an officer, director, or board member of any organization with a financial or political interest in this article.

David Skidmore authored the summary language for this paper. Becca Portman assisted with data visualization.

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An economist explains: What you need to know about inflation

Assistant Professor, Department of Economics, Toronto Metropolitan University

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Nicholas Li does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

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Inflation is one of the most pressing political and economic issues of the moment, but there are many misconceptions about how inflation is measured, where it comes from and how it impacts the average person.

In June, inflation in Canada reached a 40-year high of 8.1 per cent . While there are signs inflation may be moderating , many Canadians have dealt with the surging cost of living by cutting back on expenses , working more to increase their income, drawing on their savings or taking on more debt .

As an economics professor who conducts research on prices and consumption, I would like to provide some insight into how inflation is measured and how it is impacting Canadians and the economy at large.

What is inflation?

Inflation refers to a general increase in prices and the resulting decline in the purchasing power of money. While most of us can sense whether inflation is high or low from everyday purchases, the inflation rate that gets reported in the press and discussed by policy-makers is a specific measure created by a small army of statisticians and data collectors.

Statistics Canada constructs the Consumer Price Index (CPI) used to track inflation through a two-step process. In the first step, Statistics Canada collects over one million price quotes on virtually anything purchasable in the country.

Prices are recorded in a variety of ways, and the frequency and geography of price collection depends on the item. For example, items with prices that change quickly like food or gasoline, or vary across locations like rent, are collected more frequently than items that are collected once a year, like university tuition or insurance rates.

In the second step, Statistics Canada aggregates these prices to generate the all-item Consumer Price Index by weighing each item’s price change by its share of total consumer spending. These weights are occasionally updated to reflect changes in consumer spending patterns .

The most recent update in 2021 reflects some pandemic-related spending changes, such as a lower weight for food (15.75 per cent) and transportation (16.16 per cent), but a higher weight for shelter (29.67 per cent).

Statistics Canada and the Bank of Canada also measure “ core inflation ” which removes items with the most volatile prices (food and energy) from the CPI to provide a better sense of slower-moving, long-term cost pressures.

What causes inflation?

Prices are determined by supply and demand . High inflation is a sign that, across the economy, demand for goods and services exceeds their supply.

Demand has been strong due to strong employment and wage growth , cheap credit , pandemic-related payments from governments and pandemic-related shifts in demand towards goods consumed at home .

Supply has been disrupted by the pandemic’s effects on Chinese factories , international supply chains , container shipping , trucking and the Russian invasion of Ukraine that led to recent spikes in food and energy prices around the world.

Inflation feels higher than it is

Many Canadians feel like prices rose by more than 8.1 per cent in the last year. Beyond specific criticism of the CPI methodology in Canada , there are at least two reasons for this.

First, consumer spending is measured through surveys that capture the diversity of spending patterns in the population, but collapse this diversity into a single set of weights that treats each dollar of spending equally. Spending patterns vary with age, income, location, household composition and taste, and your personal budget might bear little resemblance to the weights used for the CPI.

Second, we are more likely to notice price changes for items we purchase frequently , and we tend to notice price increases more than decreases . The items with the highest price increases in the last year — energy and food — have these characteristics, and we are less likely to notice the (lower) inflation rate for furniture, electronics, education and health goods that balance these out.

We also pay a lot of attention to soaring house prices and interest rates — especially in big cities — but the cost of owned accommodation in the CPI is based on historical averages of housing prices (25 years) and interest rates (five years) that reflect long-term financing costs for the average homeowner, not someone buying a house today.

How does inflation impact us?

There are winners and losers when it comes to inflation. While it can hurt businesses that end up passing cost increases onto their customers , it can benefit others by allowing them to raise their prices without customer backlash because “everyone else is doing it.”

High inflation is often, but not always, accompanied by high wage growth . Individuals who earn no or below-inflation wages are hurt, while individuals with wages indexed to inflation or who are able to negotiate better wages can benefit. Individuals like seniors on fixed incomes are often hurt by inflation, although many government benefits are indexed to inflation .

Some asset prices are better at keeping pace with inflation. Prices of housing, stocks, art and precious metals may go up, while assets with fixed dollar values like cash and bonds do not.

Inflation can make it easier to repay debts, as long as wages or other asset prices keep pace. Inflation can also benefit government finances as tax revenues rise relative to the dollar value of the debt.

While the source of our current inflation is irrelevant to consumers, it matters for economic policy. Central banks and governments must decide whether to curb demand and risk recession by raising interest rates , cutting spending or raising taxes, or wait and hope that supply-side inflation pressures ease up on their own.

We can only hope that it will not take a major recession to end this period of high inflation (unlike the last major effort by the Bank of Canada to lower inflation ) and that Canada avoids “ stagflation ,” the combination of high inflation and high unemployment that afflicted many economies in the late 1970s.

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Macro Economic Essays

These are a collection of essays written for my economic blogs.

Exchange Rate Essays

• Effects of a falling Dollar
• Why Dollar keeps falling
• Discuss Policies to Stop the Dollar Falling
• Does Devaluation Cause Inflation?
• Benefits and Costs of Falling Dollar
• Reasons for Falling Dollar
• The Dollar as the World’s Reserve Currency

Economic Growth Essays

• Evaluate Benefits of Economic Growth
• Essays on Recessions
• Causes of Recessions
• Problems of Recovering from a Recession
• What can Increase Long-Run Economic Growth?
• Discuss Effect of a fall in the Savings Ratio

Inflation Essays

• Discuss the Difficulties of Controlling Inflation
• Should the aim of the Government be to Attain Low Inflation?
• Explain What Can Cause a Sustained Increase in the Rate of Inflation
• Reasons for low inflation in the UK
• Inflation Explained
• Difficulties of Inflation targeting
• Hyperinflation

Unemployment Essays

• Explain what is meant by Natural Rate of Unemployment?
• Should the Main Macro Economic Aim of the Government be Full Employment?
• The True Level of Unemployment in the UK
• What explains low inflation and low unemployment in the UK?

Demand Side Policies

• Discuss effect of Expansionary demand-side policies on Balance of Payments and Environment
• Effects of a Falling Stock Market
• How do Mortgage Defaults affect and Economy?
• Discuss the effect of increased Government spending on education
• Phillips Curve – Trade-off between Inflation and Unemployment

Development Economics

• Why Growth may not benefit developing countries
• Does Aid Increase Economic Welfare?
• Problems of Free Trade for Developing Economies

Fiscal Policy

• Will US Economy benefit from Tax Cuts?
• Can Fiscal Policy solve Unemployment?
• Explain Reasons for UK Current Account Deficit
• Benefits of Globalisation for Developing and Developed Countries

Monetary Policy

• Discuss Effects of an Increase in Interest Rates
• How MPC set Interest Rates
• Benefits of High-Interest Rates (and recessions)
• Who Sets interest rates – Markets or Bank of England?

Economic History

• Economics of the 1920s
• What Caused Wall Street Crash of 1929?
• UK economy under Mrs Thatcher
• Economy of the 1970s
• Lawson Boom of the 1980s
• UK recession of 1991
• The great recession 2008-13

General Economic Essays

• The Dismal Science
• Difference Between Economists and Non Economists
• War and Recessions
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• Overvalued Housing Markets
• What Went Wrong with US Economy?
• Problem with Bailing out financial sector
• Problems of Personal Debt
• Problem of Inflation
• National Debt in the UK
• How To Survive a Recession
• Can A recession be a good thing?

Chinese Economy

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• Should we worry about a strong China
• Chinese Growth and Costs of Growth
• Chinese Interest Rates and Economic Growth

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Inflation: Types, Causes and Effects (With Diagram)

Inflation and unemployment are the two most talked-about words in the contemporary society.

These two are the big problems that plague all the economies.

Almost everyone is sure that he knows what inflation exactly is, but it remains a source of great deal of confu­sion because it is difficult to define it unam­biguously.

1. Meaning of Inflation:

Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget may be financed by the additional money creation. But the situation of monetary expansion or budget deficit may not cause price level to rise. Hence the difficulty of defining ‘inflation’.

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Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the price of only one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in the general level or aver­age of prices’. In other words, inflation is a state of rising prices, but not high prices.

It is not high prices but rising price level that con­stitute inflation. It constitutes, thus, an over­all increase in price level. It can, thus, be viewed as the devaluing of the worth of money. In other words, inflation reduces the purchasing power of money. A unit of money now buys less. Inflation can also be seen as a recurring phenomenon.

While measuring inflation, we take into ac­count a large number of goods and services used by the people of a country and then cal­culate average increase in the prices of those goods and services over a period of time. A small rise in prices or a sudden rise in prices is not inflation since they may reflect the short term workings of the market.

It is to be pointed out here that inflation is a state of disequilib­rium when there occurs a sustained rise in price level. It is inflation if the prices of most goods go up. Such rate of increases in prices may be both slow and rapid. However, it is difficult to detect whether there is an upward trend in prices and whether this trend is sus­tained. That is why inflation is difficult to define in an unambiguous sense.

Let’s measure inflation rate. Suppose, in December 2007, the consumer price index was 193.6 and, in December 2008, it was 223.8. Thus, the inflation rate during the last one year was

223.8- 193.6/ 193.6 x 100 = 15.6

As inflation is a state of rising prices, de­flation may be defined as a state of falling prices but not fall in prices. Deflation is, thus, the opposite of inflation, i.e., a rise in the value of money or purchasing power of money. Disinflation is a slowing down of the rate of inflation.

2. Types of Inflation:

As the nature of inflation is not uniform in an economy for all the time, it is wise to distin­guish between different types of inflation. Such analysis is useful to study the distribu­tional and other effects of inflation as well as to recommend anti-inflationary policies. Infla­tion may be caused by a variety of factors. Its intensity or pace may be different at different times. It may also be classified in accordance with the reactions of the government toward inflation.

Thus, one may observe different types of inflation in the contemporary society:

A. On the Basis of Causes:

(i) Currency inflation:

This type of infla­tion is caused by the printing of cur­rency notes.

(ii) Credit inflation:

Being profit-making institutions, commercial banks sanction more loans and advances to the public than what the economy needs. Such credit expansion leads to a rise in price level.

(iii) Deficit-induced inflation:

The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the government may ask the central bank to print additional money. Since pumping of additional money is required to meet the budget deficit, any price rise may the be called the deficit-induced inflation.

(iv) Demand-pull inflation:

An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull in­flation (henceforth DPI). But why does aggregate demand rise? Classical economists attribute this rise in aggre­gate demand to money supply. If the supply of money in an economy ex­ceeds the available goods and services, DPI appears. It has been described by Coulborn as a situation of “too much money chasing too few goods.”

Keynesians hold a different argu­ment. They argue that there can be an autonomous increase in aggregate de­mand or spending, such as a rise in con­sumption demand or investment or government spending or a tax cut or a net increase in exports (i.e., C + I + G + X – M) with no increase in money sup­ply. This would prompt upward adjust­ment in price. Thus, DPI is caused by monetary factors (classical adjustment) and non-monetary factors (Keynesian argument).

DPI can be explained in terms of Fig. 4.2, where we measure output on the horizontal axis and price level on the vertical axis. In Range 1, total spending is too short of full employment out­put, Y F . There is little or no rise in the price level. As demand now rises, out­put will rise. The economy enters Range 2, where output approaches towards full employment situation. Note that in this region price level begins to rise. Ul­timately, the economy reaches full em­ployment situation, i.e., Range 3, where output does not rise but price level is pulled upward. This is demand-pull in­flation. The essence of this type of in­flation is that “too much spending chas­ing too few goods.”

(v) Cost-push inflation:

Inflation in an economy may arise from the overall increase in the cost of production. This type of inflation is known as cost-push inflation (henceforth CPI). Cost of pro­duction may rise due to an increase in the prices of raw materials, wages, etc. Often trade unions are blamed for wage rise since wage rate is not completely market-determinded. Higher wage means high cost of production. Prices of commodities are thereby increased.

A wage-price spiral comes into opera­tion. But, at the same time, firms are to be blamed also for the price rise since they simply raise prices to expand their profit margins. Thus, we have two im­portant variants of CPI wage-push in­flation and profit-push inflation.

Any­way, CPI stems from the leftward shift of the aggregate supply curve:

B. On the Basis of Speed or Intensity:

(i) Creeping or Mild Inflation:

If the speed of upward thrust in prices is slow but small then we have creeping inflation. What speed of annual price rise is a creeping one has not been stated by the economists. To some, a creeping or mild inflation is one when annual price rise varies between 2 p.c. and 3 p.c. If a rate of price rise is kept at this level, it is con­sidered to be helpful for economic development. Others argue that if annual price rise goes slightly beyond 3 p.c. mark, still then it is considered to be of no danger.

(ii) Walking Inflation:

If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation of walking inflation. When mild inflation is allowed to fan out, walking inflation appears. These two types of inflation may be described as ‘moderate inflation’.

Often, one-digit inflation rate is called ‘moder­ate inflation’ which is not only predict­able, but also keep people’s faith on the monetary system of the country. Peoples’ confidence get lost once moderately maintained rate of inflation goes out of control and the economy is then caught with the galloping inflation.

(iii) Galloping and Hyperinflation:

Walking inflation may be converted into running inflation. Running inflation is danger­ous. If it is not controlled, it may ulti­mately be converted to galloping or hyperinflation. It is an extreme form of inflation when an economy gets shatter­ed.”Inflation in the double or triple digit range of 20, 100 or 200 p.c. a year is labelled “galloping inflation”.

(iv) Government’s Reaction to Inflation:

In­flationary situation may be open or suppressed. Because of anti-infla­tionary policies pursued by the govern­ment, inflation may not be an embar­rassing one. For instance, increase in income leads to an increase in con­sumption spending which pulls the price level up.

If the consumption spending is countered by the govern­ment via price control and rationing device, the inflationary situation may be called a suppressed one. Once the government curbs are lifted, the sup­pressed inflation becomes open infla­tion. Open inflation may then result in hyperinflation.

3. Causes of Inflation:

Inflation is mainly caused by excess demand/ or decline in aggregate supply or output. Former leads to a rightward shift of the aggregate demand curve while the latter causes aggregate supply curve to shift left­ward. Former is called demand-pull inflation (DPI), and the latter is called cost-push infla­tion (CPI). Before describing the factors, that lead to a rise in aggregate demand and a de­cline in aggregate supply, we like to explain “demand-pull” and “cost-push” theories of inflation.

(i) Demand-Pull Inflation Theory:

There are two theoretical approaches to the DPI—one is classical and other is the Keynesian.

According to classical economists or mon­etarists, inflation is caused by an increase in money supply which leads to a rightward shift in negative sloping aggregate demand curve. Given a situation of full employment, classi­cists maintained that a change in money supply brings about an equiproportionate change in price level.

That is why monetarists argue that inflation is always and everywhere a monetary phenomenon. Keynesians do not find any link between money supply and price level causing an upward shift in aggregate demand.

According to Keynesians, aggregate demand may rise due to a rise in consumer demand or investment demand or govern­ment expenditure or net exports or the com­bination of these four components of aggreate demand. Given full employment, such in­crease in aggregate demand leads to an up­ward pressure in prices. Such a situation is called DPI. This can be explained graphically.

Just like the price of a commodity, the level of prices is determined by the interaction of aggregate demand and aggregate supply. In Fig. 4.3, aggregate demand curve is negative sloping while aggregate supply curve before the full employment stage is positive sloping and becomes vertical after the full employ­ment stage is reached. AD 1 is the initial aggregate demand curve that intersects the aggregate supply curve AS at point E 1 .

The price level, thus, determined is OP 1 . As ag­gregate demand curve shifts to AD 2 , price level rises to OP 2 . Thus, an increase in aggre­gate demand at the full employment stage leads to an increase in price level only, rather than the level of output. However, how much price level will rise following an increase in aggregate demand depends on the slope of the AS curve.

(ii) Causes of Demand-Pull Inflation:

DPI originates in the monetary sector. Mon­etarists’ argument that “only money matters” is based on the assumption that at or near full employment excessive money supply will in­crease aggregate demand and will, thus, cause inflation.

An increase in nominal money supply shifts aggregate demand curve rightward. This enables people to hold excess cash bal­ances. Spending of excess cash balances by them causes price level to rise. Price level will continue to rise until aggregate demand equals aggregate supply.

Keynesians argue that inflation originates in the non-monetary sector or the real sector. Aggregate demand may rise if there is an increase in consumption expenditure following a tax cut. There may be an autonomous increase in business investment or government expendi­ture. Government expenditure is inflationary if the needed money is procured by the gov­ernment by printing additional money.

In brief, increase in aggregate demand i.e., in­crease in (C + I + G + X – M) causes price level to rise. However, aggregate demand may rise following an increase in money supply gen­erated by the printing of additional money (classical argument) which drives prices up­ward. Thus, money plays a vital role. That is why Milton Friedman argues that inflation is always and everywhere a monetary phenom­enon.

There are other reasons that may push ag­gregate demand and, hence, price level up­wards. For instance, growth of population stimulates aggregate demand. Higher export earnings increase the purchasing power of the exporting countries. Additional purchasing power means additional aggregate demand. Purchasing power and, hence, aggregate de­mand may also go up if government repays public debt.

Again, there is a tendency on the part of the holders of black money to spend more on conspicuous consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused by a variety of factors.

(iii) Cost-Push Inflation Theory:

In addition to aggregate demand, aggregate supply also generates inflationary process. As inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is usu­ally associated with non-monetary factors. CPI arises due to the increase in cost of produc­tion. Cost of production may rise due to a rise in cost of raw materials or increase in wages.

However, wage increase may lead to an in­crease in productivity of workers. If this hap­pens, then the AS curve will shift to the right- ward not leftward—direction. We assume here that productivity does not change in spite of an increase in wages.

Such increases in costs are passed on to consumers by firms by rais­ing the prices of the products. Rising wages lead to rising costs. Rising costs lead to rising prices. And, rising prices again prompt trade unions to demand higher wages. Thus, an inflationary wage-price spiral starts. This causes aggregate supply curve to shift leftward.

This can be demonstrated graphically where AS 1 is the initial aggregate supply curve. Below the full employment stage this AS curve is positive sloping and at full em­ployment stage it becomes perfectly inelastic.

Intersection point (E 1 ) of AD 1 and AS 1 curves determine the price level (OP 1 ). Now there is a leftward shift of aggregate supply curve to AS 2 . With no change in aggregate demand, this causes price level to rise to OP 2 and output to fall to OY 2 . With the reduction in output, employment in the economy de­clines or unemployment rises. Further shift in AS curve to AS 3 results in a higher price level (OP 3 ) and a lower volume of aggregate out­put (OY 3 ). Thus, CPI may arise even below the full employment (Y F ) stage.

(iv) Causes of Cost-Push Inflation:

It is the cost factors that pull the prices up­ward. One of the important causes of price rise is the rise in price of raw materials. For in­stance, by an administrative order the govern­ment may hike the price of petrol or diesel or freight rate. Firms buy these inputs now at a higher price. This leads to an upward pres­sure on cost of production.

Not only this, CPI is often imported from outside the economy. Increase in the price of petrol by OPEC com­pels the government to increase the price of petrol and diesel. These two important raw materials are needed by every sector, espe­cially the transport sector. As a result, trans­port costs go up resulting in higher general price level.

Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions demand higher money wages as a compen­sation against inflationary price rise. If in­crease in money wages exceed labour produc­tivity, aggregate supply will shift upward and leftward. Firms often exercise power by push­ing prices up independently of consumer de­mand to expand their profit margins.

Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in cost of production. For instance, an overall in­crease in excise tax of mass consumption goods is definitely inflationary. That is why govern­ment is then accused of causing inflation.

Finally, production setbacks may result in decreases in output. Natural disaster, gradual exhaustion of natural resources, work stop­pages, electric power cuts, etc., may cause ag­gregate output to decline. In the midst of this output reduction, artificial scarcity of any goods created by traders and hoarders just simply ignite the situation.

Inefficiency, corruption, mismanagement of the economy may also be the other reasons. Thus, inflation is caused by the interplay of various factors. A particular factor cannot be held responsible for any inflationary price rise.

4. Effects of Inflation:

People’s desires are inconsistent. When they act as buyers they want prices of goods and services to remain stable but as sellers they expect the prices of goods and services should go up. Such a happy outcome may arise for some individuals; “but, when this happens, others will be getting the worst of both worlds.”

When price level goes up, there is both a gainer and a loser. To evaluate the conse­quence of inflation, one must identify the na­ture of inflation which may be anticipated and unanticipated. If inflation is anticipated, peo­ple can adjust with the new situation and costs of inflation to the society will be smaller.

In reality, people cannot predict accurately fu­ture events or people often make mistakes in predicting the course of inflation. In other words, inflation may be unanticipated when people fail to adjust completely. This creates various problems.

One can study the effects of unanticipated inflation under two broad head­ings:

(a) Effect on distribution of income and wealth; and

(b) Effect on economic growth.

(a) Effects of Inflation on Distribution of Income and Wealth:

During inflation, usu­ally people experience rise in incomes. But some people gain during inflation at the ex­pense of others. Some individuals gain be­cause their money incomes rise more rapidly than the prices and some lose because prices rise more rapidly than their incomes during inflation. Thus, it redistributes income and wealth.

Though no conclusive evidence can be cited, it can be asserted that following catego­ries of people are affected by inflation differ­ently:

(i) Creditors and debtors:

Borrowers gain and lenders lose during inflation because debts are fixed in rupee terms. When debts are repaid their real value declines by the price level increase and, hence, creditors lose. An individual may be interested in buying a house by taking loan of Rs. 7 lakh from an in­stitution for 7 years.

The borrower now wel­comes inflation since he will have to pay less in real terms than when it was borrowed. Lender, in the process, loses since the rate of interest payable remains unaltered as per agree­ment. Because of inflation, the borrower is given ‘dear’ rupees, but pays back ‘cheap’ ru­pees. However, if in an inflation-ridden economy creditors chronically loose, it is wise not to advance loans or to shut down business.

Never does it happen. Rather, the loan-giving institution makes adequate safeguard against the erosion of real value. Above all, banks do not pay any interest on current account but charges interest on loans.

(ii) Bond and debenture-holders:

In an economy, there are some people who live on interest income—they suffer most. Bondhold­ers earn fixed interest income: These people suffer a reduction in real income when prices rise. In other words, the value of one’s sav­ings decline if the interest rate falls short of inflation rate. Similarly, beneficiaries from life insurance programmes are also hit badly by inflation since real value of savings deterio­rate.

(iii) Investors:

People who put their money in shares during inflation are expected to gain since the possibility of earning of business profit brightens. Higher profit induces own­ers of firm to distribute profit among inves­tors or shareholders.

(iv) Salaried people and wage-earners:

Any­one earning a fixed income is damaged by in­flation. Sometimes, unionised worker suc­ceeds in raising wage rates of white-collar workers as a compensation against price rise. But wage rate changes with a long time lag. In other words, wage rate increases always lag behind price increases. Naturally, inflation results in a reduction in real purchasing power of fixed income-earners.

On the other hand, people earning flexible incomes may gain during inflation. The nominal incomes of such people outstrip the general price rise. As a re­sult, real incomes of this income group in­crease.

(v) Profit-earners, speculators and black marketers:

It is argued that profit-earners gain from inflation. Profit tends to rise during inflation. Seeing inflation, businessmen raise the prices of their products. This results in a bigger profit. Profit margin, however, may not be high when the rate of inflation climbs to a high level.

However, speculators dealing in business in essential commodities usually stand to gain by inflation. Black marketers are also ben­efited by inflation.

Thus, there occurs a redistribution of in­come and wealth. It is said that rich becomes richer and poor becomes poorer during infla­tion. However, no such hard and fast gener­alisation can be made. It is clear that someone wins and someone loses during inflation.

These effects of inflation may persist if in­flation is unanticipated. However, the redistributive burdens of inflation on income and wealth are most likely to be minimal if inflation is anticipated by the people. With anticipated inflation, people can build up their strategies to cope with inflation.

If the annual rate of inflation in an economy is anticipated correctly people will try to protect them against losses resulting from inflation. Workers will demand 10 p.c. wage increase if inflation is expected to rise by 10 p.c.

Similarly, a percent­age of inflation premium will be demanded by creditors from debtors. Business firms will also fix prices of their products in accordance with the anticipated price rise. Now if the en­tire society “learn to live with inflation”, the redistributive effect of inflation will be mini­mal.

However, it is difficult to anticipate prop­erly every episode of inflation. Further, even if it is anticipated it cannot be perfect. In addi­tion, adjustment with the new expected infla­tionary conditions may not be possible for all categories of people. Thus, adverse redistributive effects are likely to occur.

Finally, anticipated inflation may also be costly to the society. If people’s expectation regarding future price rise become stronger they will hold less liquid money. Mere hold­ing of cash balances during inflation is unwise since its real value declines. That is why peo­ple use their money balances in buying real estate, gold, jewellery, etc. Such investment is referred to as unproductive investment. Thus, during inflation of anticipated variety, there occurs a diversion of resources from priority to non-priority or unproductive sectors.

(b) Effect on Production and Economic Growth:

Inflation may or may not result in higher output. Below the full employment stage, inflation has a favourable effect on production. In general, profit is a rising function of the price level. An inflationary situation gives an incen­tive to businessmen to raise prices of their prod­ucts so as to earn higher volume of profit. Ris­ing price and rising profit encourage firms to make larger investments.

As a result, the multi­plier effect of investment will come into opera­tion resulting in a higher national output. How­ever, such a favourable effect of inflation will be temporary if wages and production costs rise very rapidly.

Further, inflationary situation may be as­sociated with the fall in output, particularly if inflation is of the cost-push variety. Thus, there is no strict relationship between prices and output. An increase in aggregate demand will increase both prices and output, but a supply shock will raise prices and lower output.

Inflation may also lower down further pro­duction levels. It is commonly assumed that if inflationary tendencies nurtured by experi­enced inflation persist in future, people will now save less and consume more. Rising sav­ing propensities will result in lower further outputs.

One may also argue that inflation creates an air of uncertainty in the minds of business community, particularly when the rate of in­flation fluctuates. In the midst of rising infla­tionary trend, firms cannot accurately estimate their costs and revenues. That is, in a situa­tion of unanticipated inflation, a great deal of risk element exists.

It is because of uncertainty of expected inflation, investors become reluc­tant to invest in their business and to make long-term commitments. Under the circum­stance, business firms may be deterred in in­vesting. This will adversely affect the growth performance of the economy.

However, slight dose of inflation is neces­sary for economic growth. Mild inflation has an encouraging effect on national output. But it is difficult to make the price rise of a creep­ing variety. High rate of inflation acts as a dis­incentive to long run economic growth. The way the hyperinflation affects economic growth is summed up here. We know that hyper-inflation discourages savings.

A fall in savings means a lower rate of capital forma­tion. A low rate of capital formation hinders economic growth. Further, during excessive price rise, there occurs an increase in unpro­ductive investment in real estate, gold, jewel­lery, etc. Above all, speculative businesses flourish during inflation resulting in artificial scarcities and, hence, further rise in prices.

Again, following hyperinflation, export earn­ings decline resulting in a wide imbalances in the balance of payment account. Often gallop­ing inflation results in a ‘flight’ of capital to foreign countries since people lose confidence and faith over the monetary arrangements of the country, thereby resulting in a scarcity of resources. Finally, real value of tax revenue also declines under the impact of hyperinfla­tion. Government then experiences a shortfall in investible resources.

Thus economists and policymakers are unanimous regarding the dangers of high price rise. But the consequence of hyperinfla­tion are disastrous. In the past, some of the world economies (e.g., Germany after the First World War (1914-1918), Latin American coun­tries in the 1980s) had been greatly ravaged by hyperinflation.

The German inflation of 1920s was also catastrophic:

During 1922, the German price level went up 5,470 per cent. In 1923, the situation wors­ened; the German price level rose 1,300,000,000 (1.3 billion) times. By October of 1923, the post­age in the lightest letter sent from Germany to the United States was 200,000 marks. But­ter cost 1.5 million marks per pound, meat 2 million marks, a loaf of bread 200,000 marks, and an egg 60,000 marks! Prices increased so rapidly that waiters changed the prices on the menu several times during the course of a lunch!! Sometimes, customers had to pay the double price listed on the menu when they observed it first!!! A photograph of the period shows a German housewife starting the fire in her kitchen stove with paper money and children playing with bundles of paper money tied together into building blocks!

Currently (September 2008), Indian economy experienced an inflation rate of al­most 13 p.c.—an unprecedented one over the last 16 or 17 years. However, an all-time record in price rise in India was struck in 1974-75 when it rose more than 25 p.c. Anyway, peo­ple are ultimately harassed by the high dose of inflation. That is why, it is said that ‘infla­tion is our public enemy number one.’ Rising inflation rate is a sign of failure on the part of the government.

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What is inflation, and should we worry? An economist explains

Inflation is a concern. Hyperinflation is a disaster. A high-denomination banknote from the late 2000s. Image:  Robin Pomeroy

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Stay up to date:, global economic imbalances.

• Inflation was low for decades in much of the developed world before COVID.
• A surge in demand, some problems of supply and soaring energy costs have caused a big jump in inflation rates.
• Is this a blip, or is inflation back to stay, and what can be done?
• UBS Chief Economist Paul Donovan talks to the Radio Davos podcast.

As the world emerges from COVID, economies are revving back to life - but so is something that many parts of the world have not seen much of for decades - inflation.

So what is inflation and why has it suddenly reared up around the world?

UBS Chief Economist Paul Donovan , author of The Truth About Inflation , spoke to Radio Davos.

Have you read?

Why do oil prices matter to the global economy an expert explains, what is the impact of inflation on low-income households, 7 chief economists on how to solve the pandemic’s labour market paradox, what is inflation, and should we worry an interview with paul donovan.

Robin Pomeroy: Inflation is something everyone has been talking about and you even wrote a book about it called The Truth About Inflation , which is exactly what we want to get to in this interview: What is inflation? What is true, what is false about it? Why is inflation for you, as an economist and as an individual, such an important issue?

We have this idea that there is a single inflation number which affects us all. And that just isn't true.

Paul Donovan: It's important because I think it's it's very often misunderstood. We have this idea that there is a single inflation number which affects us all. And that just isn't true. The inflation experienced by older people tends to be higher. The inflation experienced by lower income people tends to be higher because of what they buy. Older people buy healthcare, lower income people are buying food, energy and housing in disproportionate amounts. And that gives them a higher inflation rate. So really, if you want to avoid inflation, you need to be young and rich.

Investors also, I think, get very confused about aspects of inflation. So consumer price inflation, which is the number most people look at, actually is not a very good guide to corporate pricing power because companies tend not to sell to consumers - companies sell to other companies. So it's a different measure - producer price inflation - that gives us a better indication of pricing power. Costs are driven by wage inflation. So this idea that there's a single nice statistic that tells us everything we need to know about price changes just isn't true, and we need to really understand the detail of what's going on to properly be able to assess the economic consequences of inflation moving up or inflation moving down.

Do we believe the inflation rate?

Robin Pomeroy: Individuals, we as people, sometimes find it hard to accept the official inflation rate because of biases we may have. Could you explain that a little bit?

Paul Donovan: People never believe the official inflation statistics, and they tend to believe that inflation is higher than it actually is. Why is that? Well, it's two behavioural economic concepts which are actually very well understood. So the first is loss aversion, and this is the fact that we are genetically programmed to remember and react to bad news more than good news. We run away from the sabre tooth tiger three times as fast as we run towards our next meal. So because of loss aversion, which is this sort of ancient behavioural trait, people remember price increases and they forget about the price cuts. And so you end up with this sort of bias that you're ignoring the fact that your flat screen TV fell in price last year, and you're remembering the fact that the price of your Snickers bar has gone up over the course of the last year.

Because of loss aversion, which is this ancient behavioural trait, people remember price increases and they forget about the price cuts.

But then we have this second behavioural trait, which is frequency bias, and this is a really big problem. People remember the price of something they buy frequently - that means food and fuel. The result is you get a very distorted view of what's driving inflation. So, for example, if I come into my office and I see that the price of a Snickers bar in a vending machine here has gone from 50 pence to 60 pence, I know I'm going to get colleagues coming up to me all the time and saying, 'inflation's out of control, we've got 20% inflation'. Now, with the best will in the world, my colleagues can only consume so many chocolate bars in a 24-hour period - it's not a major part of their overall budget. But every single time they go to the vending machine, they're reminded the price has gone up by 20% and that sticks in the mind. And so what we then have is this combination that we are focused on high-frequency purchases, and we tend to remember the price increases not the price declines. And that can give us a very distorted view of what's going on with average prices in the economy.

What's happening with inflation now?

Robin Pomeroy: So what is happening with inflation now globally? Everyone's talking about a resurgence in inflation. It seems that in many parts of the world there's not been inflation that's been above a point that we would consider problematic in many parts of the world, but now perhaps we are at a point where that's the case. Could you tell us - is that true what I'm saying, that there has been this historical period? And what is happening now?

Is this really inflation? That's that's where economists start to disagree.

Paul Donovan: In developed economies, by and large, we have had a 20-25 year period of pretty low inflation. Now there's been the odd spike, but generally speaking, prices have come in sort of around a 1.5-3-3.5% range of increase every year on an average index. And that, of course, is perfectly fine.

What we're now seeing is inflation rates come in quite a way above that. So in the United States, the latest inflation number for headline CPI - consumer price inflation - is 7% year over year, which is a very high number. Now is this really inflation? Well, that's that's where economists start to disagree a little bit. Because inflation is a general increase in prices, lots of prices rising by a large amount, all at the same time. And that's important because if lots and lots of prices are rising, that's telling you that there's an imbalance in the overall economy and that's something that policymakers need to address. But if you've got one or two prices rising a lot and other prices behaving more or less normally, then that's telling you that there's a problem in one or two markets, but not in the economy at large. We have got slightly stronger inflation for most of the economy and one or two price increases that are really quite extraordinary. And that's a pattern that we're seeing pretty much globally. Energy is behind a lot of the headline numbers. The used car market, the new car market, has also had some distortions because there have been problems with supply there over the last year. This is what's really pushing up the the headline inflation rate.

Inflation - the policy makers

Robin Pomeroy: At a recent conversation at the Davos Agenda , we had senior economists and central bankers talking about inflation. The head of the IMF, the head of the Bank of Japan, the head of the European Central Bank. I'd like to play you a clip from Christine Lagarde, the governor of the European Central Bank, with her view on where inflation is at right now.

Christine Lagarde (speaking at the Davos Agenda 2022 ): We have to ask ourselves, where is it [inflation] coming from? Is it likely to last? And we are trying to figure out how long it will last, because that is going to be critical in really composing the policy response that will be needed. And what do we see under the numbers? Well, we see 50% energy prices. It is not just the recovery, it is also geopolitical factors that are critically important at the moment, unfortunately. It is also some idiosyncratic factors. It is some weather-related factors. And the rest, essentially, taking out a few base effects that will eventually clear out in the next month, actually, we see a lot of this super-strong recovery that has outpaced supply, which was constrained. And as a result of that, you all, we all, talk about the bottlenecks, the congestion of ports, the lack of truck drivers and what have you. So then you ask yourself: these two big factors, are they going to be with us for the long term? Are they going to affect this inflation number and make it sustainable? And will that dictate our monetary policy response?

We are not seeing this sustainable movement that would lead to inflation spiralling out of control. On the contrary, we assume — and again, lesson of humility here, there is a lot of uncertainty about it — but we assume for the moment that energy prices will stabilise in the course of '22, that those bottlenecks and those congested ports and drivers missing in action, and all the rest of it, will also stabilise in the course of '22, and that gradually those inflation numbers will decline.

Robin Pomeroy: Christine Lagarde, governor of the European Central Bank, seemingly cautiously optimistic that inflation will start to come back under control because the things she mentioned are transitory problems there. Do you agree with her forecast?

Paul Donovan: Broadly, I would agree with President Lagarde that inflation is going to come down because the increase in the oil price is slowing, and that means the contribution of the oil price to inflation is slowing. And other factors, I think, are also going to be coming down. Demand, which has been quite extraordinary, is going to normalise as we go through this year.

We're hearing a lot from policymakers about supply chain problems and supply chain bottlenecks. This is politics - it's not economics. Because when we look at what's happened with global supply, global supply simply surged last year. Global manufacturing output: all time record high. Global volume of trade: up 11% on the World Trade Organisation's numbers. The volume of shipping through the Suez Canal: all-time record high, even with ships going sideways , they still get an all-time record high volume of shipping! So we're seeing supply chains work wonderfully throughout 2021. This idea that supply chains are crumbling ruins around the world is complete nonsense.

You've got to go back to the end of wartime rationing to see so strong a surge in demand for durable goods.

But what we had last year was a simply extraordinary level of demand. In the United States, demand for durable goods surged in the strongest increase we have seen since 1946. You've got to go back to the end of wartime rationing to see so strong a surge in demand for durable goods. And why was that? Well, that was because, during the pandemic, people saved money and once they were released from the restrictions around COVID and were able to go out and spend the money, they went out and spent the money. So you've had this extraordinary, extraordinary surge in demand, which has overwhelmed a valiant effort by supply to meet that demand. So here we have a bit of an imbalance in the economy. Demand is a lot stronger than supply, and that has pushed up some prices of goods. But of course, that surge in demand cannot last, and we're already starting to see it fade in the US and possibly also in the UK. Because once the savings are spent, you have to go back to normal levels of demand. And that seems to be where we're moving to. And as we normalise demand, we're going to normalise inflation rates with a little bit of a lag because prices take a little while to adjust, but normalising inflation seems to me very, very likely this year.

Robin Pomeroy: So we should all take a deep breath and kind of ride this wave. I guess the question is with inflation is: will it spiral? Let me play this little clip from someone else on that panel at the Davos Agenda week. This is Brazilian Economy Minister Paulo Guedes.

Paulo Guedes (speaking at the Davos Agenda 2022 ) : I don't think inflation will be transitory at all. I think these supply adverse shocks will fade away gradually, but there's no arbitrage anymore to be exploited by the Western side. So I think the central banks are sleeping at the driver wheel. They should be aware. And I think inflation will be a problem, a real problem, very soon for the Western world.

Inflation - what causes a spiral?

Robin Pomeroy: So that was Paulo Guedes, the economy minister of Brazil, taking the other opinion, saying that things will spiral out of control. What are the risk factors that do push inflation to spiral upwards? What are the policy levers available and whether they might or might not be useful this time around?

Labour costs in a developed economy are about 70% of inflation.

Paul Donovan: So the simple answer is labour costs. Now, labour costs in a developed economy are about 70% of inflation. We all focus on things like commodity prices. Commodities really aren't that important to inflation - about 15% is down to commodities. Labour costs are the big one. And it's important to recognise here that we're not talking about wages. So wages is how much you take home. But actually what a company is interested in when it's setting prices is, 'how much do I have to spend on labour entirely to produce a unit of output?' The wage rate going up is not all we've got to consider. We've also got to consider how hard are people working, because if people are working harder, then they should be paid more money, something I repeatedly remind my bosses of. If you've got people who are working harder, they're producing more output - paying them more money isn't necessarily inflationary. So the US restaurant sector is a really good example of this. If we look at the data for December, restaurant sales in the United States were over 19% higher than they were in January of 2020. But you've achieved that increase in restaurant sales with 2.3% fewer staff. So in that situation, of course, what's happening is staff are working harder or in some restaurants staff have been replaced by computers. The only thing the restaurant employee does is actually prepare the food for you. So this automation means that you can use fewer people to achieve more output, and so therefore you can afford to pay those people a little bit more. So the way that economists look at this is through something called unit labour costs. Now the problem with unit labour costs is this is data that's revised very, very often, and it's not a very stable statistic, to be perfectly honest. But that's really what we're looking at. If we start to see wages increasing more rapidly than output is increasing, that would be something that would start to be problematic because then those wage costs would be passed on in higher prices and then workers may respond with increased wage demands.

I think it's very unlikely to happen. It happened in the 1970s in a very, very different world. The US president, President Nixon, was setting wages and prices personally, it was a state control. The price of hamburger in the United States was personally set by President Nixon in the Oval Office. Quite remarkable. And that whole collapse of that pricing structure led to an inflation bout. The unionised nature of wage bargaining also led to increased inflation pressure. We're nowhere near any of that now.

Inflation, wages and productivity

Robin Pomeroy: You're talking about this word 'productivity' there aren't you? That's the term economists use. So 'it's OK to increase wages if productivity increases'. I just wonder, I mean, in a hamburger restaurant that might apply, but what about lots of areas where the output is quite difficult to measure? What about the millions of people who work in schools and in hospitals? How do you measure the productivity of a teacher or of a nurse? You know, a nurse who's worked her fingers to the bone, or his, through the pandemic, who deserves a pay rise, who's got to deal with these inflationary pressures. There will be pressure, won't there, to increase wages for millions of people around the world, very often low paid people who have tough jobs. But it's very hard to measure, I would have thought, productivity increases for them, isn't it?

Paul Donovan: It is. There are ways that you can try and do this and you have to come up with, you know: 'What is the value of healthcare?', 'What is the value of education?' It's controversial. The UK, for example, measures the value of education based on the number of students that are taught, whereas France measures the value of education based on how much they pay their teachers. There are more and more sophisticated ways of measuring output, which is helpful and which does allow us to see a little bit more about what's going on in terms of productivity and the value of what people are producing in the economy. But we've got to recognise that the pandemic has accelerated an awful lot of structural change, and data is scrambling to keep up with this. But things like working from home change productivity, change efficiency. The increase of self-employment, we've seen a massive increase in self-employment in many, many developed economies in the aftermath of the pandemic. That's not necessarily being captured in the data, but it's still output and productivity and income. So it's becoming a lot more complicated as we go through this structural upheaval in the economy.

The inflation policy levers

Robin Pomeroy: So let's talk a bit about the policies now. We've quoted central bankers who are in charge of setting interest rates. Could you just take us back to the basics and say what is it that policymakers are looking out for and what is it they can do, at least in theory, to control inflation?

There's a limit to what central bankers can do. There's some prices that they've got to sit there and say: 'You know what? Sit it out for 12 months and this is going to stop being a problem'.

Paul Donovan: We have fiscal policy, we have monetary policy, and inflation is generally put down to the monetary policy makers. That's not always entirely practical. So if we look at some of the current inflation, there's nothing Fed Chair Powell can do to change global oil prices. He is not a used car sales person. There's nothing he can do to change the price of a 2001 Honda Civic. So there's a limit to what central bankers can do. There's some prices that they've really got to sit there and say, 'You know what? Sit it out for 12 months and this is going to stop being a problem'. And that's effectively what central bankers are having to do. But there are other prices that they can influence, and they can influence to some extent wage growth, indirectly, they can influence some other cyclical prices by influencing the cost of credit in the economy. And by raising the cost of credit - raising interest rates - what of course you are doing is limiting the ability of people to demand goods and therefore you bring supply and demand into balance, and that helps reduce inflation pressures. You may also give people an incentive to save money rather than spend money if you've raised the interest rate. But we have to recognise the limitations. We've just got to burn through this demand and then after that see where we are. And so that's what I think is is happening. Central banks know that inflation is going to be coming down this year because the technical factors are going to fade. So what they are looking to do is not to sort of squeeze inflation out of the system - they're not looking to create a recession. What they're looking to do is have interest rates that are a level that allow growth after this demand surge to settle back into a more normal pattern. And that's quite a less aggressive policy than when you're trying to actually push down on inflation. Central banks are saying, 'Look, inflation's coming down, and once it's down, we want to keep it there'. That's a slightly different approach that they're going to be taking.

Hyperinflation

Robin Pomeroy: Let's just go back to inflation as this kind of bogeyman that some people fear. And you've got countries, haven't you, that have this collective memory of something far worse than that - of hyperinflation? We know that the Germans, even people who aren't old enough to remember it, there's still this kind of societal memory of hyperinflation there. Could you remind us what hyperinflation is and how bad inflation can get and why we should be so scared of it in those circumstances.

In a hyperinflation episode people can lose everything.

Paul Donovan: There isn't really a formal definition of what hyperinflation is. I would say that once you're talking about a 50% inflation rate, you're getting pretty close to a hyperinflation scenario. And it's where prices are changing constantly. That becomes socially disruptive. You're changing social status of people. You're changing the relative value of jobs, of positions in society, of incomes. Normally, a hyperinflation episode involves a huge transfer of wealth from savers to borrowers. Borrowers benefit, savers suffer. And that's what people remember. Again, it's that loss aversion. In a hyperinflation episode people can lose everything - they lose their social status, they lose their income. And that's why hyperinflation episodes tend to be remembered for multi-generations. So Germany had two hyperinflation episodes: 1923 and then immediately after the Second World War. Singapore is another interesting society where there's a very strong fear of inflation coming, not from Singapore's hyperinflation episode, but from the hyperinflation of nationalist China after the war and then a lot of emigres from nationalist China went and settled in Singapore and they took with them the memory of the very, very destructive power of a very, very high inflation rate. So hyperinflation tends to cause considerable concern.

If you've got an economist running a central bank, you will not have hyperinflation.

It's something which happens deliberately, to be perfectly honest. If you've got an economist running a central bank, you will not have hyperinflation because hyperinflation is essentially caused by printing too much money. In 1923, the Reichsbank 's President Havenstein in Germany, who wasn't an economist, he was a lawyer, responded to the German economic situation just simply printing more and more money. And this famous occasion where he gave a speech saying, 'Don't worry, we've ordered more printing presses. We're going to be able to print even more money and it will all be fine. And that will get rid of the inflation.' Complete misunderstanding of what was going on, to the extent that by the end of the hyperinflation episode, the central bank was printing money where they only printed one side of the banknote, the other side was blank paper because there wasn't enough time to print both sides of the banknote before the money devalued and lost all sense of value.

We've seen that more recently in places like Zimbabwe, the worst hyperinflation episode ever was in Czechoslovakia after the Second World War. So we've had all of these these episodes. It's caused by a complete failure to observe the laws of economics. As long as you observe the laws of economics, you maintain some semblance of balance between money supply and money demand.

Robin Pomeroy: That's a reassuring note, perhaps on which to end it. Paul Donovan, thanks very much for explaining inflation to us. We're going to keep a close eye on it. Thanks for joining us on Radio Davos.

Paul Donovan: Thanks so much for your time.

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Home — Essay Samples — Economics — Political Economy — Inflation

Essays on Inflation

Inflation essay topics and outline examples, essay title 1: understanding inflation: causes, effects, and economic policy responses.

Thesis Statement: This essay provides a comprehensive analysis of inflation, exploring its root causes, the economic and societal effects it generates, and the various policy measures employed by governments and central banks to manage and mitigate inflationary pressures.

• Introduction
• Defining Inflation: Concept and Measurement
• Causes of Inflation: Demand-Pull, Cost-Push, and Monetary Factors
• Effects of Inflation on Individuals, Businesses, and the Economy
• Inflationary Policies: Central Bank Actions and Government Interventions
• Case Studies: Historical Inflationary Periods and Their Consequences
• Challenges in Inflation Management: Balancing Growth and Price Stability

Essay Title 2: Inflation and Its Impact on Consumer Purchasing Power: A Closer Look at the Cost of Living

Thesis Statement: This essay focuses on the effects of inflation on consumer purchasing power, analyzing how rising prices affect the cost of living, household budgets, and the strategies individuals employ to cope with inflation-induced challenges.

• Inflation's Impact on Prices: Understanding the Cost of Living Index
• Consumer Behavior and Inflation: Adjustments in Spending Patterns
• Income Inequality and Inflation: Examining Disparities in Financial Resilience
• Financial Planning Strategies: Savings, Investments, and Inflation Hedges
• Government Interventions: Indexation, Wage Controls, and Social Programs
• The Global Perspective: Inflation in Different Economies and Regions

Essay Title 3: Hyperinflation and Economic Crises: Case Studies and Lessons from History

Thesis Statement: This essay explores hyperinflation as an extreme form of inflation, examines historical case studies of hyperinflationary crises, and draws lessons on the devastating economic and social consequences that result from unchecked inflationary pressures.

• Defining Hyperinflation: Thresholds and Characteristics
• Case Study 1: Weimar Republic (Germany) and the Hyperinflation of 1923
• Case Study 2: Zimbabwe's Hyperinflationary Collapse in the Late 2000s
• Impact on Society: Currency Devaluation, Poverty, and Social Unrest
• Responses and Recovery: Stabilizing Currencies and Rebuilding Economies
• Preventative Measures: Policies to Avoid Hyperinflationary Crises

The Impact of Inflation Reduction Act on The International Economic Stage

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Inflation cools but rising prices still dominate Americans’ view of economy

Paul Solman Paul Solman

Diane Lincoln Estes Diane Lincoln Estes

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• Copy URL https://www.pbs.org/newshour/show/inflation-cools-but-rising-prices-still-dominate-americans-view-of-economy

Inflation cooled somewhat in April, according to new numbers from the Bureau of Labor Statistics. The consumer price index rose at an annual rate of 3.4 percent, in line with expectations. But overall, inflation hasn't yet come down quite to the levels that many people have been hoping for. Economics correspondent Paul Solman reports.

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Geoff Bennett:

Inflation cooled somewhat last month. That's according to new numbers from the Bureau of Labor Statistics.

The Consumer Price Index rose at an annual rate of 3.4 percent. That's in line with expectations. But, overall, inflation hasn't yet come down quite to the levels that many people have been hoping for.

Our economics correspondent, Paul Solman, has the story.

Paul Solman:

The latest CPI data prices, of goods and services did rise last month, but at a slightly slower pace.

Christopher Conlon, Associate Professor of Economics, New York University Stern School of Business: I think this is good news, particularly because what the Federal Reserve generally looks at is core CPI, and that's down to 3.6 percent year-on-year, which is actually the lowest level since April 2021.

Core CPI, in other words, explains New York University's Chris Conlon, everything but food and fuel prices.

Christopher Conlon:

One of the things that's been pushing up CPI this month has been the increase in gasoline prices.

But we shouldn't necessarily be looking at that?

yes, I think there are a lot of reasons why gasoline prices tend to be volatile, particularly this time of year, that have nothing to do with sort of overall inflation. Crude prices are actually been heading downward.

And food prices can be similarly jumpy, for short-term reasons, in contrast to the longer-term causes of, say, the great COVID inflation that started all this, though, by now, you may be as tired of hearing them and seeing the footage as we are, backed-up supply chain ships due to the stuck-at-home spending spree, stimulus checks, labor shortages, firms hiking prices above their own costs.

But, today, that's pretty much behind us, according to the Harvard Business School's Alberto Cavallo.

Alberto Cavallo, Professor of Business Administration, Harvard Business School: Goods inflation has come down significantly. And we are back to pre-pandemic levels. What still remains is the impact of shelter inflation, or rents, which is a category that tends to lag a lot.

Shelter costs, measured mostly by rents, are more than a third of the CPI and a clear source of lag, says Cavallo.

Alberto Cavallo:

Landlords putting their houses, for rent, they don't have a very good idea of what's happening with supply, with demand. They may test high rents for a while, and it takes longer for them to internalize and realize that the conditions will require lower rents. And, naturally, that makes the inflation rate take longer to come down.

Economists have a phrase to describe this, says Chris Conlon, rockets and feathers.

When costs go up, prices go up like a rocket. They go up really fast. And when costs go down, prices fall like a feather, that is, they float to the ground really slowly.

But though inflation has swooned since peaking above 9 percent in 2022, we remain preoccupied. Why?

Stefanie Stantcheva, Professor of Political Economy, Harvard University: People tend to associate inflation with a bad economy. We feel like it is eroding our living standards.

Harvard researcher Stefanie Stantcheva.

Stefanie Stantcheva:

When I ask people what emotions do you feel when you see rising prices, predominantly, it's very negative emotions such as anger, fear, and stress. And while they're quite widespread, they're especially concentrated among lower-income respondents.

And, crucially, that's because inflation hits different folks differently, says Cavallo.

We all tend to focus on what we call average inflation for an average consumer. But each one of us experiences an actual different inflation based on the products we do buy. We have, for example, low-income households consuming a lot more food than high-income households. If there's suddenly a lot of inflation in food, the low-income households actually experience more inflation.

So, yes, the data show price hikes tapering, but not for everyone equally, echoes Stantcheva.

We know there's inflation inequality, where the basket of goods that people consume will vastly shape the inflation experience. So, I think this is very important to bear in mind when thinking about people's stress responses, reactions, lived experience that might just not well be captured by our official statistics.

Which may help explain why consumer sentiment sank in may, many Americans feeling that inflation hasn't dropped fast enough and could even get worse.

For the "PBS NewsHour," Paul Solman.

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Paul Solman has been a correspondent for the PBS NewsHour since 1985, mainly covering business and economics.

Diane Lincoln Estes is a producer at PBS NewsHour, where she works on economics stories for Making Sen$e.

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What is inflation? What causes it? Here's how it's defined and what the latest report means

The latest inflation readings showed a mixed bag as drops in grocery and used car prices balanced out increases in rent and gasoline.

Overall prices increased 3.4% from a year earlier, down from 3.5% in March, according to the Bureau of Labor Statistic's consumer price index , a gauge of goods and services costs throughout the economy. Meanwhile, on a monthly basis, costs rose 0.3%, below the 0.4% rise the previous month but above the 0.1% to 0.2% readings that prevailed last fall.

Grocery prices dropped 0.2% after flatlining the previous two months, gasoline prices rose 2.8% and used car prices declined by 1.4%. Rent, measured in March, rose .4% month over month.

Core prices, which strip out volatile food and energy items and are watched more closely by the Fed, increased 0.3% after three straight 0.4% bumps. Annual inflation by that measure fell to 3.6%, the lowest reading since April 2021.

The Federal Reserve's goal for annual inflation is 2%.

Protect your assets: Best high-yield savings accounts of 2023

But what is inflation? Why does it matter? Here's what you need to know.

What is inflation? 

Inflation is the decline of purchasing power in an economy caused by rising prices,  according to Investopedia .

The root of inflation is an increase in an economy's money supply that allows more people to enter markets for goods, driving prices higher.

Inflation in the United States is measured by the Consumer Price Index (CPI), which bundles together commonly purchased goods and services and tracks the change in prices.

A slowdown in inflation is called  disinflation  and a reduction in prices is called  deflation .

What causes inflation? 

Inflationary causes include:

• Demand pull : An inflationary cycle caused by demand outpacing production capabilities that leads to prices rising
• Cost-push effect : An inflationary effect where production costs are pushed into the final cost
• Built-in inflation : An increase in inflation as a result of people bargaining to maintain their purchasing power

Recently, some financial observers have assigned a new cause to the inflationary portfolio.

Independent financial research firm Fundstrat's head of research Tom Lee said on CNBC in March that corporate greed was a key driver to inflation.

What is hyperinflation?

Hyperinflation is the rapid and uncontrolled increase of inflation in an economy,  according to Investopedia .

The phenomenon is rare but when it occurs, the effects are devastating.  Hyperinflation in Yugoslavia  caused people to barter for goods instead of using the country's currency, which would be replaced by the German mark to stabilize the economy.

Hungary experienced  a daily inflation rate  of 207% between 1945 and 1946, the highest ever recorded.

Consumer Price Index month over month

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Rent Is Harder to Handle and Inflation Is a Burden, a Fed Financial Survey Finds

The Federal Reserve’s 2023 survey on household financial well-being found Americans excelling in the job market but struggling with prices.

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By Jeanna Smialek

American households struggled to cover some day-to-day expenses in 2023, including rent, and many remained glum about inflation even as price increases slowed.

That’s one of several takeaways from a new Federal Reserve report on the financial well-being of American households. The report suggested that American households remained in similar financial shape to 2022 — but its details also provided a split screen view of the U.S. economy.

On the one hand, households feel good about their job and wage growth prospects and are saving for retirement, evidence that the benefits of very low unemployment and rapid hiring are tangible. And about 72 percent of adults reported either doing OK or living comfortably financially, in line with 73 percent the year before.

But that optimistic share is down from 78 percent in 2021, when households had just benefited from repeated pandemic stimulus checks. And signs of financial stress tied to higher prices lingered, and in some cases intensified, just under the report's surface.

Inflation cooled notably over the course of 2023, falling to 3.4 percent at the end of the year from 6.5 percent going into the year. Yet 65 percent of adults said that price changes had made their financial situation worse. People with lower income were much more likely to report that strain: Ninety-six percent of people making less than $25,000 said that their situations had been made worse.

Renters also reported increasing challenges in keeping up with their bills. The report showed that 19 percent of renters reported being behind on their rent at some point in the year, up two percentage points from 2022.

Interestingly, slightly fewer households were taking action — like switching to cheaper products or delaying big purchases — to defray their higher costs compared with 2022. Still, about 79 percent of households indicated that they had done something to offset climbing costs, suggesting that Americans have not yet broadly accepted high prices as an unavoidable reality of life.

The Fed’s annual checkup on household finances is particularly relevant this year. Consumer confidence has been depressed even though the job market is booming and inflation is cooling notably, a mystery that has befuddled analysts and bedeviled the White House.

Polls show that President Biden is suffering as Americans take a dim view of the economy under his administration. Donald J. Trump, the presumptive Republican nominee for November’s presidential election, has been hammering Mr. Biden’s economic record.

The report underscores that even though inflation is cooling, it remains a major concern for many Americans, one that may be a big enough worry to take the shine away from an economy that is growing quickly and adding jobs.

Part of the continued concern, many economists speculate, is because households pay more attention to price levels — which are sharply higher than they were as recently as 2020 — than to price changes, which is what statisticians mean when they talk about inflation. To use an example, a person may focus on the fact that his or her latte now costs $5 instead of $3, rather than the fact that it is no longer climbing in price as quickly as it was last year.

“When I talk to folks, they all tell me that they want interest rates to be lower and they also tell me that prices are too high,” Raphael Bostic, the president of the Federal Reserve Bank of Atlanta, said in an interview with reporters on Tuesday morning. “People remember where prices used to be, and they remember that they didn’t have to talk about inflation, and that was a very comfortable place.”

The Fed has raised interest rates to 5.3 percent from near zero as recently at 2022 in a bid to cool the economy and stamp out rapid price increases. While that, too, is painful for many households — placing home-buying further out of reach and making credit card balances painfully expensive — officials like Mr. Bostic emphasize that the policy is necessary.

“We’ve got to get inflation back to 2 percent as quickly as we can,” Mr. Bostic said, referring to the inflation rate that was roughly normal before the pandemic and that is the Fed’s goal.

Jeanna Smialek covers the Federal Reserve and the economy for The Times from Washington. More about Jeanna Smialek

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• Economic News

US Economy News Today: Fed's Waller Gives Latest Inflation Report a C+ Grade

Taylor Tompkins has worked for more than a decade as a journalist covering business, finance, and the economy. She has logged thousands of hours interviewing experts, analyzing data, and writing articles to help readers understand economic forces. She is the Economics Editor for news at Investopedia.

Welcome to Investopedia's economics live blog, where we explain what the day's news says about the state of the U.S. economy and how that's likely to affect your finances. Here we compile data releases, economic reports, quotes from expert sources and anything else that helps explain economic issues and why they matter to you.

Today, officials from the Federal Reserve Open Markets Committee are speaking on their thoughts for the path ahead in the fight against inflation.

The Government Sells 42 Million Gallons of Gas Ahead of Summer Travel

To lower gas prices ahead of a heavy travel season for many, the Department of Energy is selling 42 million gallons of gas in the country's reserves.  

“The Biden-Harris Administration is laser-focused on lowering prices at the pump for American families, especially as drivers hit the road for summer driving season,” said U.S. Secretary of Energy Jennifer Granholm in a prepared statement.

The average gallon of gas nationwide costs $3.60, according to AAA, up from a year ago, but lower than in recent weeks. By putting more gasoline into the supply, costs should stay low as many hit the road for Memorial Day.

Banks Should Prepare for Continued High Interest Rates, Fed Official Says

With interest rates likely to remain at their current levels for some time, banks will need to be prepared to manage these risks, said Federal Reserve Vice Chair Michael Barr Tuesday.

Pointing to an economy that was “quite strong” and supported by low unemployment, Barr echoed the remarks of other Federal Reserve officials who said that interest rates were sufficiently high enough to bring down inflation, given time. 

“We need to see more evidence of continued progress on inflation for us to be in a position to think about adjusting policy,” Barr told a Dallas Federal Reserve conference on regional banking

-Terry Lane

Federal Reserve Official Gives Latest Inflation Report 'C+' Grade But Says Rate Hikes Unlikely

One Federal Reserve official gave the most recent inflation report a middling grade and said he would need to see several improved inflation readings before he could vote to lower interest rates from their current decades-high levels . 

Federal Reserve Governor Christopher Waller told the Peterson Institute for International Economics Tuesday he would grade the latest reading of the Consumer Price Index (CPI) at a “C+.” But while progress on inflation was slow, it was still welcome news, he said.

“It is good to see monthly inflation falling, even if it requires looking out to the second decimal point,” Waller said.

However, future inflation reports will need to earn better grades in order for him to vote to cut interest rates, he said. Waller, like other Fed officials recently , said rates need to be held steady until price pressures ease.

“In the absence of a significant weakening in the labor market, I need to see several more months of good inflation data before I would be comfortable supporting an easing in the stance of monetary policy,” he said. 

He also said it was unlikely that inflation would accelerate enough to require raising rates.

Waller said wage growth is still a little too high to meet the Fed’s annual inflation target of 2%, but “not that high,” and he believes inflation could be brought down without significantly impacting the labor market.

“I don’t see the need for some big increase in unemployment to do that,” he said.

Department of Energy. " U.S. Department of Energy Announces Sale of Northeast Gasoline Supply Reserve as Americans Hit the Road for Summer Driving Season ."

AAA. " NATIONAL AVERAGE GAS PRICES ."

Dallas Federal Reserve. “ Regional Banking: Navigating the Future .”

Federal Reserve Board. “ Speech by Governor Waller on the economic outlook .”

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