Definition of Inflation
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When inflation occurs, each unit of currency buys fewer goods and services, resulting in a decrease in the purchasing power of money. This phenomenon is typically measured by indices such as the Consumer Price Index (CPI), which tracks changes in the cost of a basket of consumer goods.
Key Causes of Inflation
Inflation arises from several interconnected factors. Demand-pull inflation happens when aggregate demand exceeds supply, often due to increased consumer spending, government expenditure, or investment. Cost-push inflation results from rising production costs, such as higher wages or raw material prices, which producers pass on to consumers. Built-in inflation occurs when workers demand higher wages to keep up with past price increases, creating a wage-price spiral. Central banks' monetary policies, like expanding the money supply through low interest rates, can also contribute by making more money available for spending.
Practical Example: The 1970s Oil Crisis
During the 1970s, the OPEC oil embargo caused a sharp rise in oil prices, exemplifying cost-push inflation. This increased energy costs for businesses and consumers worldwide, leading to higher prices for transportation, manufacturing, and everyday goods. In the United States, inflation rates soared above 10% annually, demonstrating how external shocks can trigger widespread price increases and reduce economic stability.
Importance and Economic Applications
Inflation influences economic growth, employment, and living standards. Moderate inflation (around 2%) can encourage spending and investment by signaling economic expansion, but high inflation erodes savings, distorts investment decisions, and can lead to uncertainty. Policymakers use tools like interest rate adjustments to control it, ensuring price stability that supports long-term planning in businesses and households.