UK Accounting Glossary
a general and progressive increase in prices
Inflation is a broad increase in prices. In practical terms, inflation means goods and services are being valued as more desirable than money. This also affects wages; periods of high inflation tend to be marked by increases in average income. Inflation can be caused by either too few goods offered for sale or too much money in circulation. The most common measure of inflation is the consumer price index (CPI).
Prior to Bretton Woods and the elimination of the gold standard, persistent inflation was relatively rare. In the US, for example, inflation for the entire period from the Revolution through to 1914 was four per cent. The move from currencies backed by hard assets to floating currencies backed by the “full faith and credit” of governments has nearly eliminated deflation by removing impediments to printing more currency. Consequently, excessive inflation has become the primary concern of central banks.
In economics, inflation is a fall in the market value or purchasing power of money. This is equivalent to a rise in the general level of prices. Inflation is the opposite of deflation. Zero or very low positive inflation is called price stability,
In some contexts, the word “inflation” is used to mean an increase in the money supply, which is sometimes seen as the cause of price increases. Some economists (of the Austrian school) still prefer this meaning of the term, rather than to mean the price increases themselves. Thus, for example, some observers of the 1920s in the United States refer to “inflation” even though prices were not increasing at the time. Below, the word “inflation” will be used to refer to a general increase in prices unless otherwise specified.
Inflation can be contrasted with “reflation,” i.e., a reduction in the rate of deflation, that is, the general level of prices are falling at a decreasing rate. A related term is “disinflation”, which means to reduce the rate of inflation (but typically not by enough to cause deflation).
Inflation is measured by observing the change in the price of a large number of goods and services in an economy (usually based on data collected by government agencies, though labour unions and business magazines have also done this job). The prices of goods and services are combined to give a price index measuring an average price level, the average price of a set of products. The inflation rate is the percentage rate of increase in this index; while the price level might be seen as measuring the size of a balloon, inflation refers to the increase in its size.
consumer price indexes (CPIs) which measure the price of a selection of goods purchased by a “typical consumer”. In many industrial nations, annualised percentage changes in these indexes are the most commonly reported inflation figure. These measures are often used in wage and salary negotiations since employees wish to have (nominal) pay raises that equal or exceed the rate of increase of the CPI. Sometimes, labour contracts include cost of living escalators (or adjustments) that imply nominal pay raises automatically occur with due to CPI increases, usually at a slower rate than actual inflation (and after inflation has occurred).
producer price indexes (PPIs) which measure the price received by a producer. This differs from the CPI in that price subsidisation, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any resulting increase in the CPI. This allows a rough-and-ready prediction of CPI inflation tomorrow based on PPI inflation today.
wholesale price indexes which measure the change in the price of a selection of goods at wholesale (i.e., typically prior to sales taxes). These are very similar to the PPI.
commodity price indexes which measure the change in the price of a selection of commodities. In the case of the gold standard the sole commodity used was gold. While under the USA bimetallic standard the index included both gold and silver.
GDP deflator which is based on calculations of the gross domestic product: it is based on the ratio of the total amount of money spent on GDP (nominal GDP) to the inflation-corrected measure of GDP (constant-price or “real” GDP). (See real vs. nominal in economics.) It is the broadest measure of the price level. Deflators are also calculated for components of GDP such as personal consumption expenditure. In the United States, the Federal Reserve has shifted over to using the personal consumption deflator and other deflators for guiding its anti-inflation policies.
The role of inflation in the economy
A great deal of economic literature concerns the question of what causes inflation and what effects it has. A small amount of inflation is often viewed as having a positive effect on the economy. One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Many prices are “sticky downward” and tend to creep upward so that efforts to attain a zero inflinflation rate (a constant price level) punish other sectors with falling prices, profits, and employment. Thus, some business executives see mild inflation as “greasing the wheels of commerce.” Efforts to attain complete price stability can also lead to deflation (steadily falling prices), which can be very destructive, encouraging bankruptcy and recession (or even depression).
Inflation may also have negative effects on the economy:
Increasing uncertainty may discourage investment and saving.
It will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a more flexible income, for example from profits and most wages which may keep pace with inflation.
Similarly, it will redistribute wealth from those who lend a fixed amount of money to those who borrow (if the lenders are caught by surprise or cannot adjust to inflation). For example, where the government is a net debtor, as is usually the case, it will reduce this debt redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden tax.
International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade.
Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank.)
Menu costs: Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.
hyperinflation: if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.
There are different schools of thought as to what causes inflation.
According to Neo-Keynesian economic theory, there are three major types of inflation, as part of what Robert J. Gordon (http://faculty-web.at.nwu.edu/economics/gordon/indexlayers.html) calls the “triangle model”:
These three types of inflation can be added up at any time to get an explanation of the current inflation rate. However, over time, the first two (and the actual inflation rate) affect the amount of built-in inflation: persistently high (or low) actual inflation leads to higher (lower) built-in inflation.
Within the context of the triangle model, there are two main elements: movements along the Phillips Curve, for example, as unemployment rates fall, encouraging greater inflation, and shifts of that curve, as when inflation rises or falls at a given unemployment rate.
A major demand-pull theory centres on the supply of money: inflation may be caused by an increase in the quantity of money in circulation relative to the ability of the economy to supply (its potential output). This has been seen most graphically when governments have financed spending in a crisis by printing money excessively (say, due to war or civil war conditions), often leading to hyperinflation where prices rise at extremely high rates (say, doubling every month).
The money supply is also thought to play a major role in determining levels of more moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economics by contrast typically emphasise the role of aggregate demand in the economy rather than the money supply in determining inflation. That is, for Keynesians, the money supply is only one determinant of aggregate demand.
A fundamental concept in such Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggested that price stability was a trade-off against employment. Therefore some level of inflation could be considered desirable in order to minimize unemployment. The Philips curve model described the US experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation) experienced in the 1970s.
Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) due to such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy “normally” suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model.
Another Keynesian concept is the potential output (sometimes called the “natural gross domestic product”), a level of GDP where the economy is at its optimal level of production, given institutional and natural constraints. This level of output corresponds to the NAIRU or the “natural” rate of unemployment or the full-employment unemployment rate. In this framework, the built-in inflation rate is determined endogenously (by the normal workings of the economy):
if GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that all else equal, inflation will accelerate as suppliers increase their prices and built-in inflation worsens. This causes the Phillips curve to shift in the stagflationary direction, toward greater inflation and greater unemployment. This kind of “inflationary acceleration” may have been seen in the late 1960s in the U.S., when Vietnam war spending (counteracted only by small tax hikes) kept unemployment below 4 per cent for several years.
if GDP falls below its potential level (and unemployment is above the NAIRU), all else equal inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation: there is disinflation. This causes the Phillips curve to shift in the desired direction, toward less inflation and less unemployment. This disinflation may have been seen in the early 1980s when Fed chief Paul Volcker’s anti-inflation campaign kept unemployment high for several years and at almost 10 per cent for two years.
If GDP is equal to potential (and the unemployment rate equals the NAIRU), the inflation rate will not change, as long as there are no supply shocks. In the “long run,” most neo-Keynesian macroeconomists see the Phillips Curve as vertical. That is, the unemployment rate is given and equal to the NAIRU, while there are a large number of possible inflation rates that can prevail at that unemployment rate.
However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change due to policy: for example, high unemployment under Prime Minister Margaret Thatcher in the U.K. may have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed, unable to find jobs that fit their skills in the British economy. A rise in structural unemployment implies that a smaller percentage of the labour force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.
Most non-Keynesian theories of inflation can be understood within the neo-Keynesian perspective as assuming that the NAIRU and potential output are both unique and are attained relatively quickly. With the “supply-side” at a fixed level, the amount of inflation is then determined by aggregate demand. The fixed supply side also implies that government and private-sector spending are always in conflict so that government deficit spending leads to crowding out of the private sector and has no effect on the level of employment. Thus, it is only the money supply and monetary policy that determine the inflation rate.
Supply-side economics asserts that inflation is always caused by either an increase in the supply of money or a decrease in the demand for money. The value of money is seen as being purely subject to these two factors. Thus the inflation experienced during the Black Plague in medieval Europe is seen as being caused by a decrease in the demand for money (the money stock used was gold coin and it was relatively fixed), whilst the inflation of the 1970s is regarded as been initially caused by an increased supply of money that occurred following the US exit from the Bretton Woods gold standard. Supply-side economics asserts that the money supply can grow without causing inflation as long as the demand for money also grows.
One of the factors that supply-side economists say was instrumental in ending the US experience of high inflation was the economic expansion of the 1980s ushered in by lower taxes. The argument is that an expanding economy creates an increased demand for base money and in so doing it counteracts inflation forces. An expanding economy can be seen as frequently leading to an increased demand for money and all else being equal an improvement in the value of money. In international currency markets, such a principle is reasonably undisputed however supply-side economists argue that economic expansion increases the domestic valuation of money and not just the international valuation.
Another school of thought on inflation comes from some economists (especially Austrian economists ) who claim that the only cause of inflation is the increase of the money supply relative to the output of the economy. These economists outright reject the theories behind cost-push inflation, wage push inflation and other common theories of inflation. These economists derive this belief from what is known as the Quantity Theory of Money. The Quantity Theory of Money, simply stated is that the total amount of spending in an economy is primarily determined by the total amount of money in existence. From this theory the following formula is created:
P is the general price level of consumers’ goods, DC is the aggregate demand for consumers’ goods and SC is the aggregate supply of consumers’ goods. The idea behind this formula is that the general price level of consumers’ goods will rise only if the aggregate supply of consumers’ goods goes down relative to the aggregate demand for consumers’ goods, or if the aggregate demand increases relative to the aggregate supply of consumers’ goods. Based on the idea that total spending is based primarily on the total amount of money in existence, the economists calculate aggregate demand for consumers’ goods based on the total quantity of money. Therefore, they posit that as the quantity of money increases, total spending increases and the aggregate demand for consumers’ goods increases as well. For this reason, the economists who believe in the Quantity Theory of Money also believe that the only cause for rising prices in a growing economy (this means aggregate supply of consumers’ goods is increasing), is an increase of the total quantity of money in existence, which is caused by monetary policies of central banks. The central bank of the United States is the Federal Reserve.
According to the adherents of “growth-oriented” theories of the economy – which include both conservative supply-side economists and many neo-Keynesians – inflation is caused by misallocated demand. For the supply-side theorist, this means too much government demand, and the solution to inflation is to lower marginal tax rates on investment. To the neo-Keynesian, this means that goods are mispriced, and supply shocks result when externalities which have accumulated over time are suddenly priced into a good, for example, when pollution in an area starts to cause noticeable illnesses that must be treated, and the pollution cleaned up. To them, the solution is to correctly price goods, which will reshape demand away from the over-consumption of seemingly cheap, but in reality expensive, resources.
There are a number of methods which have been suggested to stop inflation. Central Banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations (i.e., using monetary policy). High-interest rates (and slow growth of the money supply) are the traditional way that Central Banks fight inflation, using unemployment and the decline of production to prevent price increases.
However, Central Banks view the means of controlling inflation differently. For instance, some follow a symmetrical inflation target while others only control inflation when it gets too high.
Monetarists emphasize increasing interest rates (reducing the money supply, monetary policy) to fight inflation. Keynesians emphasize reducing demand in general, often through fiscal policy, using increased taxation or reduced government spending to reduce demand. (They also note the role of monetary policy here.) Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some stable reference currency such as gold. This would be a return to the gold standard. All of these policies are achieved in practice through a process of open market operations.
Another method attempted is simply instituting wage and price controls (“incomes policies”). For example, they were tried in the United States in the early 1970s (under President Nixon). One of the main problems with these controls was that they were used at the same time as demand-side stimulus was applied so that supply-side limits (the controls, potential output) were in conflict with demand growth. In general, most economists regard price controls as counterproductive in that they tend to distort the functioning of the economy (encouraging shortages, decreases in the quality of products, etc.) However, this cost may be “worth it” if it avoids a serious recession, which can have even greater costs.
In fact, controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high.
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This glossary post was last updated: 9th February 2020.