Inflation - What is It, What Causes It, and When is It Bad

Most of us would say that higher inflation is a bad thing. But, it is not at all clear why we should care so much about inflation.

How do we usually define inflation? ‘Inflation is a process of continuously rising prices, or equivalently, of a continuously falling value of money’ (Laidler and Parkin, 1975, p. 741) See New Palgrave Dictionary of Economics

Surely everyone would agree that we have no measured inflation here.

Now consider a particular kind of rise in the price level. Can we argue that there is again NO inflation? Surely there has been a fall in the purchasing power of any given amount of money. But, is that inflation?

JUMP It appears that there has been a mere jump in the price level - not a continuous and sustained rise in the general level of prices. But should a jump be considered inflation? And, what might cause a jump in the price level like this?

Let's look a little closer and more precisely at this.

We usually just assume that the price increase was uniformly spread over the period - it is an average

But, there are infinitely many ways we can allocate the price increase over the period - and one of these ways includes zero inflation and a jump

Here I have used the computer to draw a curve of a variable growing at a constant 5% per period.

Should we consider a jump here to be an increase in inflation above 5% ?

What Factors Might Cause a Jump in the Price Level Here is a List (1) Bad Weather (2) A Rise in the Foreign Exchange Rate (i.e. Price of Foreign Money) (3) Increase in Sales Taxes (4) A Rise in Oil Prices (5) More Regulations (e.g. an Increase in the Minimum Wage) Do these really cause inflation or merely jumps in the price level. Can they affect interest rates and if so how do they do that? Should we deduct them when we have inflation computed to get a core inflation rate? What causes inflation if these do not?

Disinflation is becoming more and more prevalent in the world

Shoeleather costs Menu costs Relative price variability Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth The Costs of Inflation

Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings. Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings. Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts. The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand. Also, extra trips to the bank take time away from productive activities.

Menu costs are the costs of adjusting prices. During inflationary times, it is necessary to update price lists and other posted prices. This is a resource-consuming process that takes away from other productive activities.

Inflation distorts relative prices. Consumer decisions are distorted, and markets are less able to allocate resources to their best use.

Inflation exaggerates the size of capital gains and increases the tax burden on this type of income. With progressive taxation, capital gains are taxed more heavily. The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. The after-tax real interest rate falls, making saving less attractive.

When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account. Inflation causes dollars at different times to have different real values. Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.

Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. These redistributions occur because many loans in the economy are specified in terms of the unit of account—money.