Significance

Percentage increase in price level. When most prices grow, there is inflation, provided the other prices don't drop too heavily.

If inflation is not compensated by nominal increases of income, people become poorer.

High and variable inflation makes economic price forecasting more difficult and decision-making processes may be negatively affected.

Extremely high inflation attracts too much daily attention from households and decision-makers, distracting them from more important tasks.

Computation

Economists attempted to distinguish the inflation rate as a continuous systematic process of general price increase from two other situations:

1. an abrupt once-and-for-all overall price increase;
2. a price increase of a narrow group of goods or services to be rather considered as a change in relative prices between that group and the rest of the prices (the former get more expensive, the latter relatively cheaper).

From an empirical point of view, this distinction is unpractical and not used: central statistical offices measure inflation in reference to some average of prices growth, irrespective of the abovementioned distinction.

Incomes, wages and asset prices (like share quotations) are not included in the averaged "prices", thus inflation has important real effects (i.e. on quantities), to the extent it is not perfectly matched by soaring income and asset prices.

Basic types of inflation

Different types of inflations can have widely different determinants, effects and remedies.

There is no strictly binding definition of ranges of intensity in price increase. Still, some indications can be given as it follows.

Hyperinflation is the most extreme inflation phenomenon, with yearly price increases of three-digits percentage points and an explosive acceleration.

Extremely high inflation could range anywhere between 50% and 100%. High inflation is a situation of price increase of, say, 30%-50% a year. Both kinds can be stable or dangerously accelerate to enter in an hyperinflation condition.

Moderate inflation can be differently defined around the world, given the different inflation histories. As an indication only, one could consider an inflation as moderate when it ranges from 5% to 25-30%. For some countries, the higher part of this range is already "high inflation".

Low inflation can be characterized from 1-2% to 5%. Around zero there is no inflation (price stability). Below zero, a country faces deflation.

A transversal classification distiguish inflations, basing on their broadly-defined origins:

1. domestic demand;
2. domestic costs, as wages;
3. external sources, as oil price increases or currency relative devaluation.

A systematic institutional difference is between countries having or not having (partial or total) indexation of wages (and other income sources).

Indexation makes inflation much less painful, but normally keeps it at a higher level and increases the risk of a continous acceleration.

Determinants

A widely dispersed price increase as it is, inflation is the immediate result of firms' decisions.

These decisions may result from coordination and monopoly/oligopoly dynamics, as well as from the attempt to increase margins and profits.

But there is no need for formal coordination: a favourable demand situation, with higher income and booming propensity to consumption, makes price increase easier.

A generalized cost increase, as with wages, energy prices (especially oil prices), devaluation, and certain taxes, is clearly conducive to inflation. A mediation is given by productivity improvements, which reduce unitary costs of production.

Conversely, extensive liberalizations in sectors where prices were rising can lead to a lower inflation rate, thanks to the new entrants and the tougher competition.

Large increases in money quantity, especially if clearly exceeding nominal GDP growth, risk to accelerate the current inflation rate. In other words, if present inflation plus real GDP growth is (much) less than money-quantity rate of growth, there is a consistent risk of acceleration, unless other factors push in the opposite direction.

A pro-inflation pressure may come also from fiscal deficit, with different dynamics depending on ways of financing it (bonds sold to the market or to the central bank, i.e. with a sharp increase of money quantity).

An important determinant of inflation is given by expectations on future rate of inflation, to the extent they are widely accepted and exert influence on decision-making processes, as with long and medium-term wage contracts.

Oil price fluctuations exert a distictive important influence on inflation throughout the world. The increase abroad of prices for products that our country purchase, if not counteracted by a re-valuation of the currency, exerts a pressure on the price level, possibly inducing "imported inflation". Inflation in the country's trade partners then spread out and can feedback there.

Another sector where there are wide fluctuation is agriculture: food prices are volatile, especially when a number of real world events are amplified by speculation. A relatively similar phenomenon relates to raw materials and industry inputs such as minerals. The attempt by statistical offices to ignore price movements in volatile sectors generates the computation of "core inflation". By contrast "headline" inflation is what the media report more often (being easier to communicate) and tend to influence the perception of inflation by the (media-exposed) population.

Impact on other variables

Uncompensated inflation reduces incomes, thus consumption and savings, both in aggregate and with particular reference to certain social groups (e.g. the elderly, as surveyed here). Through a Keynesian multiplier, income and consumption will cumulatively fall further.

Inflation hits the poor harder than the rich because:

1. for the poor, the share of consumption in total income is larger, so the increase of (goods' and services') prices generates a steeper reduction in savings (if any) and of real income;

2. the composition of the purchases' basket can be skewed towards goods whose price rises more than average, as it happened in UK in 2011;

3. in the industries where the price structure is approximately log-normal, e.g. a large number of goods have a price lower than the average, the poor, who has a certain relatively low reserve price that he can afford to pay, will see many more goods going beyond that threshold (becoming unaffordable) than the rich, who has a much higher riserve price (in a region where few goods are);

In this graphical example, the poor has a (black) reserve price of 50 and before inflation can afford almost the majority of goods on that market. The rich has a (purple) reserve price and can afford almost all the goods. With inflation, the number of goods at the different prices (the Y axis) shifts (from the red to the blue curve), with the goods costing less than 50 becoming a small minority but with only a tiny shrinking of the affordable goods for the rich.

4. while, in response to higher prices, the rich can reduce the level of quality of purchased goods, the poor is already purchasing low-priced low-quality goods - the only reaction, if anything, is to stop purchasing, leaving a deeper dissatisfaction of needs;

5. the poor has a much narrower cumulative bundle of durable goods at home, so that with purchases shrinking due to uncompensated inflation, its standard of living and the share of need satisfaction falls more than the rich (which is "buffered" by the goods purchased earlier);

6. the needs that will be less satisfied because of reduction in purchases are more basic - thus important - to the effect that the reduction is more painful and with far reaching negative consequences (e.g. by postponing or abandoning maintenance expenditures, the poor will have higher probabilities of low-performing or even broken goods; by renouncing to satisfaction of very basic goods - such as hygene or shelter in a house - the poor loses social acceptability, increases the likelyhood of diseases, etc.);

7. the working poor is poor because has a weak negotiating command on the resources generated thanks to his work (productivity); conversely, the rich can often react to inflation by asking (and obtaining) higher wages;

8. the rich is more likely to get revenue from commercial and non-working activities (such as dividends and interests from previous investments, resulting from savings and rents), which can raise more than the general level of prices (inflation-leaders).

If inflation is mainy demand-pulled, it vanishes the increases in nominal effective demand and it frustrates consumption expectations.

By contrast, if inflation is mainly due to efforts of increasing margins and profits, it is possible a rise in consumption in high-income groups.

Investment should be discouraged by uncertainty about future engendered by inflation and its wide fluctuation.

Still, to the extent that benefits of inflation are mainly reaped by domestic firms, the real interest rate for investment fall inversely with mounting inflation. Thus, a low or moderate inflation may help investments, at least to the extent they are actually influenced by real interest rates and until a central bank intervention.

In fact, central banks can try to control the inflation rate through a sharp increase in real interest rates, more than proportionally reflected in nominal interest rates.

This move usually provokes a fall in investment and a revaluation of currency. The first effect brakes domestic demand, the second the foreign one.

Summarizing some of these arguments, higher inflation leads to higher nominal interest rates. In a first phase, the latter may not keep pace with inflation, thus real interest rates may fall. But afterwards, if the central bank does not accomodate inflation, the real interest rates are kept much higher than before.

Still, too many elements are intertwinned, so that these relationships should be treated with great caution.

In absence of central bank reaction, it is for example common that inflation tends to provoke currency devaluation, opening a vicious circle.

This is certainly the case with hyperinflation. In fact, in this case, central banks often choose to fix a certain exchange rate target as a nominal anchor in the battle against inflation: with fixed exchange rates, inflation makes import cheaper in comparison to domestic products, so that domestic firms face more intense competition, which should brake inflation.

Until the fall in inflation does not takes place, domestic goods become more expensive in a international comparison, typically with a fall in exports and a rise of imports, heavily deteriorationg the trade balance.

At the same time, if indexed, local wages and incomes will improve their international purchasing power, thanks to fixed nominal exchange rate.

On financial markets of fixed-interest bonds, an increase of inflation will reduce the burden of debt and interest payments.

In the case of large public debt, inflation is an important relief for the State (also through larger tax revenues and lower personnel costs), menacing to engender a political tolerance toward inflation.

Long-term trends

World-wide inflation has peaked in the '70s, because of two oil crises. Afterwards, inflation has become a major target of public powers and it has been decelerating in most countries.

Nonetheless, significant episodes of hyperinflation are still common and many stagnating economies can't take off both because of inflation and anti-inflationary policies.

Business cycle behaviour

Domestic-based inflation is pro-cyclical, arousing from positive demand conditions and higher wages as it is.

External inflationary impulse can begin virtually at any point of domestic business cycle.

Imported inflation, if strong enough, is heavily anti-cyclical, since it engenders a fall in output growth. In fact, not only it reduces consumption as every generalized uncompensated price increase, but also it usually prompts requests for compensating higher wages, giving rise to self-propelling cost inflation. These requests are usually only partially accomodated, leaving real incomes lower. Central bank restrictive policies do the rest.

Data

Inflation rates for 170 countries (1970-1996)

Inflation rates for 192 countries (1969-2011)

Oil world prices (1861-1999)

Comparable wages for 162 jobs in 132 countries

Exchange rates for 200 currencies, spanning across more than 20 years

EU data for all the variables in IS-LM model (Germany, France, Italy, Spain, UK, Switzerland and other 13 European countries)

Formal models

An interactive map of how the economy works according to a basic macroeconomic scheme: the IS-LM model

A simulation model of an exporter firm - to play and understand how inflation depends on international trade

Related papers

Food inflation in Trinidad and Tobago - in the wider framework on reducing reliance on vulnerable economic sectors