Inflation can be defined as a general rise in price levels and a fall in the value of money. It occurs when the amount of buying power exceeds the output of goods and services or when the money supply exceeds available goods and services. Inflation is normally measured as a percentage increase in price indexes like the Consumer Price Index or Producer Price Index over a set period of time, usually yearly. Governments have several policy options for controlling inflation including tightening the money supply through monetary policy tools or reducing private and public spending through fiscal policy like tax increases.

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INTRODUCTION-
INFLATION
Inflation can be defined as a rise in the general price level and therefore a fall in
the value of money. Inflation occurs when the amount of buying power is higher
than the output of goods and services. Inflation also occurs when the amount of
money exceeds the amount of goods and services available. As to whether the
fall in the value of money will affect the functions of money depends on the
degree of the fall. Basically, refers to an increase in the supply of
currency or credit relative to the availability of goods and
services, resulting in higher prices. Therefore, inflation can be measured in
terms of percentages. The percentage increase in the price index, as a rate
per cent per unit of time, which is usually in years. The two basic price
indexes are used when measuring inflation, the producer price index (PPI) and
the consumer price index (CPI) which is also known as the cost of living
index number.

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History:
Annual inflation rates in the United States from 1666 to 2004.Increases in the
quantity of money or in the overall money supply (or debasement of the means
of exchange) have occurred in many different societies throughout history,
changing with different forms of money used. For instance, when gold was used
as currency, the government could collect gold coins, melt them down, mix
them with other metals such as silver, copper or lead, and reissue them at the
same nominal value. By diluting the gold with other metals, the government
could issue more coins without also needing to increase the amount of gold used
to make them. When the cost of each coin is lowered in this way, the
governments profit from an increase in seignior age. This practice would
increase the money supply but at the same time the relative value of each coin
would be lowered. As the relative value of the coins becomes lower, consumers
would need to give more coins in exchange for the same goods and services as
before. These goods and services would experience a price increase as the value
of each coin is reduced.
Song Dynasty China introduced the practice of printing paper money in order to
create fiat currency during the 11th century and, according to Daniel Headrick,
"paper money allowed governments to spend far more than they received in
taxes... in wartime, and the Song were often at war, such deficit
spending caused runaway inflation." The problem of paper money inflation
continued after the Song Dynasty. Peter Bernholz writes that "from then on,
nearly every Chinese dynasty up to the Ming began by issuing some stable and
convertible paper money and ended with pronounced inflation caused by
circulating ever increasing amounts of paper notes to finance budget deficits."

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Related definitions:
The term "inflation" originally referred to increases in the amount of money in
circulation, and some economists still use the word in this way. However, most
economists today use the term "inflation" to refer to a rise in the price level. An
increase in the money supply may be called monetary inflation, to distinguish it
from rising prices, which may also for clarity be called 'price
inflation'. Economists generally agree that in the long run, inflation is caused by
increases in the money supply.
Other economic concepts related to inflation include: deflation – a fall in the
general price level, disinflation –a decrease in the rate of
inflation, hyperinflation – an out-of-control inflationary spiral, stagflation – a
combination of inflation, slow economic growth and high unemployment
and reflation – an attempt to raise the general level of prices to counteract
deflationary pressures.
Since there are many possible measures of the price level, there are many
possible measures of price inflation. Most frequently, the term "inflation" refers
to a rise in a broad price index representing the overall price level for goods and
services in the economy. The Consumer Price Index (CPI), the Personal
Consumption Expenditures Price Index (PCEPI) and the GDP deflator are some
examples of broad price indices. However, "inflation" may also be used to
describe a rising price level within a narrower set of assets, goods or services
within the economy, such as commodities (including food, fuel,
metals), tangible assets (such as real estate), financial assets (such as stocks,
bonds), services (such as entertainment and health care), or labour. The Reuters-
CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI)
are examples of narrow price indices used to measure price inflation in
particular sectors of the economy. Core inflation is a measure of inflation for a
subset of consumer prices that excludes food and energy prices, which rise and
fall more than other prices in the short term. The Federal Reserve Board pays
particular attention to the core inflation rate to get a better estimate of long-term
future inflation trends overall.

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How inflation is measured?
Inflation is normally given as a percentage and generally in years or in
some instances quarterly and is derived from the Consumer Price
Index (CPI).However, there are two main indices used to measure inflation. The
first is the Consumer Price Index, or the CPI. The CPI is a measure of the
price of a set group of goods and services. The "bundle," as the group
is known, contains items such as food, clothing, gasoline, and even
computers. The amount of inflation is measured by the change in the cost of the
bundle: if it costs 5% more to purchase the bundle than it did one year before,
there has been a 5% annual rate of inflation over that period based on the CPI.
You will also often hear about the "Core Rate" or the "Core CPI." There
are certain items in the bundle used to measure the CPI that are
extremely volatile, such as gasoline prices.
By eliminating the items that can significantly affect the
cost of the bundle (in either direction) on a month-to-month basis, the
Core rate is thought to be a better indicator of real inflation, the slow, but steady
increase in the price of goods and services. The second measure of inflation
is the Producer Price Index, or the PPI. While the CPI indicates the
change in the purchasing power of a consumer, the PPI measures the change in
the purchasing power of the producers of those goods. The PPI
measures how much producers of products are getting on the wholesale level,
i.e. the price at which a good is sold to other businesses before the good is sold
to a consumer. The PPI actually combines a series of smaller indices that
cross many industries and measure the prices for three
types of goods: crude, intermediate and finished. Generally,
the markets are most concerned with the finished goods
because these are a strong indicator of what will happen with
future CPI reports. The CPI is a more popular measure of inflation than the PPI,
but investors watch both closely. Subsequently, when either the prices of
goods or services or the supply of money rises; this is considered as
inflation.
Depending on the characteristics and the intensity of inflation,
there are several types, namely.
Creeping inflation:
When there is a general rise in prices at very low rates, which is
usually between 2-4 per cent annually, this is known as creeping inflation.
Whereas, trotting inflation occurswhen the percentage has risen
from 5 to almost per cent. At this level it is a warning signal for
most governments to take measures to avoid exceeding double-digit figures

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Trotting inflation:
Galloping inflation:
Another type of inflation is the galloping inflation, where the
rate of inflation is increasing at a noticeable speed and at a
remarkable rate, usually from 10-20 per cent
Hyper inflation :
However, when the inflation rate rises to over 20% it is generally
considered as hyperinflation and at this stage it is almost uncontrollable
because it increases more rapidly in such a little time frame. The main
difference between the galloping and hyperinflation is that
hyperinflation occurs when prices rise at any moment and there is no
level to which the prices might rise.
During World War II certain countries experienced a hyperinflation,
where the price index rose from 1 to over 1,000,000,000 in Germany
during January 1922 to November 1923.Inflation comes in different
forms and those at are familiar with the economic matters would
observe that there are trends in the way that prices are moving
gradual and irregular in relation to aggregate sections of the economy. This
suggest that there is more than one factor that causes inflation and as
different sections of the economy develop it gives rise to different types
inflationary periods.
The main causes ofinflation are:
Demand-pull inflation:
Demandpull inflation occurs when the consumers, businesses or
the government’s demand for goods and services exceed the supply;
therefore the cost of the item rises, unless supply is perfectly elastic.
Because we do not live in a perfect market supply is somewhat
inelastic and the supply of goods and services can only be increased if
the factors of production are increased. The increase in demand is created
from in increase in other areas, such as the supply of money, the increase
of wages which would then give rise in disposable income, and once the
consumers have more disposal income this would lead to aggregate
spending. As a result of the aggregate spending there would also be an
increase in demand for export sand possible hoarding and profiteering from
producers. The excessive demand, the prices of final goods and services
would be forced to increase and this increase gives rise to inflation.

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Cost-push inflation:
Cost-push inflation is caused by an increase in production costs. It is generally
caused by an increase in wages or an increase in the profit margins of the
entrepreneurs. When wages are increased, this causes the business owner to in
turn increase the price of final goods and services which would be
passed onto the consumers and the same consumers are also the
employees. As a result of the increase in prices for final goods and services the
employees realise that their income is insufficient to meet their
standard of living because the basic cost of living has increased. The
trade unions then act as them editor for the employees and negotiate better
wages and conditions of employment. If the negotiations are successful and the
employees are given the requested wage increase this would further affect the
prices of goods and services and invariably affected. On the other hand,
when firms attempt to increase their profit margins by making
the prices more responsive to supply of a good or service instead of the demand
for that said good or service. This is usually done regardless to the state of the
economy. This can be seen in monopolistic economies where the firm
is the only supplier or by entrepreneurs that are seeking a larger profit for
their own self interests.
Deflation:
It is the state of falling price level which occurs a time when the supply of
goods & services increases rapidly.
Monetary inflation:
Monetary inflation occurs when there is an excessive supply of money. It is
understood that inflation, where the rate of inflation is increasing
at a noticeable speed and at a remarkable rate, usually from 10-20 per cent
the government increases the money supply faster than the qua
ntity of goodsincreases, which results in inflation. Interestingly as
the supply of goods increase the money supply has to increase or else prices
actually go down. When a dollar is worth less because the supply of dollars has
increased, all businesses are forced to raise prices just to get the same value for
their products.
Structural inflation:
Planned inflation that is caused by a government's monetary policy is called
structural inflation. This type of inflation is not caused by the excess of demand
or supply but is built into an economy due to the government’s monetary policy.
In developed countries they are characterized by a lack of adequate resources
like capital, foreign exchange, land and infrastructure. Furthermore, over-
population with the majority depending on agriculture for their livelihood
means that there is a fragmentation of the land holdings. There are other

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institutional factors like land-ownership, technological backwardness and low
rate of investment in agriculture. These features are typical of the developing
economies. For example, in developing country where the majority of
the p o p ulatio n live in the rural areas and d ep end o n agric
ulture and the go vernment implements a new industry, some people
get employment outside the agricultural sector and settle down in urban areas.
Because there might be an unequal distribution of landownership and tenancy,
technological backwardness and low rates ofinvestments in
agriculture inclusive of inadequate growth of the domestic sup
ply of food whichcorresponds with an increase in demand arisi
ng from increasing urbanization and population prices increase. Food
being the key wage-good, an increase in its price tends to raise other prices as
well. Therefore, some economists consider food prices to be the major factor,
which leads to inflation in the developing economies.
Another type of inflation is imported inflation. This occurs when the
inflation of goods and services from foreign countries that are experiencing
inflation are imported and the increase in prices for that imported good or
service will directly affect the cost of living. Another way imported
inflation can add to our inflation rate is when overseas firms
increase their prices and we pay more for our goods increasing our
own inflation.
Methodsofcontrol:
A high inflation rate is undesirable because it has negative
consequences. However, there medic for such inflation depends on the
cause. Therefore, government must diagnose its causes before implementing
policies.
Monetary Policy:
Inflation is primarily a monetary phenomenon. Hence, the most logical solution
to check inflation is to check the flow of money supply by devising
appropriate monetary policy and carefully implementing such measures. To
control inflation, it is necessary to
controltotal expenditures because under conditions of full emplo
yment, increase in totalexpenditures will be reflected in a general
rise in prices, that is, inflation. Monetary policy is used to control
inflation and is based on the assumption that a rise in prices is due to
excess of monetary demand for goods and services by the
consumers/households because easy bank credit is available to them. Monetary
policy, thus, pertains to banking and credit availability of loans to firms and

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households, interest rates, public debt and
itsmanagement, and the mo netary s tand ard . Mo netary man
agement is aimed at thecommercial banking systems, and through this
action, its effects are primarily felt in the economy as a whole. By directly
affecting the volume of cash reserves of the banks, can regulate the supply of
money and credit in the economy, thereby influencing the structure of interest
rates and the availability of credit. Both these, factors affect the components
of aggregate demand and the flow of expenditure in
the economy.The central bank’s monetary management methods, t
he devices for decreasing or increasing the supply of money
and credit for monetary stability is called monetary policy. Central
banks generally use the three quantitative measures to control the volume of
credit in an economy, namely:
1. Raising bank rates
2. Open market operations and
3. Variable reverse ratio
However, there are various limitations on the effective working of the quantitati
ve measures of credit control adapted by the central banks and, to that
extent, monetary measures to control inflation are weakened. In fact,
in controlling inflation moderate monetary measures, by themselves, are
relatively ineffective. On the other hand, drastic monetary measures are not
good for the economic system because they may easily send the economy into a
decline. In a developing economy there is always an increasing need for
credit. Growth requires red it expansion but to check inflation,
there is need to contract credit. In such a encounter, the best course
is to resort to credit control, restricting the flow of credit in to the
unproductive, inflation-infected sectors and speculative activities, and
growth-in during sector. It should be noted that the impression that
the rate of spending can diversifying the flow of credit towards the
most desirable needs have productive and be controlled rigorously by
the contraction of credit or money supply is wrong in the context of modern
economic societies. In modern community, tangible, wealth is
typically represented by claims in the form of securities, bonds, etc., or near
moneys, as they are called. Such near moneys are highly liquid assets,
and they are very close to being money. They increase the general

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liquidity of the economy. In these circumstances, it is not so simple to control
the rate of spending or total outlays merely by controlling the quantity
of money. Thus, there is no immediate and direct relationship between money
supply and the price level, as is normally conceived by the traditional quantity
theories. When there is inflation in an economy, monetary restraints can, in
conjunction with other measures, play a useful role in controlling inflation.
Fiscal measures:
Inflation, where the rate of inflation is increasing at a noticeable speed and at a
remarkable rate, usually from 10-20 per cent those government
expenditures is shortened. Along with public expenditure, governments
must simultaneously increase taxes
thatwould effectively reduce private expenditure, in an effect to
minimise inflationary pressures. It is known that when more
taxes are imposed, the size of the
disposableinc o me d iminis hes , als o the magnitud e o f the in
flatio nary gap in regard s to theavailability of the supply of goods
and services. In some instances, tax policy has been directed
towards restricting demand without
restricting level of production. For example, excise duties
or sales tax on various commodities may take away the buying power
from the consumer goods market without discouraging the level of production.
However, some economists point out that this is not a correct way of combating
inflation because it may lead to a regressive status within the economy. As a
result, this may lead to a further rise in prices of goods and services,
and inflation can spread from one sector of the economy to another
and from one type of goods and services to another. Therefore, a
reduction in public expenditure, and an increase in taxes produces a
cash surplus in the budget. Keynes, however, suggested a programme of
compulsory savings, such as deferred pay as an anti-inflationary
measure. Deferred pay indicates that the consumer defers a part of his or
her wages by buying savings bonds (which, of course, is a sort of public
borrowing), which are redeemable after a particular period of time, this is
sometimes called forced savings. Additionally, private savings have a strong
disinflationary effect on the economy and an increase in these is an
important measure for controlling inflation. Government policy should
therefore, include devices for increasing savings. A strong savings drive reduces
the spendable income of the consumers, without any harmful effects of any kind

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that are associated with higher
taxation.Furthermore, the effects of a large deficit budget, which
is mainly responsible for inflation, can be partially offset by
covering the deficit through public borrowings. It should be noted that
it is only government borrowing from non-bank lenders that has a
disinflationary effect. In addition, public debt may be managed in such
a way that the supply of money in the country may be controlled. The
government should avoid paying back any of its past loans during
inflationary periods, in order to prevent an increase in the circulation of
money. Anti-inflationary debt management also includes cancellation of public
debt held by the central bank out of a budgetary surplus. Fiscal policy by
itself may not be very effective in combating inflation;
therefore a combination of fiscal and monetary tools can work
together in achieving the desired outcome.
Direct measures of control :
Direct controls refer to the regulatory measures undertaken to convert
an open inflation into a repressed one. Such regulatory measures involve
the use of direct control on prices and rationing of scarce goods. The
function of price control is a fix a legal ceiling, beyond which prices
of particular goods may not increase. When ceiling prices are fixed and
enforced, it means prices are not allowed to rise further and so, inflation is
suppressed. Under price control, producers cannot raise the price
beyond a specified level, even though there may be a pressure of
excessive demand forcing it up. For example, during wartimes, price
control was used to suppress inflation. In times of the severe scarcity of certain
goods, particularly, food grains, government may have to enforce rationing,
along with price control. The main function of rationing is to divert
consumption from those commodities whose supply needs to be restricted for
some special reasons; such as, to make the commodity more available
to a larger number of Households. Therefore, rationing becomes essential
when necessities, such as food grains, are relatively scarce. Rationing has the
effect of limiting the variety of quantity of goods available for the good
cause of price stability and distributive impartiality. However,
according to Keynes, “rationing involves a great deal of waste, both of
resources and of employment.” Another control measure that was
suggested is the control of wages as it often becomes necessary in
order to stop a wage-price spiral. During galloping inflation, it
maybenecessary to apply a wageprofit freeze. Ceilings on wage
s and profits keep down disposable income and, therefore the total

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effective demand for goods and services. On the other hand, restrictions on
imports may also help to increase supplies of essential commodities and
ease the inflationary pressure. However, this is possible only
to a limited extent, depending upon the balance of payments situation.
Similarly, exports may also be reduced in an effort to increase the availability of
the domestic supply of essential commodities so that inflation is eased. But a
country with a deficit balance of payments cannot dare to cut exports and
increase imports, because the remedy will be worse than the disease
itself. In overpopulated countries like India, it is also essential
to check the growth of the population through an effective family
planning programme, because this will help in reducing the increasing
pressure on the general demand for goods and services. Again, the
supply of real goods should be increased by producing more. Without
increasing production, inflation just cannot be controlled. Some economists
have even suggested indexing in order to minimise certain ill-effects
of inflation. Indexing refers to monetary corrections through periodic
adjustments in money incomes of the people and in the values of
financial assets such as savings deposits, which are held by them
in relation to the degrees of price rise. Basically, if the annual price
were to rise to 20%, the money incomes and values of financial assets are
enhanced by 20%, under the system of indexing. Indexing also saves the
government from public wrath due to severe inflation persisting over a long
period. Critics, however, do not favour indexing, as it does not cure
inflation but rather it encourages living with inflation.
Therefore, it is a highly discretionary method. In general, monetary
and fiscal controls may be used to repress excess demand but direct controls can
be more useful when they are applied to specific scarcity areas. As a result,
anti-inflationary policies should involve varied
programmes and cannot exclusively depend on a particular type of measure
only.
Other monetary phenomena:
In Keynes’view, rising prices in all situations cannot be termed
as inflation. In a condition of under-employment, when an increase in
money supply and rising prices are accompanied by the expansion of output and
employment, but when1here are bottlenecks in the economy, an increase in
money supply may cause cost and prices to rise more than the expansion of
output and employment. This may be termed as “semi-inflation”
or “reflation” till the ceiling of full employment is reached. Once full

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employment level is reached, the entire increase in money supply is reflected
simply by the rising prices – the real inflation.
Incidentally, Keynes mentions the following four related terms
while discussing the concept of inflation:
 Deflation
 Disinflation
 Reflation
 Stagflation
Deflation:
It is a condition of falling prices accompanied by a decreasing level of
employment, output and income. Deflation is just the opposite of inflation.
Deflation occurs when the total expenditure of the community is not equal to
the existing prices. Consequently, the supply of money decreases and as a result
prices fall. Deflation can also be brought about by direct contractions in
spending, either in the form of a reduction in government
spending, personal spending or investment spending. Deflation has
often had the side effect of increasing unemployment in an economy,
since the process often leads to a lower level of demand in the
economy. However, each and every fall in price cannot be called deflation. The
process of reversing inflation without either creating unemployment or
reducing output is called disinflation and not deflation. Therefore,
some perceive deflation as an underemployment phenomenon.
Disinflation:
When prices are falling due to anti-inflationary measures adopted by the
authorities, with no corresponding decline in the existing level of
employment, output and income, the result of this is disinflation.
When acute inflation burdens an economy, disinflation is implemented
as a cure. Disinflation is said to take place when deliberate attempts
are made to curtail expenditure of all sorts to lower prices and money incomes
for the benefit of the community.
Reflation:
Reflation is a situation of rising prices, which is deliberately
undertaken to relieve a depression. Reflation is a means of motivating the
economy to produce. This is achieved by increasing the supply of money

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or in some instances reducing taxes, which is the opposite of disinflation.
Governments can use economic policies such as reducing taxes, changing the
supply of money or adjusting the interest rates; which in turn motivates the
country to increase their output. The situation is described as semi-inflation or
reflation.
Stagflation:
Stagflation is a stagnant economy that is combined with inflation. Basically,
when prices are increasing the economy is decreasing. Some economists
believe that there are two main reasons for stagflation. Firstly, stagflation
can occur when an economy is slowed by an unfavourable supply, such as an
increase in the price of oil in an oil importing country, which tends to raise
prices at the same time that it slows the economy by
making production less profitable. In the 1970's inflation and
recession occurred in different economies at the same time.
Basically, what happened was that there was plenty of liquidity in
the system and people were spending money as quickly as they got it
because prices were going up quickly. This gave rise to the second reason for
stagflation.
Effects:
General
An increase in the general level of prices implies a decrease in the purchasing
power of the currency. That is, when the general level of prices rises, each
monetary unit buys fewer goods and services. The effect of inflation is not
distributed evenly in the economy, and as a consequence there are hidden costs
to some and benefits to others from this decrease in the purchasing power of
money. For example, with inflation, those segments in society which own
physical assets, such as property, stock etc., benefit from the price/value of their
holdings going up, while those who seek to acquire them will need to pay more
for them. Their ability to do so will depend on the degree to which their income
is fixed. For example, increases in payments to workers and pensioners often
lag behind inflation, and for some people income is fixed. Also, individuals or
institutions with cash assets will experience a decline in the purchasing power
of the cash. Increases in the price level (inflation) erode the real value of money
(the functional currency) and other items with an underlying monetary nature.
Debtors who have debts with a fixed nominal rate of interest will see a
reduction in the "real" interest rate as the inflation rate rises. The real interest on
a loan is the nominal rate minus the inflation rate. The formula R = N-
I approximates the correct answer as long as both the nominal interest rate and
the inflation rate are small. The correct equation is r = n/i where r, n and i are

14. 14
expressed as ratios (e.g. 1.2 for +20%, 0.8 for −20%). As an example, when the
inflation rate is 3%, a loan with a nominal interest rate of 5% would have a real
interest rate of approximately 2%. Any unexpected increase in the inflation rate
would decrease the real interest rate. Banks and other lenders adjust for this
inflation risk either by including an inflation risk premium to fixed interest rate
loans, or lending at an adjustable rate.
Negative:
High or unpredictable inflation rates are regarded as harmful to an overall
economy. They add inefficiencies in the market, and make it difficult for
companies to budget or plan long-term. Inflation can act as a drag on
productivity as companies are forced to shift resources away from products and
services in order to focus on profit and losses from currency
inflation. Uncertainty about the future purchasing power of money discourages
investment and saving. And inflation can impose hidden tax increases, as
inflated earnings push taxpayers into higher income tax rates unless the tax
brackets are indexed to inflation.
With high inflation, purchasing power is redistributed from those on fixed
nominal incomes, such as some pensioners whose pensions are not indexed to
the price level, towards those with variable incomes whose earnings may better
keep pace with the inflation. This redistribution of purchasing power will also
occur between international trading partners. Where fixed exchange rates are
imposed, higher inflation in one economy than another will cause the first
economy's exports to become more expensive and affect the balance of trade.
There can also be negative impacts to trade from an increased instability in
currency exchange prices caused by unpredictable inflation.
Hoarding
People buy durable and/or non-perishable commodities and other goods as
stores of wealth, to avoid the losses expected from the declining purchasing
power of money, creating shortages of the hoarded goods.
Social unrest and revolts
Inflation can lead to massive demonstrations and revolutions. For example,
inflation and in particular food inflation is considered as one of the main
reasons that caused the 2010–2011Tunisian revolution and the 2011 Egyptian
revolution, according to many observers including Robert zoellick, president of
the World Bank. Tunisian president Zine El Abidine Ben Ali was ousted,
Egyptian President Hosni Mubarak was also ousted after only 18 days of
demonstrations, and protests soon spread in many countries of North Africa and
Middle East.

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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
goods. Hyperinflation can lead to the abandonment of the use of the country's
currency, leading to the inefficiencies of barter.
Allocative efficiency
A change in the supply or demand for a good will normally cause its relative
price to change, signaling to buyers and sellers that they should re-allocate
resources in response to the new market conditions. But when prices are
constantly changing due to inflation, price changes due to genuine relative price
signals are difficult to distinguish from price changes due to general inflation,
so agents are slow to respond to them. The result is a loss of allocative
efficiency.
Shoe leather cost
High inflation increases the opportunity cost of holding cash balances and can
induce people to hold a greater portion of their assets in interest paying
accounts. However, since cash is still needed in order to carry out transactions
this means that more "trips to the bank" are necessary in order to make
withdrawals, proverbially wearing out the "shoe leather" with each trip.
Menu costs
With high inflation, firms must change their prices often in order to keep up
with economy-wide changes. But often changing prices is itself a costly activity
whether explicitly, as with the need to print new menus, or implicitly, as with
the extra time and effort needed to change prices constantly.
Business cycles
According to the Austrian Business Cycle Theory, inflation sets off the business
cycle. Austrian economists hold this to be the most damaging effect of inflation.
According to Austrian theory, artificially low interest rates and the associated
increase in the money supply lead to reckless, speculative borrowing, resulting
in clusters of malinvestments, which eventually have to be liquidated as they
become unsustainable.

16. 16
Positive
Labour-market adjustments
Nominal wages are slow to adjust downwards. This can lead to prolonged
disequilibrium and high unemployment in the labour market. Since inflation
allows real wages to fall even if nominal wages are kept constant, moderate
inflation enables labour markets to reach equilibrium faster.
Room to maneuver
The primary tools for controlling the money supply are the ability to set
the discount rate, the rate at which banks can borrow from the central bank,
and open market operations, which are the central bank's interventions into the
bonds market with the aim of affecting the nominal interest rate. If an economy
finds itself in a recession with already low, or even zero, nominal interest rates,
then the bank cannot cut these rates further (since negative nominal interest
rates are impossible) in order to stimulate the economy – this situation is known
as a liquidity trap. A moderate level of inflation tends to ensure that nominal
interest rates stay sufficiently above zero so that if the need arises the bank can
cut the nominal interest rate.
Mundell–Tobin effect
The Nobel laureate Robert Mundell noted that moderate inflation would induce
savers to substitute lending for some money holding as a means to finance
future spending. That substitution would cause market clearing real interest
rates to fall. The lower real rate of interest would induce more borrowing to
finance investment. In a similar vein, Nobel laureate James Tobin noted that
such inflation would cause businesses to substitute investment in physical
capital (plant, equipment, and inventories) for money balances in their asset
portfolios. That substitution would mean choosing the making of investments
with lower rates of real return. (The rates of return are lower because the
investments with higher rates of return were already being made before.) The
two related effects are known as the Mundell–Tobin effect. Unless the economy
is already overinvesting according to models of economic growth theory, that
extra investment resulting from the effect would be seen as positive.
Instability with deflation
Economist S.C. Tsaing noted that once substantial deflation is expected, two
important effects will appear; both a result of money holding substituting for

17. 17
lending as a vehicle for saving. The first was that continually falling prices and
the resulting incentive to hoard money will cause instability resulting from the
likely increasing fear, while money hoards grow in value, that the value of those
hoards are at risk, as people realize that a movement to trade those money
hoards for real goods and assets will quickly drive those prices up. Any
movement to spend those hoards "once started would become a tremendous
avalanche, which could rampage for a long time before it would spend
itself." Thus, a regime of long-term deflation is likely to be interrupted by
periodic spikes of rapid inflation and consequent real economic disruptions.
Moderate and stable inflation would avoid such a seesawing of price
movements.
Financial market inefficiency with deflation
The second effect noted by Tsaing is that when savers have substituted money
holding for lending on financial markets, the role of those markets in
channelling savings into investment is undermined. With nominal interest rates
driven to zero, or near zero, from the competition with a high return money
asset, there would be no price mechanism in whatever is left of those markets.
With financial markets effectively euthanized, the remaining goods and physical
asset prices would move in perverse directions. For example, an increased
desire to save could not push interest rates further down (and thereby stimulate
investment) but would instead cause additional money hoarding, driving
consumer prices further down and making investment in consumer goods
production thereby less attractive. Moderate inflation, once its expectation is
incorporated into nominal interest rates, would give those interest rates room to
go both up and down in response to shifting investment opportunities, or savers'
preferences, and thus allow financial markets to function in a more normal
fashion.
Causes:
Historically, a great deal of economic literature was concerned with the question
of what causes inflation and what effect it has. There were different schools of
thought as to the causes of inflation. Most can be divided into two broad areas:
quality theories of inflation and quantity theories of inflation. The quality theory
of inflation rests on the expectation of a seller accepting currency to be able to
exchange that currency at a later time for goods that are desirable as a buyer.
The quantity theory of inflation rests on the quantity equation of money that

18. 18
relates the money supply, its velocity, and the nominal value of
exchanges. Adam Smith and David Hume proposed a quantity theory of
inflation for money, and a quality theory of inflation for production.
Currently, the quantity theory of money is widely accepted as an accurate model
of inflation in the long run. Consequently, there is now broad agreement among
economists that in the long run, the inflation rate is essentially dependent on the
growth rate of money supply relative to the growth of the economy. However,
in the short and medium term inflation may be affected by supply and demand
pressures in the economy, and influenced by the relative elasticity of wages,
prices and interest rates. The question of whether the short-term effects last long
enough to be important is the central topic of debate between monetarist and
Keynesian economists. In monetarism prices and wages adjust quickly enough
to make other factors merely marginal behavior on a general trend-line. In
the Keynesian view, prices and wages adjust at different rates, and these
differences have enough effects on real output to be "long term" in the view of
people in an economy.
Unemployment
A connection between inflation and unemployment has been drawn since the
emergence of large scale unemployment in the 19th century, and connections
continue to be drawn today. However, the unemployment rate generally only
affects inflation in the short-term but not the long-term. In the long term,
the velocity of money supply measures such as the MZM ("Money Zero
Maturity," representing cash and equivalent demand deposits) velocity is far
more predictive of inflation than low unemployment.
In Marxian economics, the unemployed serve as a reserve army of labour,
which restrain wage inflation. In the 20th century, similar concepts in
Keynesian economics include the NAIRU (Non-Accelerating Inflation Rate of
Unemployment) and the Phillips curve.
Rational expectations theory
Rational expectations theory holds that economic actors look rationally into the
future when trying to maximize their well-being, and do not respond solely to
immediate opportunity costs and pressures. In this view, while generally
grounded in monetarism, future expectations and strategies are important for
inflation as well.
A core assertion of rational expectations theory is that actors will seek to "head
off" central-bank decisions by acting in ways that fulfil predictions of higher
inflation. This means that central banks must establish their credibility in
fighting inflation, or economic actors will make bets that the central bank will
expand the money supply rapidly enough to prevent recession, even at the

19. 19
expense of exacerbating inflation. Thus, if a central bank has a reputation as
being "soft" on inflation, when it announces a new policy of fighting inflation
with restrictive monetary growth economic agents will not believe that the
policy will persist; their inflationary expectations will remain high, and so will
inflation. On the other hand, if the central bank has a reputation of being
"tough" on inflation, then such a policy announcement will be believed and
inflationary expectations will come down rapidly, thus allowing inflation itself
to come down rapidly with minimal economic disruption.
Heterodox views
There are also various heterodox theories that downplay or reject the views of
the Keynesians and monetarists.
Austrian view
The Austrian School stresses that inflation is not uniform over all assets, goods,
and services. Differences among markets depends on how newly created money
and credit enter the economy. Because of this disparity, Austrians argue that
considering only the aggregate price level can be very misleading when
analyzing the effects of inflation.
The modern-day Austrian School follows Ludwig von Mises view that price
inflation can only be prevented by strict control of the money supply. Mises
wrote:
In theoretical investigation there is only one meaning that can rationally be
attached to the expression Inflation: an increase in the quantity of money (in the
broader sense of the term, so as to include fiduciary media as well), that is not
offset by a corresponding increase in the need for money (again in the broader
sense of the term), so that a fall in the objective exchange-value of money must
occur .
Real bills doctrine
Within the context of a fixed specie basis for money, one important controversy
was between the quantity theory of money and the real bills doctrine (RBD).
Within this context, quantity theory applies to the level of fractional reserve
accounting allowed against specie, generally gold, held by a bank. Currency and
banking schools of economics argue the RBD, that banks should also be able to
issue currency against bills of trading, which is "real bills" that they buy from
merchants. This theory was important in the 19th century in debates between
"Banking" and "Currency" schools of monetary soundness, and in the formation
of the Federal Reserve. In the wake of the collapse of the international gold
standard post 1913, and the move towards deficit financing of government,
RBD has remained a minor topic, primarily of interest in limited contexts, such

20. 20
as currency boards. It is generally held in ill repute today, with Frederic
Mishkin, a governor of the Federal Reserve going so far as to say it had been
"completely discredited."
The debate between currency, or quantity theory, and banking schools in Britain
during the 19th century prefigures current questions about the credibility of
money in the present. In the 19th century the banking school had greater
influence in policy in the United States and Great Britain, while the currency
school had more influence "on the continent", that is in non-British countries,
particularly in the Latin Monetary Union and the earlier Scandinavia monetary
union.
Anti-classical or backing theory
Another issue associated with classical political economy is the anti-classical
hypothesis of money, or "backing theory". The backing theory argues that the
value of money is determined by the assets and liabilities of the issuing agency.
Unlike the Quantity Theory of classical political economy, the backing theory
argues that issuing authorities can issue money without causing inflation so long
as the money issuer has sufficient assets to cover redemptions. There are very
few backing theorists, making quantity theory the dominant theory explaining
inflation.

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Conclusion
All these inflation related topics one day relates to everyone. In my future it will
definitely relate to me when it comes to house shopping or buying a new car,
from the interest rates in mortgages to car loans, also from just buying weekly
groceries or investments. Or even for retirement, and how much pension you
receive you will need to make a plan and in case the cost of living is high.
 All these things will have to be considered depending on how well the economy
is doing and always having a plan B in ever it happens that a major economic
crisis happens.
 In reality, low inflation rate and an upward economic growth is never possible.
Never the less, low inflation rate means slow economic growth. Whenever,
money is in excess, there is bidding by the consumers due to which the cost of
goods escalates.