Inflation (basic Macro)
Inflation is a process of continuous increase in the overall level of prices. Relative price shifts (one good's price goes up, but another's goes down by a similar magnitude) are not inflation. The average price of all goods must go up to qualify. Inflation is caused by too much money chasing too few goods. If the value of goods produced increases at a greater rate than the rate of increase in nominal spending (the total amount of money spent in the economy), we get deflation. If the rate of increase in nominal spending is higher than increases in production, inflation occurs. To illustrate this, we can use the equation of exchange.
MV=PY
MV is nominal spending
P is the price level.
Y is the level of output.
V - Velocity of Money is how often money is exchanged.
M - The amount of money in the economy.
It works just like the ideal gas law. If one side goes up, the other side has to react as well. Either P or Y can react to changes in MV. Usually in the short run, Y reacts faster and in the long run P reacts and Y returns to what it was before the change.
Inflation is mostly considered harmful, but why does it occur? The vast majority of inflation is caused by an increasing money supply(M). Since the government is the monopoly currency issuer, and determines the capital and reserve requirements for banks (for intro students, don't worry about that part too much), they are mostly responsible for inflation. Changes in V and Y are outside the government's control, for the most part. Increasing the money supply is a very easy way for governments to raise revenue. Simply put, they print the money and spend it. However, since it is so easy, most developed countries have structured their central banks to prevent too much revenue being raised that way as it leads to hyperinflation. Instead, governments print a more controlled amount and mainly finance expenses through debt and taxation. Few solid economic reasons for inflation are given, although a couple are worth mentioning. First, and most importantly, workers are very resistant to taking nominal pay cuts. No one likes their wage to go down, so a small level of inflation allows companies to lower people's wages slowly over time without lowering their nominal wage. Given that productivity rises over time, companies shouldn't have to do this very often. During cyclical downturns when employers need to cut wages the most, general prices tend to fall. What's the point of having inflation during booms when unemployment is 3%, but then having deflation when unemployment is 10%? Generally high inflation levels don't seem to be a good way of dealing with the money illusion. If anything, it's an argument for stable prices, since at least that's easy for most people to understand.
The other theoretical justification for creating inflation is the Phillips Curve, which I don't believe exists. For one thing, the empirical correlation between inflation and unemployment is positive (either both are high, or both are low). Inflation raises the opportunity cost of holding money (by making it a poor store of value), which encourages people to invest more in productive assets. High levels of inflation, however, can reduce firms' profitability, so this effect is probably only a net positive at low levels of inflation.
The costs of inflation are varied and significant. Keynes once said that
"...the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens... There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."
Inflation is a tax on holding money. It takes money away from those who have currency (not wealth!) and gives it to those who have access to the printing press. It usually harms the middle and lower middle classes the most, since the rich are able to shelter their wealth using commodities, stocks and other inflation-protected assets. Inflation makes it easier to pay back loans by lowering their value, which puts strains on the banking sector. It also forces banks to charge a higher interest rate to account for the risk of inflation and expected inflation. Since governments are frequently a debtor, they like inflation, since it reduces the amount they have to pay back to bondholders.
Prices signal information about scarcity and demand. They tell market participants a lot of information about how much other people value things and how hard those goods are to produce. If the price goes up, it could be because more people want it, signalling for suppliers to expand production. If one supplier is suffering difficulty, the price rises in the short run, but that causes other suppliers to expand production to take advantage of the higher profitability. It also creates incentives for people to conserve the good - either using it more sparingly or finding substitutes. The prices of raw materials signal to producers their relative value in production of other goods.
Inflation screws up the price signals. When the government prints and spends money, suppliers of the goods it purchases get a signal that demand has increased for their product. They expand production and prices (moving along the supply curve). Suppliers first thing that demand for their particular product has increased, when in fact, demand for all products have increased (in nominal terms - people are spending more money on everything). They increase their production, thinking themselves more profitable. As they try to buy more raw materials (steel, wood, workers, etc), the prices of those resources increase. Production becomes more expensive, and suppliers have to raise prices to compensate. Customers notice the higher prices and reduce their demand back to the levels they were before the inflationary increase.
As the money moves through the economy, it sends ripples of high prices emanating from the point where the money was first spent. The businesses where the money is first spent see higher prices first, since the story above happens to them first. In our economy (America), the government spends the newly issued currency buying government bonds (OMOs). This distorts interest rates, which are the prices of money in the future at various times. The interest rate is driven down at first, but over time rises to reflect inflation as per the Fisher Equation. Because the interest rate determines the cost at which firms can borrow capital and the present values of that capital, it distorts the economy a lot when the government moves the interest rate around. Since it has such a powerful effect, it is very popular with central bankers. It gives them the power to target asset prices, capital investment, prices and reduce the borrowing cost for government all at once.
Inflation also has some other minor costs, such as shoeleather costs, menu costs, and redistribution effects. Menu costs are the costs to firms of going through the hassle of changing prices. Shoeleather costs are the costs associated of consumers of dealing with the hassle of inflation - going shopping more often, having to put you money in the form of commodities and stocks instead of holding large cash balances, etc. Wikipedia's inflation article, actually isn't too good. Inflation is too controversial for wikipedia to do clearly. All kinds of crackpot theories get put on the site just to keep everyone happy.
MV=PY
MV is nominal spending
P is the price level.
Y is the level of output.
V - Velocity of Money is how often money is exchanged.
M - The amount of money in the economy.
It works just like the ideal gas law. If one side goes up, the other side has to react as well. Either P or Y can react to changes in MV. Usually in the short run, Y reacts faster and in the long run P reacts and Y returns to what it was before the change.
Inflation is mostly considered harmful, but why does it occur? The vast majority of inflation is caused by an increasing money supply(M). Since the government is the monopoly currency issuer, and determines the capital and reserve requirements for banks (for intro students, don't worry about that part too much), they are mostly responsible for inflation. Changes in V and Y are outside the government's control, for the most part. Increasing the money supply is a very easy way for governments to raise revenue. Simply put, they print the money and spend it. However, since it is so easy, most developed countries have structured their central banks to prevent too much revenue being raised that way as it leads to hyperinflation. Instead, governments print a more controlled amount and mainly finance expenses through debt and taxation. Few solid economic reasons for inflation are given, although a couple are worth mentioning. First, and most importantly, workers are very resistant to taking nominal pay cuts. No one likes their wage to go down, so a small level of inflation allows companies to lower people's wages slowly over time without lowering their nominal wage. Given that productivity rises over time, companies shouldn't have to do this very often. During cyclical downturns when employers need to cut wages the most, general prices tend to fall. What's the point of having inflation during booms when unemployment is 3%, but then having deflation when unemployment is 10%? Generally high inflation levels don't seem to be a good way of dealing with the money illusion. If anything, it's an argument for stable prices, since at least that's easy for most people to understand.
The other theoretical justification for creating inflation is the Phillips Curve, which I don't believe exists. For one thing, the empirical correlation between inflation and unemployment is positive (either both are high, or both are low). Inflation raises the opportunity cost of holding money (by making it a poor store of value), which encourages people to invest more in productive assets. High levels of inflation, however, can reduce firms' profitability, so this effect is probably only a net positive at low levels of inflation.
The costs of inflation are varied and significant. Keynes once said that
"...the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens... There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."
Inflation is a tax on holding money. It takes money away from those who have currency (not wealth!) and gives it to those who have access to the printing press. It usually harms the middle and lower middle classes the most, since the rich are able to shelter their wealth using commodities, stocks and other inflation-protected assets. Inflation makes it easier to pay back loans by lowering their value, which puts strains on the banking sector. It also forces banks to charge a higher interest rate to account for the risk of inflation and expected inflation. Since governments are frequently a debtor, they like inflation, since it reduces the amount they have to pay back to bondholders.
Prices signal information about scarcity and demand. They tell market participants a lot of information about how much other people value things and how hard those goods are to produce. If the price goes up, it could be because more people want it, signalling for suppliers to expand production. If one supplier is suffering difficulty, the price rises in the short run, but that causes other suppliers to expand production to take advantage of the higher profitability. It also creates incentives for people to conserve the good - either using it more sparingly or finding substitutes. The prices of raw materials signal to producers their relative value in production of other goods.
Inflation screws up the price signals. When the government prints and spends money, suppliers of the goods it purchases get a signal that demand has increased for their product. They expand production and prices (moving along the supply curve). Suppliers first thing that demand for their particular product has increased, when in fact, demand for all products have increased (in nominal terms - people are spending more money on everything). They increase their production, thinking themselves more profitable. As they try to buy more raw materials (steel, wood, workers, etc), the prices of those resources increase. Production becomes more expensive, and suppliers have to raise prices to compensate. Customers notice the higher prices and reduce their demand back to the levels they were before the inflationary increase.
As the money moves through the economy, it sends ripples of high prices emanating from the point where the money was first spent. The businesses where the money is first spent see higher prices first, since the story above happens to them first. In our economy (America), the government spends the newly issued currency buying government bonds (OMOs). This distorts interest rates, which are the prices of money in the future at various times. The interest rate is driven down at first, but over time rises to reflect inflation as per the Fisher Equation. Because the interest rate determines the cost at which firms can borrow capital and the present values of that capital, it distorts the economy a lot when the government moves the interest rate around. Since it has such a powerful effect, it is very popular with central bankers. It gives them the power to target asset prices, capital investment, prices and reduce the borrowing cost for government all at once.
Inflation also has some other minor costs, such as shoeleather costs, menu costs, and redistribution effects. Menu costs are the costs to firms of going through the hassle of changing prices. Shoeleather costs are the costs associated of consumers of dealing with the hassle of inflation - going shopping more often, having to put you money in the form of commodities and stocks instead of holding large cash balances, etc. Wikipedia's inflation article, actually isn't too good. Inflation is too controversial for wikipedia to do clearly. All kinds of crackpot theories get put on the site just to keep everyone happy.