## Inflation: Prices on the Rise

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**Canonical URL:** [Inflation: Prices on the Rise](https://www.imf.org/-/media/files/publications/fandd/back-to-basics/oner-inflation.pdf)

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### Definition and measurement
- Inflation is the rate of increase in prices over a given period of time; most commonly measured over a year.
- Consumer price index (CPI):
  - Constructed from a household-survey-derived basket of commonly purchased items.
  - The cost of this basket at a given time expressed relative to a base year is the CPI.
  - Example: if the base year CPI is 100 and the current CPI is 110, inflation is 10 percent over the period.
- Core consumer inflation:
  - Excludes prices set by the government and the more volatile prices of products, such as food and energy.
  - Focuses on underlying and persistent trends in inflation and is closely watched by policymakers.
- GDP deflator:
  - Broader coverage than the CPI; contents vary each year and reflect everything produced in an economy.
  - Includes nonconsumer items (such as military spending) and is not a good measure of the cost of living.
- CPI basket management:
  - Mostly kept constant over time for consistency, but tweaked to reflect changing consumption patterns and new goods.

### Economic effects: the good and the bad
- Real income and purchasing power:
  - If nominal income does not increase as much as prices, purchasing power falls and real (inflation-adjusted) income declines.
  - Real income is a proxy for the standard of living: when real incomes rise, the standard of living rises, and vice versa.
- Distributional effects and fixed-rate contracts:
  - Recipients and payers of fixed interest rates experience changes in real purchasing power.
  - Example: a pensioner receiving a fixed 5 percent yearly increase to their pension loses purchasing power if inflation is higher than 5 percent.
  - Example: a borrower with a fixed-rate mortgage of 5 percent benefits from 5 percent inflation because the real interest rate (nominal rate minus the inflation rate) would be zero.
- High inflation and hyperinflation:
  - Some countries have experienced hyperinflation defined as 1,000 percent or more a year.
  - In 2008, Zimbabwe experienced one of the worst cases of hyperinflation ever, with estimated annual inflation at one point of 500 billion percent.
  - Extreme inflationary episodes have forced countries to take painful policy measures, sometimes giving up their national currency.
- Deflation risks:
  - Falling prices cause consumers to delay purchases, reducing economic activity and growth.
  - Japan experienced a long period of nearly no economic growth largely because of deflation.
  - Preventing deflation during the global financial crisis that began in 2007 motivated prolonged low interest rates and other liquidity-supporting monetary policies by the US Federal Reserve and other central banks.
- Policy objective consensus:
  - Most economists now believe low, stable, and predictable inflation is good for an economy.
  - Predictable inflation can be incorporated into contracts and interest rates, reducing distortion.
  - Many central bankers adopt inflation targeting as their primary policy objective.

### Causes of inflation
- Excess money growth:
  - Long-lasting high inflation is often the result of lax monetary policy; if the money supply grows too big relative to the size of an economy, the purchasing power of the currency falls (quantity theory of money).
- Supply shocks and cost-push inflation:
  - Natural disasters or sharp increases in input costs (for example, high oil prices) can reduce supply or raise production costs, leading to cost-push inflation.
  - The food and fuel inflation of 2008 is cited as a global example where sharply rising prices transmitted inflation across countries by trade.
- Demand shocks and demand-pull inflation:
  - Demand boosts (for example, a stock market rally) or expansionary policies (lower interest rates or higher government spending) can raise demand; if demand exceeds production capacity, demand-pull inflation can result.
- Expectations and inflation inertia:
  - If people and firms expect higher prices, they incorporate those expectations into wage negotiations and contractual price adjustments, which can become self-fulfilling.
  - Basing expectations on the recent past contributes to inflation inertia.

### How policymakers deal with inflation
- Policy choice depends on inflation drivers:
  - If overheating and excess demand are the causes, central banks can implement contractionary policies, usually by raising interest rates to rein in aggregate demand.
- Exchange-rate-based discipline:
  - Some central bankers have fixed the exchange rate to impose monetary discipline by tying domestic monetary policy to that of another country.
  - Such policies may be ineffective when inflation is driven by global rather than domestic developments.
- Administrative price setting and subsidies:
  - Governments may set prices directly to prevent pass-through of high global prices (as seen in 2008), typically resulting in large subsidy bills to compensate producers for lost income.
- Managing expectations and credibility:
  - Central banks increasingly rely on influencing inflation expectations to reduce inflation.
  - Policymakers announce intentions to keep economic activity low temporarily to bring down inflation, aiming to affect expectations and contract adjustments.
  - Greater central bank credibility increases the influence of such pronouncements on inflation expectations.

*CEYDA ONER is a deputy division chief in the IMF’s Finance Department.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/back-to-basics/oner-inflation.pdf_