Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole. In other words, inflation is an upward movement in the average level of prices, as defined in Economics by Parkin and Bade.
Its opposite is deflation, a downward movement in the average level of prices. The boundary between inflation and deflation is price stability.
The Link Between Inflation and Money
An old adage holds that inflation is too many dollars chasing too few goods. Because inflation is a rise in the general level of prices, it is intrinsically linked to money.
To understand how inflation works, imagine a world that only has two commodities: oranges picked from orange trees and paper money printed by the government. In a drought year when oranges are scarce, one would expect to see the price of oranges rise, because quite a few dollars would be chasing very few oranges. Conversely, if there was a record orange crop, one would expect to see the price of oranges fall because orange sellers would need to reduce their prices in order to clear their inventory.
These scenarios represent inflation and deflation, respectively. However, in the real world, inflation and deflation are changes in the average price of all goods and services, not just one.
Altering the Money Supply
Inflation and deflation can also result when the amount of money in the system changes. If the government decides to print a lot of money, then dollars will become plentiful relative to oranges, as in the earlier drought example.
Thus, inflation is caused by the number of dollars rising relative to the number of oranges (goods and services). Similarly, deflation is caused by the number of dollars falling relative to the number of oranges (goods and services).
Therefore, inflation is caused by a combination of four factors: the supply of money goes up, the supply of other goods goes down, demand for money goes down and demand for other goods goes up. These four factors are thus linked to the basics of supply and demand.
Different Types of Inflation
Now that we have covered the basics of inflation, it is important to note that there are many types of inflation. These types of inflation are differentiated from each other by the cause that drives the price increase. To give you a taste, let's briefly go over cost-push inflation and demand-pull inflation.
Cost-push inflation is a result of a decrease in aggregate supply. Aggregate supply is the supply of goods, and a decrease in aggregate supply is mainly caused by an increase in wage rate or an increase in the price of raw materials. Essentially, prices for consumers are pushed up by increases in the cost of production.
Demand-pull inflation occurs when there is an increase in aggregate demand. Simply put, consider how when demand increases, prices are pulled higher.