Inflation & Its Causes and Effects

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Inflation is the rise in the general level of prices. This is equivalent to a fall in the value or purchasing power of money. It is the opposite of deflation.

Measuring inflation

Inflation is measured by observing the changes in prices of goods in the economy using econometric techniques. The rises in prices of the various goods are combined to give a price index that reflects the change in prices of these many goods, where the inflation rate is the rate of increase in this index. There is no single true measure of inflation, because the value of inflation will depend on the weight given to each good in the index. Examples of common measures of inflation include: • consumer price indexes which measure the price of a selection of goods purchased by a "typical consumer". In many industrial nations, annualised percentage changes in these indexes are the most commonly reported inflation figure. • producer price indexes which measure the price of a selection of inputs purchased by a "typical firm". • wholesale price indexes which measure the change in price of a selection of goods at wholesale (i.e., typically prior to sales taxes). • GDP deflator which is used to adjust measures of gross domestic product for inflation.

The role of inflation in the economy

A great deal of economic literature concerns the question of what causes inflation and what effects it has. A small amount of inflation is often viewed as having a positive effect on the economy. One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Inflation may also have negative effects on the economy: • Increasing uncertainty may discourage investment and saving. • Redistribution

o It will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages...
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