What Is Inflation?

How Supply and Demand Can Cause Inflation

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

You may have heard of this saying before: 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 this works, imagine a world that only has 2 commodities: oranges picked from orange trees, and paper money printed by the government. In a year where there is a drought and oranges are scarce, one would expect to see the price of oranges rise. This is because there will be quite a few dollars chasing very few oranges. Conversely, if there is a record number of crop or oranges, one would expect to see the price of oranges fall because orange sellers will need to reduce their prices in order to clear their inventory.

These scenarios are 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 occur by changing the amount of money in the system.

If the government decides to print a lot of money, then dollars will become plentiful relative to oranges like in the earlier drought example. 

Thus, inflation is caused by the amount of dollars rising relative to the amount of oranges (goods and services). Similarly, deflation is caused by the amount of dollars falling relative to the amount of oranges (goods and services).

Therefore, inflation is caused by a combination of 4 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 4 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. 

More Information

Other readings you may be interested in after reading this may be  Why Don't Prices Decline During A Recession?, which explains why we generally do not have deflation during recessions.

Also, if you want to learn more about the link between interest rates and inflation, read  Calculating and Understanding Real Interest Rates.