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What Is Inflation?
To understand inflation, we must first understand what the word means. By common economic definition, 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, it is an upward movement in the average level of prices over a period of time. It is also the opposite of deflation, or falling prices.
Neither inflation excess, nor deflation is a good thing. A little inflation, especially if it is accompanied by a sustainable improvement in economic activity, is not necessarily bad. A little inflation, for our purposes, would be 1%-3%. Deflation, which last appeared during the Great Depression of the 1930s, is never a good thing, for it is almost always accompanied by falling economic output, (i.e., a recession).
As for inflation, when the price level rises, each unit of currency buys fewer goods and services. Inflation is also an erosion in the purchasing power of money. The most recognizable gauges of inflation are the Producer Price Index, which measures price changes at the wholesale level, and the Consumer Price Index, which gauges retail inflation. Both measures are issued in the middle of every month, an hour before the start of trading on the major U.S. financial exchanges. One report usually follows the other by a day or two, with the PPI most often being the first of the two reports issued.
Why is inflation bad? Simply put, inflation erodes the value of our money, meaning that more money must be employed to chase fewer goods. The most common example, from many college textbooks of a generation or two ago, was the picture of a person taking a cart carrying a large cash hoard to the store to buy a loaf of bread. That example was used to bemoan the specter of hyperinflation in Germany's ill-fated Weimar Republic during the 1920s.
Now, to be sure, we are not faced with such dire pricing problems today, not, at least, in this country. However, we all go to the supermarket, and we see the steady progression of food prices upward. In fact, even though we are now in a classically low inflation period, prices never seem to go down, whether it is butter, eggs, meat, fish, or household goods. It is the same in restaurants. In a period when wages are not rising very, such cost increases can be catastrophic for many affected families.
Then, why is the converse, namely deflation, bad? That is because the most celebrated instance of sustained deflation took place during the Great Depression. There was nothing good about that period, to be sure, for as historians know, it was followed by the conflagration of World War II. Indeed, deflation has often had the side effect of increasing unemployment, since falling prices often lead to a lower level of demand in the economy.
In sum, neither inflation in excess, nor deflation is a good thing. As Aristotle opined two thousand years ago, the mean between extremes is the best outcome.