Monday, April 29, 2013

What is Inflation?

What Is Inflation?
Inflation is described as the rate at which the general level of prices for goods and services is rising and the purchasing power of your currency is falling or in other words the increased cost of living. As inflation rises every dollar will buy a smaller percentage of a good. For example if inflation rises at 2% per year an item that is worth $1 will cost $1.02 in a year. The rate that inflation increases and decreases is watched very closely by central banks all over the world.
The cause of inflation depends on many different variables. For example if there is an increase in the money supply it can cause inflation. This is shown in the aggregate supply and aggregate demand model that measures the price level in relation to income. If the price of oil increases it can cause inflation in the economy. There are many different factors that can cause an increase or decrease in inflation. The countries central bank is charged with the task of managing inflation in the economy. The central bank can attempt to control the inflation by performing open market operations.
Is inflation bad? The common perception is that inflation is always negative. However this is not true. Inflation  is only negative if it is unanticipated because it causes a mis-allocation of resources. If the rate of inflation is known workers will be able to adjust their wages in order to counteract the increase in the price level. If the inflation rate is supposed to be at 2% workers will ask for a 2% raise in their wages to counter the rise in inflation. But if there is unanticipated inflation in the economy if workers are asking for a 2% increase in wages more money will be put into their employers salaries thus causing a mis-allocation of resources.
Deflation is the opposite of inflation. when prices fall in an economy you have deflation. Deflation in considered negative if people see an item dropping in price they tend to wait for it to drop further instead of buying it right away. However deflation is not always a negative phenomenon. If falling prices are a result of increased productivity it can reflect strong growth in an economy.


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