What is inflation?

Inflation is always and everywhere a monetary phenomenon Milton Friedman.

Not all economists agree with Friedman's definition - or about anything else. But, put simply, inflation is when the price of goods and services rise. This can apply to a specific example e.g. Eggs cost more this year or across an entire economy or group of economies

Harold Wilson famously referred to 'the pound in your pocket' remaining the same. This was misleading then (you still had your pound but it bought less) and perhaps baffling now in the age of the cashless society.

Broadly, however, general inflation means that a basket of goods will cost more now than it did before. In response workers demand more wages to buy those same goods. This can lead to what is called an inflationary spiral: too much money chasing too few goods.

What causes inflation?

Small and steady price rises are generally considered positive for an economy. The Bank of England, for example, currently sets a target of 2% to 'help everyone plan for the future'. But this can be affected by external factors - tariffs on imported goods is one topical example.

The crucial determinant of inflation is the amount a government spends on providing services. If there is a shortfall between a state's income and expenditure then it has to find a way of paying for the excess. 

As Mr Uriah Heep suggested the options may not be pretty. Essentially they boil down to increasing income (raise tax) decreasing government expenditure or borrowing the amount needed. 

This last option is inflationary, especially if the bank considers the loan to be high risk and charges higher interest. Reducing public expenditure was broadly the approach taken the Reagan & Thatcher governments, though neither entirely succeeded. 

Perhaps the most crucial intervention to relieve the 1970s inflation crisis was that of Federal Reserve Chairman Paul Volcker, who 'squeezed out' inflation by (temporarily) setting punishingly high interest rates. 

How bad can get hyperinflation get? 

Extreme or hyperinflation can have a disastrous impact on an  economy. The classic example in Weimar Germany in 1923 when a price loaf of bread rose from 250 marks in January to 200,000 marks in December.

Our image of that time is of middle-class Germans taking wheelbarrows of money to the supermarket. The impact was felt across the society and manifested itself in unexpected ways. Amity Shales cites the example of student fees:

The Department of Canonical Law at the University of Munich had a budget of 2,000 marks in 1922. Yet the subscription price for a single scholarly journal was already 10,000 marks. 

In other words the college did not have the money to buy a copy of its own magazine!

What is deflation? Is it a good thing?