If every price in an economy doubled overnight, and every wage doubled too, would anyone be worse off? The instinct is to say no. The reason inflation matters, and the reason central banks fight it so hard, is that this never happens evenly. Some prices move first, some wages lag, some savings are eroded, and the losses fall on people who did nothing wrong.
Inflation
A sustained increase in the general price level of an economy over a period of time.
Both 'sustained' and 'general' carry marks. A one-off jump in the price of one good is neither. Candidates who write only 'prices going up' typically score one mark out of two.
Inflation has two broad causes. Demand-pull inflation occurs when total demand in the economy grows faster than the economy's ability to supply, so buyers bid prices up. Cost-push inflation occurs when the costs of production rise, through wages, imported raw materials or a weaker exchange rate, and firms pass those costs on. The distinction matters because the appropriate policy response differs: demand-pull responds to tighter demand management, whereas cost-push does not and may worsen under it.
A country's currency depreciates sharply, raising the price of imported oil and components. This is most likely to cause:
Deflation
A sustained fall in the general price level of an economy over a period of time.
Inflation is measured with the Consumer Prices Index (CPI). Statisticians choose a basket of goods and services that a typical household buys, record their prices regularly, and give each item a weight according to how much of household spending goes on it, so that a rise in the price of food counts for more than a rise in the price of matches. The cost of the basket is compared with its cost in a base year, which is given the value 100. An index of 112 means prices are 12% higher than in the base year, and the percentage change in the index from one year to the next is the rate of inflation.
Building a weighted price index
A country's basket has four categories. Their weights and this year's price indices (base year = 100) are: Food: weight 40, price index 110. Housing: weight 30, price index 105. Transport: weight 20, price index 120. Other: weight 10, price index 100. Calculate the weighted price index and state what it shows.
Governments have several ways to control inflation, and each works best against a particular cause. Contractionary monetary policy, raising interest rates, makes borrowing dearer and saving more attractive, so spending falls; it works against demand-pull inflation. Contractionary fiscal policy, raising taxes or cutting government spending, reduces total demand directly. Supply-side policies, such as training and investment in infrastructure, raise productivity so that the economy can produce more without prices rising, and are the main answer to cost-push inflation, though they take years to work. The first two can reduce inflation quickly but at the cost of slower growth and higher unemployment.
The consequences fall unevenly. Savers lose if interest rates sit below the inflation rate, while borrowers gain as the real value of their debt shrinks. Those on fixed incomes lose most, because their income does not adjust. Firms face uncertainty that discourages investment. And if domestic inflation exceeds that of trading partners, exports become less price competitive.