What is inflation?
Most people are undoubtedly aware that inflation has to do with price increases. What is perhaps less well-known is that the meaning of the word inflation has changed somewhat over time. Originally the word inflation was used to describe a characteristic of money – that its value was eroded. This happens when all prices in an economy rise at the same rate over time. When all prices rise at the same rate, households’ incomes (for example wages) increase as much as their expenses. This means that households have to pay more for the same quantity of goods. However, neither household consumption nor its actual value (utility) is affected when all prices rise at the same rate.
Inflation in this sense can essentially only arise when a central bank supplies too much money. Or as the noted economist and Nobel laureate Milton Friedman once put it: "Inflation is always and everywhere a monetary phenomenon". The most well-known examples of periods of high inflation, so-called hyperinflation, were also characterised by a drop in the value of money due to central banks printing excessive quantities of banknotes.
Over time, however, the meaning of the word inflation has changed somewhat. Today it is often used synonymously with the words price increase and can thereby describe any kind of price rises, not just increases in all prices. For example, one often hears of wage inflation, domestic inflation or imported inflation. None of these terms mean an increase in all prices. Rather, they refer to rises in the prices of certain specific goods or services, such as goods produced in Sweden in the case of domestic inflation.
Prices of individual goods or services can increase for several reasons. One reason is that mentioned above – that the central bank supplies too much money. Besides this, it is most common for prices to rise faster when economic activity is high than when it is low, as demand for goods and services is stronger during a boom. Prices can also be affected by changes in supply conditions, like when meat prices rose in spring 2001 due in part to mad cow disease and foot-and-mouth disease, or when electricity prices fluctuate as a result of changed weather conditions.
A more in-depth description of how the meaning of the word inflation has changed over time can be found in the below article.