21 INFLATION: WHAT IT IS, WHY A LITTLE HELPS, AND WHAT CAUSES IT

Inflation is one of those topics that catches our attention, through the news or through our own experience. You notice it when the price of everyday things like eggs or bread goes up while your income stays the same. If your wage no longer buys as much as it did a year ago, it is natural to feel worse off. That loss of buying power is what inflation does.

Inflation became a worry around the world after the COVID-19 pandemic. Many households felt it directly, as prices rose faster than wages. This raises an important question. Should we aim for zero inflation? Surprisingly, the answer is no. Most central banks aim for inflation of around 2 per cent. This gentle rate is seen as healthy, giving the economy stability while still letting prices adjust.

Inflation becomes a problem if it drops below about 1 per cent or climbs above 3 per cent, because both extremes bring trouble. Getting the balance right matters for keeping the economy growing and protecting people’s buying power.

Why not aim for zero? Because a little inflation does several useful things, while zero brings its own dangers. Zero inflation raises the risk of deflation, where prices actually fall. Falling prices sound good, but they encourage people and businesses to put off spending and investment, since everything may be cheaper later. That slows the economy, lowers wages, and pushes unemployment up.

The Great Depression of the 1930s showed this clearly. Prices fell sharply, and deflation set in. As prices dropped, people and firms delayed buying, expecting prices to fall further. This became a vicious circle. Less spending meant lower revenue for businesses, which led to layoffs and wage cuts. As unemployment rose, demand fell again, and the downturn deepened.

Japan’s Lost Decade in the 1990s and 2000s is a more recent example. Inflation was near zero or negative, and deflation took hold. Consumers held back, businesses hesitated to invest, and the economy stagnated for years. Zero inflation, in other words, can open the door to deflation and all the harm it brings.

Moderate inflation also eases the real burden of debt over time. With no inflation at all, the real value of a debt never shrinks, which discourages borrowing and investment and can slow growth. The years after the Second World War show how this works. Countries like the United States and the United Kingdom carried high government debt from wartime spending. Moderate inflation over the 1950s and 1960s gradually reduced the real value of that debt. As the economy grew in cash terms, partly because of inflation, the debt shrank relative to the size of the economy, even without harsh spending cuts or tax rises.

The same holds for individuals. Think of a homeowner with a fixed-rate mortgage. If inflation rises modestly, wages tend to climb over time, but the monthly mortgage payment stays the same in cash terms. So the real weight of that payment, measured in buying power, slowly falls. Without inflation, that easing never happens, loans stay expensive in real terms, and people borrow and invest less.

Inflation also helps wages adjust. Workers strongly resist cuts to their pay, even in a downturn. Moderate inflation lets real wages fall gently without any cut to the cash figure, which helps protect jobs. The years after the 2008 financial crisis show this. In the United States and the UK, unemployment rose and firms were under pressure to cut costs. Rather than cutting pay, which workers fiercely resist, many firms froze wages and let inflation reduce their real value over time. If inflation is 2 per cent and your salary does not change, its buying power falls by about 2 per cent over the year. This let employers trim their real wage bill without the anger and lost morale that open pay cuts cause. Without moderate inflation, firms would have had to cut cash wages more often, leading to more conflict, lower productivity, and possibly more layoffs.

Aiming specifically at 2 per cent gives a cushion against deflation and keeps the economy away from those harmful falling-price spirals. It also gives central banks room to act. With positive inflation, interest rates can be cut when needed. At zero inflation, interest rates are already near zero, which limits how much a central bank can do to revive the economy. Economists call this the zero lower bound.

Moderate inflation gently encourages people and firms to spend and invest sooner rather than later, since money slowly loses value if it sits idle. And a steady 2 per cent target brings predictability, which supports confidence in long-term plans and contracts. Over time, economists have found that 2 per cent strikes a good balance. It keeps deflation at bay while supporting stable growth, employment, and manageable debt. That is why it has become the standard aim for central banks around the world.

There is a deeper reason both extremes are dangerous, and it has less to do with prices themselves than with what people believe prices will do next. Inflation is not only about the numbers on price tags. It is also about expectations, the story people tell themselves about the future. And expectations have a strange power: once enough people share one, they act on it, and by acting on it they help make it come true.

Picture a country where people become convinced that prices will be much higher next year. A family that was saving to buy a fridge decides to buy it today, before it costs more. A shopkeeper, expecting his own suppliers to charge more soon, raises his prices now to stay ahead. Workers, watching their money shrink, ask for bigger pay rises, and firms, expecting their costs to climb, grant them and pass the cost on. Each of these choices is sensible for the person making it. But together they do exactly what everyone feared: they push prices up faster. The expectation of high inflation becomes a cause of high inflation. Once this belief takes hold across a whole society, it feeds on itself and grows very hard to stop, because everyone is now acting to protect themselves from a future they are, between them, creating.

Now picture the opposite mood, a country where people expect prices to keep falling. The same family decides to wait before buying the fridge, sure it will be cheaper in a few months. When millions make that choice, shops sell less, so they cut their orders, then wages, then jobs. With less money moving around, prices fall further, which seems to prove the waiters right and persuades even more people to hold back. This is the deflationary trap that caught Japan and the economies of the 1930s, and it is just as self-fulfilling as its opposite. In both cases the real danger is not the day’s inflation figure but the shared belief about tomorrow, once that belief becomes the dominant mood of society.

This is why central banks care so much about what they call keeping expectations anchored. A steady, almost boring target of around 2 per cent is valuable not only for the number itself, but because it keeps everyone believing that next year will look much like this one. When people trust that prices will stay calm, they stop trying to outguess the future, and that trust quietly helps keep prices calm in turn. The real enemy, in the end, is not a little inflation, or even a lot of it for a short while. It is the moment when expectations come loose and begin to drive themselves.

If that is what inflation does and why a little of it helps, what actually causes it? This has been argued over for a long time, and no single explanation has won everyone over. One of the oldest and most mainstream views ties inflation to the money supply, captured in the phrase too much money chasing too few goods. On this view, linked to monetarist thinkers such as Milton Friedman, increasing the amount of money in the economy pushes prices up. The logic is simple. If there is more money but the same amount of goods and services, demand outruns supply and prices rise.

This idea is often illustrated by the hyperinflation of 1920s Germany. Trying to pay off war reparations and revive the economy, the German government printed money on a massive scale. Prices exploded, the currency lost its value, and the economy fell into chaos.

Beyond the money supply, economists point to different types of inflation, and this matters for a very practical reason. Each type happens in a different way, so each one has to be dealt with in a different way. Reaching for the same tool every time can miss the real problem, or even make it worse. It is worth taking the three main types in turn.

The first is demand-pull inflation, the kind Keynesian economics stresses. It happens when total demand in the economy runs ahead of what the economy can actually produce. During a strong boom, eager consumer spending, business investment, and government spending all pull in the same direction, and with more money chasing a limited supply of goods, prices rise. A classic case is the boom in the United States after the Second World War, when years of pent-up demand and heavy government spending pushed prices up. Because the problem here is simply too much demand, the cure is to cool that demand gently. This is where raising interest rates works well. Dearer borrowing slows spending and investment, demand eases back towards what the economy can supply, and prices settle. Demand-pull inflation is the type that standard monetary policy is best suited to handle.

The second is cost-push inflation, which post-Keynesian economics highlights. Here the trigger is not too much demand but rising costs of production. When wages, energy, or raw materials become more expensive, or when supply chains break down, firms face higher costs and pass them on as higher prices, even if demand is flat or falling. The surge in inflation after the COVID-19 pandemic is a clear example, when tangled global supply chains and soaring energy prices, made worse by the war in Ukraine, drove costs up across the world. Dealing with this kind of inflation is much harder, and the usual tool can even backfire. If a central bank raises interest rates to fight cost-push inflation, it does nothing to fix the real cause, the broken supply chain or the expensive oil, and it squeezes households and businesses that are already struggling with higher costs. So cost-push inflation often calls for a different response, one aimed at the supply side, such as easing shortages, supporting the households worst hit, or simply riding out a shock that will fade on its own. This is why naming the type of inflation matters so much. The wrong medicine can make the patient worse.

The third type, closely related to cost-push, is imported inflation, and it comes from beyond a country’s borders. No country is fully self-sufficient, so every country buys some of what it needs from abroad, priced in foreign currency. This kind of inflation has two sources, and they often work together. The first is the exchange rate. When a country’s currency weakens, all of those imports, oil, food, medicine, electronics, suddenly cost more in local money, and those higher prices flow through to the shops. A country that imports most of its energy can see inflation jump simply because its currency has fallen, even if nothing at home has changed. The second source is inflation in the countries you buy from. If prices are rising fast where your goods are made, that pressure can be passed on to you. In theory a trading partner’s currency should weaken as its prices rise, keeping the cost to you roughly steady, but exchange rates rarely adjust so neatly or so quickly. When a partner has high inflation and its currency does not fall to match, the gap lands on the importing country as dearer imports. Imagine a country that buys much of its fruit and vegetables from a neighbour. If that neighbour goes through a spell of high inflation and its prices rise by, say, thirty per cent in a year, while its currency falls by only ten per cent against the buyer’s money, the shopper at home ends up paying roughly twenty per cent more. The part the exchange rate did not absorb has been imported along with the vegetables. So a country can import inflation not only when its own money loses value, but also when the world it buys from grows more expensive and the exchange rate fails to absorb the difference. Dealing with this is different again, because the root of the problem lies abroad and in the currency rather than in domestic demand. The response may involve steadying the exchange rate, managing foreign currency reserves, or, over the longer term, reducing the country’s dependence on imports and building the strong institutions that give a currency lasting value. We look at exchange rates and how they are managed in detail in a later chapter.

Pulling these together, the key lesson is that inflation is not one single thing with one single cure. Demand-pull inflation calls for cooling demand, usually through interest rates. Cost-push inflation calls for care, because raising rates can punish people without touching the real cause. Imported inflation points us towards the exchange rate. In practice, inflation is usually a mix of these forces at once, which is what makes it so hard to manage and so easy to explain badly in political debate. And here is the point to hold onto. Steering inflation is, above all, the job of the central bank, working through interest rates and other tools, and above all judging which kind of inflation it is actually facing. Exactly how central banks do this, what powers they have, where those powers run out, and how they manage the exchange rate, is the subject of the chapters that follow. For now, the key idea is simply that the type of inflation decides the right response, and that getting that judgement right is one of the most important and most difficult tasks in all of economic policy.