Inflation is a process in which the average level of prices increases at a substantial rate over a considerable period of time. In short, more money is required each year to buy a given amount of goods and services. One can measure the rate of inflation as either the annual percentage rate of increase in the average price level or decrease in the value of money. Inflation properly refers only to episodes in which the rate of inflation is substantially positive over a considerable time period. What is meant by substantially positive may depend on recent experiences. In the United States during the mid-1960s an inflation rate of 3% per year aroused great alarm, but some countries' governments have proclaimed victory over inflation by bringing the rate down from 50% or even 200% per year to only 10%. A deflation is the opposite of an inflation: a period of substantially falling prices and rising value of money. EXPLANATIONS OF INFLATION Explanations of inflation run along two lines: the general, or monetary, explanation and various special-factor explanations. The monetary explanation views inflation as always and everywhere the result of an excessive growth rate of money. Special-factor explanations relate each specific inflation to particular economic conditions that occur before or during the inflation. The monetary explanation starts with the observation that rising prices are the same thing as a falling value of money. The more money there is, relative to the goods and services to be bought, the less valuable is each dollar. A period of increasing prices occurs when the quantity of money grows faster than real demand for it, measured in terms of the goods and services the money buys. Thus, an inflation requires either a rapid growth in the money supply or a persistently falling real demand for money. Rapid money-supply growth may occur for a number of reasons, depending on the type of money used in a country. When money consisted of gold coins or paper exchangeable for gold, inflations followed major gold discoveries. In the United States and most other countries money is no longer convertible to a precious metal but is either bank notes printed by the government or checking deposits exchangeable only for paper money. Rapid monetary growth can occur when the government sells securities to help finance a war or pay for other government programs, thus expanding the money supply through deficit spending; in concert with the central bank the government may encourage growth of the money supply through an expansionary \Tmonetary policy\t that increases bank reserves, and thus loanable funds. Countries may also increase their money supply to maintain a stable domestic price for an inflating foreign currency, such as the U.S. dollar. Monetarist economists believe that unusual events may decrease the growth rate of real-money demand in any particular year but that over any considerable period of time these events average out. As a result the average growth rate of real-money demand measured in terms of the goods or services to be bought is quite stable, and sustained inflations arise only from rapid money-supply growth. It is here that the special-factor explanations differ. Special-factor explanations focus on particular events or sequences of events--not necessarily directly related to the money supply--to explain an episode of inflation. An example of this approach observes that a large increase in the price of imported oil would tend to make the consuming nation poorer and so reduce its purchasing power and raise prices. A whole sequence of such events--and the absence of offsetting conditions (such as increased output) tending to increase real-money demand--may be used to explain a given inflation. Responding, the monetarist posits that over periods of four or five years there is very little variation in the growth of real money measured in terms of purchasing power. A hybrid explanation of inflation begins with some special factor as the start of the process. If the initial cause relates to the costs of producing goods and services, some economists have termed the process cost-push inflation. If, for example, the price of oil increases, the resulting increase in prices results in higher wage demands by workers who want to maintain their current standards of living. Producers may try to pass wage increases along to the consumer through higher prices; producers could meet increased wage demands by increased borrowing, which the central bank can accommodate through larger bank reserves, which increase the money supply. The government fears the temporary increase in unemployment that would result if the demands are frustrated. Thus, the argument goes, the government increases money-supply growth, which leads to further price increases and starts the whole process over again. This sort of price-cost-money vicious circle--or the so-called wage-price spiral--converts what might otherwise be a temporary increase in the rate of inflation into a substantial and sustained one. CONTEMPORARY INFLATION The average level of U.S. prices grew very little from the end of the Korean War until the mid-1960s, when contemporary inflation began. Although more rapid money growth began as early as 1962 or 1963, inflation did not immediately result. This delay occurred because the first effect of more rapid money growth is temporarily to reduce unemployment and stimulate the output of goods and services. Subsequently, however, increased growth in production costs--wages, rents, and equipment prices--results in higher final prices of goods and services purchased by consumers. The reasons for the increase in money growth in the 1960s are not clear, but at least two factors seem to have been important. First, the economic disciples of John Maynard \TKeynes\t gained new influence in the Kennedy and Johnson administrations. Many Keynesians supported the Phillips-curve model, which postulated a permanent trade-off between full employment and price increases; thus unemployment could be permanently reduced by increasing the rate of inflation by a few percentage points. Keynesian policy-makers therefore urged a stimulative monetary policy that initially seemed to work better than anticipated. Only later did rapidly rising prices and simultaneous unemployment--together with analyses of Milton \TFriedman\t and others--demonstrate the fallacy of the Phillips-curve analysis. Second, increasing U.S. involvement in the Vietnam War was financed by government deficit spending rather than taxation. Some economists argue that the inflation was especially difficult to curb because it was accompanied by a widespread economic slowdown, a phenomenon sometimes termed stagflation. The traditional methods of encouraging economic growth through monetary and fiscal policy, however, are designed to stimulate aggregate demand, and thus can result in further inflation. The government began programs to reduce excessive monetary growth on several occasions--including 1969, 1973-75, and 1979-80--but each time the initial temporary increase in unemployment persuaded political leaders to abandon the program before inflation was much reduced. A wage-and-price-control program was tried (1971-74), but it also was abandoned as costly, inequitable, and with no real effect on inflation (see \Tincomes policy\t). Major price increases for imported oil occurred in 1973-74 and again in 1979-80, but these only slightly reduced real-money-demand growth so that their ultimate effect on inflation was small. Ronald Reagan's election as president in 1980 was interpreted as a mandate to reverse the accelerating trend of inflation. The executive branch supported and encouraged Federal Reserve efforts to reduce growth in money even at the cost of the major 1981-82 recession. Inflation in 1981 slowed somewhat from the above-10% rate of 1980 and averaged only about 4.5% per year over the ten years 1981-91. This performance was not achieved easily. The 1981-82 recession, a side-effect of the anti-inflationary policies, was the most severe since World War II. Once the economy adjusted to the lower inflation, however, real output and employment grew rapidly during 1983 and 1984 as they approached normal levels. Credit for the sharp reduction in inflation after 1980 generally starts with Paul \TVolcker\t, Federal Reserve chairman from 1979 to 1987. Volcker, with the active support of the Reagan administration from 1981, led the Federal Reserve to adopt a policy of slower growth in the money supply. When Alan \TGreenspan\t replaced Volcker in the summer of 1987, he inherited a Federal Reserve System with a consensus that the central bank's goal should be to achieve stable prices. The Phillips-curve motivated attempt to use monetary policy to lower unemployment was generally agreed a proven failure. It appears that the Federal Reserve was ready to take the next step of moving from 4-5% inflation to stable prices and to begin to reduce money growth substantially. Tight monetary policy contributed to the stock market crash of October 1987, forcing the Federal Reserve to retreat temporarily. In 1988 the Federal Reserve adopted a more gradualist approach aimed at gradually reducing inflation without causing a recession. The plan was for a period of slow growth until the economy adjusted to stable prices, but the dramatic oil price increases following the August 1991 Iraqi invasion of Kuwait were sufficient to push the economy from slow growth into the mild 1990-91 recession. Nonetheless, by 1991 the Federal Reserve strategy had lowered inflation to less than 3%. In the early 1970s, U.S. inflation spread to a number of foreign countries as a result of the Bretton-Woods System, under which they agreed (1944) to maintain fixed prices for the U.S. dollar in terms of their own currencies. By 1973, however, the Bretton-Woods System had deteriorated; the U.S. dollar had been devalued, and floating exchange rates were instituted. Since then other countries have been generally free to pursue independent monetary policies. Some of the industrialized nations, such as Germany, Switzerland, and the Netherlands, have quickly and successfully controlled their rates of money growth and inflation. Others, such as France and Italy, have continued to tolerate high and rising inflation rates. Beginning in 1979, member nations of the European Community began to develop their own European Monetary System (EMS) of fixed exchange rates. From the beginning the German central bank was in fact pursuing its domestic goals of price stability, which other EMS members had to accept to avoid devaluing their currency. Increasingly, other Community members entered the EMS and accepted the goal of price stability. By 1991 the European Community was working toward the creation of a European central bank, perhaps modeled on the U.S. Federal Reserve System and a single monetary unit--possibly a circulating descendant of the "currency basket" called the European Currency Unit, or ECU. The experience of developing countries has been much more varied than that of the industrialized nations. This reflects greater diversity in political institutions and ideologies and, in particular, the ability of governments to finance their expenditures by taxes, foreign aid, or borrowing without resort to printing money. A small country that can raise sufficient funds to finance its expenditures through conventional taxes, aid, and borrowing generally chooses to fix the rate at which its domestic currency can be exchanged for the dollar, British pound, German mark, or a "basket" of several major currencies such as the \TInternational Monetary Fund\t's Special Drawing Right or the European Community's ECU. The central bank then varies the domestic money supply so that prices at home relative to those abroad are consistent with the fixed exchange rate. Domestic inflation trends will then conform to those of the country or countries with which the domestic currency can be exchanged at a fixed price. Many developing countries, however, finance large fractions of government spending by issuing new money. The financing of government expenditures through the printing of new money is called seigniorage. Argentina's seigniorage amounted to more than 6% of the gross national product (\TGNP\t) and nearly equaled all other sources of government revenue over the period 1960-75; as a result the average Argentinian inflation rate was 57% per year during this period. By contrast, among industrialized countries seigniorage averaged only 1% of the \TGNP\t and less than 6% of total government revenue. High seigniorage reflects rapid inflation, rapid growth in output, and thus the work to be done by money, or both. When governments print money fast enough that large sustained inflations result, individuals protect themselves. They conserve on the use of government-issued money, utilizing interest-bearing financial devices (\TNOW\t checking accounts, money market funds) instead. If currency inflates too rapidly, individuals may avoid the use of domestic money entirely and shift to barter or the use of foreign money. Countries tend to experience high average and highly variable inflation rates simultaneously as government financing needs fluctuate. Individuals protect themselves from uncertainty about the future value of their money by writing contracts that are indexed, normally, to a consumer price index or to the cost of foreign currency such as the U.S. dollar. These indexing provisions permit longer-term contracts to exist in countries experiencing high and variable inflation. Typically, tax and other laws contain similar indexing provisions. Nonetheless, indexing is not a perfect substitute for a stable price level. For example, because price indexes are reported with a lag of a month or two, unusually rapid inflation will lower the current purchasing power of indexed wages. Uncertainties about the real value of financial markets limit the development of domestic capital markets. Economists are still debating whether low inflation rates are a precondition or a benefit of rapid growth in real output. SOLUTIONS TO INFLATION Simple acceptance of inflation is in many ways the most appealing solution. Unexpected increases in inflation benefit debtors and hurt creditors by reducing the purchasing power of contracted payments, but a constant, expected inflation rate has no such effect. Interest rates are adjusted to account for the expected decrease in the value of money, and therefore neither side benefits. Nor is there any evidence that any particular income group is disproportionately harmed by a steady, expected inflation. Many economists believe that creeping inflation is a permanent feature of the U.S. economy. There are real costs, however, to wage indexing of contracts, marking up prices, conserving on money balances, and all of the other ways of living with inflation, so it may well be less costly in the long run to eliminate the inflation even at the cost of temporarily higher unemployment. More rapid growth in output of goods and services would increase the real-money-demand growth and so tend to reduce inflation. This goal is hard to achieve in practice. A 1% increase in real output growth would be large indeed by historical standards, yet it would only reduce inflation by a similar amount. Nonetheless, because recent U.S. inflation has occurred simultaneously with a production slowdown and even recession, some feel that more rapid growth in output is an essential element in solving recent economic problems. Elimination of excessive money growth is the most direct solution to inflation. In principle, the U.S. government or its central bank, the Federal Reserve System, could simply choose to end the excessive growth either gradually or immediately and face the unemployment that would result. A number of countries have ended severe inflation or even hyperinflations by reforming their central banks so they are charged solely with maintaining the domestic price of a stable foreign currency or earlier, gold. Such reforms eliminate the responsibility of the central bank to finance the government deficit or avoid unemployment. It is a possibility, advocated by some economists, that the United States could lead a return to the gold standard, but otherwise this option is open only to smaller economies. A constitutional amendment has been proposed requiring the Federal Reserve System to maintain a noninflationary growth rate of the money supply. All of these proposals--or even a realistic acceptance of the current inflation rate--require the government to constrain itself not to pursue short-run gains at the long-run cost of permanently higher inflation. Michael R. Darby Bibliography: Baily, Martin, and Okun, A. M., The Battle against Unemployment and Inflation, 3d ed. (1983); Darby, Michael R., et al., The International Transmission of Inflation (1983; repr. 1985); Duesenberry, J. S., Can We Control Inflation? (1974); Friedman, Milton, "Nobel Lecture: Inflation and Unemployment," Journal of Political Economy 85 (June 1977); Frisch, Helmut, Theories of Inflation (1984); Morley, S. A., Inflation and Unemployment, 2d ed. (1979); Sommers, A. T., Answers to Inflation and Recession (1975); Thurow, Lester, The Zero-Sum Solution (1986).