The term inflation has been mentioned numerous times on various threads of this forum, especially since the financial crisis. Politicians and central bankers also constantly reference inflation in one way or another. What I want to do in this post is to clarify what inflation actually is. I also want to show that the common, modern definition of inflation, i.e. the general rise in prices, is wrong and why it was and is popularised by bankers and politicians. Let us first imagine an economy where the money supply is fixed at a certain level. If in this economy demand for one product went up, while supply stayed the same, then the price for that product would go up. This would result in more money being spent on that product. As we have a fixed supply of money, the increased amount of money being spent on this specific product, must have the result of less money being spent on other products. Less money being allocated to other products equals lower demand, which results in lower prices (assuming supply remains the same). The conclusion here is that with a fixed money supply the price of one product can only go up if the price of other products goes down. It is not possible for the price of all products to go up in unison. The only way that the price of all products can go up (or down), is if the supply of money is manipulated. Therefore, it is the very actions of central banks, i.e. setting interest rates and increasing amount of money stock, that cause the increase in prices in the first place, which they are apparently trying so hard to keep at bay. Central banks, stating that their main purpose is to keep inflation low, is like a vodka distiller saying their main purpose is to reduce alcoholism, or a fire fighter setting fires in order to put them out. So this begs the question of why is the term inflation used in this way, and why are governments and central banks so insistent on creating new money? The answer to this lies in the fact, that when money is created by a central bank (through the purchase of government or corporate debt), this does not have an immediate effect on prices. It takes time for this new money to trickle down through the monetary system. However, with each step through the monetary system, the increased supply of money causes increased prices. This means that, whoever gets the money first benefits of having more money while prices are still the same. Once the money has found its way down to the consumer, prices have gone up and therefore the purchasing power of each unit of money has gone down. Ask yourself this: Why is it ok for the central bank to create money out of thin air, but you and I would go to prison for doing so? Whoever gets the new money first benefits. What this means is that a government can borrow newly created money, by issuing bonds to the central bank, spend it at current price levels, and then repay the debt some time in the future with devalued money. A currency which is devalued through inflation benefits debtors at the expense of savers, and since governments throughout the world are the most indebted organisations, it is clear why they are so in favour of causing inflation. Price deflation, which we are being so ruefully warned about, is only bad in the world of government and high levels of debts. Why would anybody be upset to walk into a shop and pay less for a product than was paid last week? The argument is made that this causes "uncertainty" and results in consumers not spending because they think they'll get a better deal next week or month. But this cannot, in any way, be backed up by what actually happens on the open market. Take flat screen TVs for example; 10 years ago a 32" plasma would have put you back about €8000 or more. Since then prices have plummeted, and are still going down, and the number of people buying plasma or LCD TVs increased exponentially. The same thing has happened with computers. The other argument is that lower prices cause profits of businesses to go down. This also is nonsense. To a business the importance lies in the margin between cost of production and price. Yes, if price goes down and cost of production stays the same or increases, then profits go down. But in a deflationary period, prices of production goods also go down, so a lower price of end product is not an issue to be concerned about. Bottom line is that the general increase in prices is the consequence of inflation, and not in itself inflation. Higher prices in general are only possible when the total supply of money is increased, which is exactly what central banks do. Saying that inflation is the rise in prices is dishonest at best, and in my opinion more aptly referred to as treachery. Here are some links and books on the topic: Hazlitt – Economics in One Lesson, Chapter 12: http://www.hacer.org/pdf/Hazlitt00.pdf Shostak – Defining Inflation: http://academy.mises.org/moodle/mod/resource/view.php?id=258 http://mises.org/daily/2914 Rothbard - What has Government Done To Our Money?