Inflation is an increase in the average level of prices as measured by a price index such as the consumer price index (CPI). A price index can be used to convert a nominal price into a real price, a price corrected for inflation.

Sustained inflation is always and everywhere a monetary phenomenon. In the long run, real GDP is determined by the real factors of production—capital, labor, and technology—so changes in the money supply cannot permanently increase real GDP. Thus, the quantity theory of money is a good guide to how prices respond to changes in the money supply in the long run. Although money is neutral in the long run, changes in the money supply can influence real GDP in the short run for a variety of reasons.

Inflation makes price signals more difficult to interpret, especially when people may suffer from money illusion. Inflation is a type of tax. Governments with few other sources of tax revenue often turn to inflation because the inflation tax is difficult to avoid.

Workers and firms will adjust to a predictable inflation by incorporating inflation rates into wage contracts and loan agreements. The tendency of the nominal interest rate to increase with expected inflation is called the Fisher effect. But inflation is often difficult to predict. When inflation is greater than expected, wealth is redistributed from lenders to borrowers. When inflation is less than expected, wealth is redistributed from borrowers to lenders. The possibility of arbitrary redistributions of wealth in either direction makes lending and borrowing more risky and thus breaks down financial intermediation.

Anything above a mild sustained rate of inflation is generally bad for an economy. Economists disagree, however, as to whether and how much small amounts of well-timed inflation can benefit an economy. In Chapter 32 and Chapter 35, we discuss at greater length how policymakers might use the short-run trade-off between inflation and output to smooth recessions and booms. This remains one of the most important and controversial “fault lines” in modern macroeconomics.

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