Inflation popularly means rising general prices, most frequently calculated by the consumer price index (CPI) — a measure of the cost of a basket of commodities purchased by a typical family. The rate of inflation refers to the percentage increase in the price level and is usually expressed at an annual rate; if the CPI rose from 100 to 132 over two years, then the price level rose by 32 per cent; that is, the rate of inflation was about 16 per cent annually. Most of the sharp inflation of the 19th and 20th centuries has been associated with major wars, and since the Second World War prices have generally risen.
In an inflationary period, distinctions must be made between money income (measured in dollars) and real income (measured in purchasing power). If money income rises by the same percentage as prices of goods, then real income is unchanged. For real income to increase, money income must rise more than prices. Inflation does not necessarily harm everyone; its main consequence is the redistribution of real income. If prices are stable (the rate of inflation is zero) and A borrows $100 from B at a 2 per cent interest rate, in 1 year B expects to receive $102 in real income. However, if prices rise by 5 per cent, then $102 will not buy what $100 would have bought a year ago; B's real income will be reduced and A's real income will be higher. Unexpected inflation therefore redistributes real income from lenders to borrowers. Pensioners who contributed to pension funds when inflation rates were low and are repaid with dollars that are worth much less than anticipated are among those harmed by inflation.
The relationship among prices, employment, wages and profits is complex. Inflation can be halted by decreasing aggregate demand (total spending), achieved with fiscal policy by reducing government expenditure or raising taxes, and with monetary policy by restricting the growth in the supply of money in the economy, thereby raising interest rates and reducing credit. However, much of the initial impact of the reduced aggregate demand is reflected in lower output and employment rather than in prices (even in the 19th century, falling prices were generally associated with fairly high levels of unemployment), so governments have chosen alternatives such as wage and price controls, although these alone will not lastingly affect inflation. However, if controls are used in conjunction with appropriate monetary and fiscal policies, they may help reduce inflation, with fewer harmful side effects.
Economists generally agree that inflation will not continue unless the money supply is allowed to increase; monetarists tend to emphasize control of the money supply, while Keynesians favour other tools such as wage and price controls. (See also Stagflation.)