 Inflation is the rise in the level of prices of goods and services in an economy over a certain period of time.  The general prices level rises, each unit of currency buys lesser of the goods and services. Consequently, inflation also reflects erosion in the purchasing power of money.

 This is a loss of real value in the internal medium of exchange and unit of account in the economy.  A chief measure of inflation is the inflation rate, the annualized percentage change in a general price index over time.

 The principal explanation for inflation is excess demand.  When too much money chases few goods leads to prices being bid up.  In the later half of the nineteenth century, this was taken literally through the quantity theory of money.

 It was believed that a change in the amount of money circulating in the economy would have a fairly immediate and proportional effect on general price levels.  Although this theory was not accepted back then, many economists now agree that change in the money supply affect the economy primarily through changes in the interest rates.

 Inflation is generally, believed to be demand driven.  In contrast, supply side explanations for inflation depend on the existence of noncompetitive markets.  If a firm, a group of firms gains sufficient power in a market, it may this market power by raising its prices in order to increase returns.

 The resulting prices are then registered as inflation.  This strategy not only requires market power but also a buoyant economy.  One of the best examples is when OPEC used its market power to quadruple the price of petroleum in the early 1970s.

 When OPEC used its market power to quadruple the price of petroleum in the early 1970s; it was so effective that the supply side shock threw most of the capitalist world into a recession.  The jumbo price rise also stimulated conservation and the use of substitutes.

 Central Banks usually seek to stabilize the rate of inflation.  In addition, some seek to keep the economy at full employment.  To do this, they usually focus on controlling an intermediate target.

 In the past, this intermediate target was money supply.  Currently, most central banks focus on influencing interest rates.  Interest rates provide an instant feedback.  The interest rate that central banks do care about is the real interest rate (the nominal rate is less than the rate of inflation).

 If, instead, the central bank focused on maintaining a particular nominal rate, it could lead to wide swings in the money supply.  For example if the central bank targets a certain nominal interest rate, say 4 percent. To do this, say it increases the money supply.

 In the short run, rates fall to 4 percent.  But then inflation starts to grow and the interest rates start to rise.  The central bank would then increase the money supply even more.  Should the central bank keep increasing the money supply, inflation will get worse.

 The result would be a runaway inflation.  To avoid this, the central bank should focus on real rates of interest.  When inflation starts to rise, real rates are likely to fall, correctly indicating that the economy is being stimulated.

 Many countries use inflation targeting.  With inflation targeting, the central bank announces an explicit inflation rate it wants to achieve.  Most of the time it commits itself to achieving this rate.

 Although, the Federal Reserve Bank, the central bank in the United States, seeks price stability, it does not currently use inflation targeting.  Instead, it often appears to be following what is called Taylor’s Rule; named after John Taylor who first proposed the rule.

 The rule predicts how the bank determines the financial funds rate (the rate private banks charge other private banks to borrow money).  To illustrate the rule, assume that if the economy is at full employment, the real federal funds rate (the federal rate minus the rate of inflation) would be 2 percent.

 Next, assume the Fed wants the inflation rate to be 3 percent. According to Taylor’s rule, the bank might set the target federal funds rate (r) so that it equals:  Target r = 2 percent + rate of inflation (rate of inflation – 3 percent) (Real GDP gap)

 The real GDP gap is the percent difference between real GDP and the full employment level of GDP (the level of GDP consistent with a stable inflation rate).  If the bank was interested only in controlling inflation (ie., inflation targeting) the weight of on the real GDP gap would be zero.

 If the bank was interested only in keeping the economy at full employment, the weight on the (rate of inflation – 3 percent) term would be zero.

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