From The Free Forex Encyclopedia
Inflation is defined as the rise of the overall prices of goods and services over a certain period in time. This means that, as general level of prices climb, the purchasing power for each unit of currency declines. For example, there is inflation if one dollar can buy two candy bars in 2000 and only one candy bar in 2009. Most economists agree that inflation is caused primarily by the imbalanced growth of money supply with respect to the rate of economic expansion. Other reasons include excessive demand for goods and services and decreased availability of supply during scarcities.
Inflation has good and bad effects depending on the people concerned. For instance, high inflation is helpful to borrowers as it decreases the real value of money they pay to their lenders. Consumers, on the other hand, are obviously hurt by high inflation as it erodes their purchasing power.
In the foreign exchange market, the issue of inflation is very important because it is one of the primary factors central banks consider when determining interest rates. The Federal Reserve, the US’s prime body in determining interest rates, use a report called the Personal Consumption Expenditure as their preferred method to measure inflation while other central banks, such as the European Central Bank, use a report called the Consumer Price Index.
The Consumer Price Index measures inflation by getting the average price of a basket of goods typically bought by a consumer and comparing it with the value of basket of goods in a different time. The resulting percent change is determined as the rate of inflation. The index is usually computed yearly, quarterly or even monthly in some countries.
As you can see, it is the job of central banks to maintain a certain balance in setting interest rates to make sure it doesn’t get too high or low and hurt the economy.
Other related issues with inflation are: disinflation – the fall in the rate of inflation; stagflation – high rate of inflation during a period of stagnant economic growth; hyperinflation – severe increase in the rate of inflation.