ECONOMICS EXPLAINED: What is inflation, and why do central banks worry about it?

Inflation is the increase in prices of goods and services in an economy over a period of time.
Dangling carrots
An increase in prices follows an increase in demand, as all goods are subject to scarcity.

Imagine a market where three people go to buy carrots. The merchant is selling only one bag of carrots and each of the three people has two euros to buy that bag. They will all try to get the carrots, but the merchant won’t sell them for more than two euros, otherwise no-one will buy them. Now if these

three people have four euros instead, they will offer more money to the merchant to try and get the bag of carrots. The merchant will find it optimal to sell the carrots at the higher price of four euros.

No longer enough
A consequence of the general increase in prices is that the value of the currency decreases: when prices go up, people can buy less with the same amount of money. Going back to the market example, now two euros can’t buy a bag of carrots anymore.

Inflation is measured through a basket of goods and services representative of what an average person usually buys. It includes, for example, bread, cars and haircuts. The content of the basket varies across countries and is updated overtime as people’s habits change.

Normal service
In a functioning economy it is normal to see a small increase in prices over the years. As companies produce more goods, unemployment decreases and individuals get a better salary, which allows them to buy more goods, thus increasing the demand and pushing prices up.

Consequently, the rate of inflation (i.e how much prices increase from one year to the next) is a good indication of a well-functioning economy. Central banks monitor it closely and want to avoid the extreme cases of hyperinflation, when the carrot process gets too extreme, and deflation, when prices decrease over time.

The European Central Bank has a 2 percent inflation target, but at the moment inflation in the eurozone is below this target. This indicates a general slowdown of the economy that has led to the bank injecting more money into the economy in recent years in order to stimulate spending.