Information > Financial Terms > This page

Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

An economic condition characterized by a rise in prices that causes their reciprocal, the purchasing power of money, to fall correspondingly.  In this general sense, inflation is the exact opposite of deflation - namely, a decline in the price level, causing the purchasing power of money to rise.  In the more specific sense, inflation is a general rise in prices not accompanied by a rise in production of goods and services.

Most concepts of inflation are based on the demand-pull type, i.e., the monetary type in which the supply of money increases without an accompanying increase in the supply of goods and services, so that prices rise.  Herewith are several definitions based on this concept.

"I define inflation as a condition brought about when the means of payment in the hands of those who will spend them increase faster than goods can be produced.  In other words, the volume and velocity of money must be related to the volume of actual and potential production of real wealth.  I asked the question:  How is it possible to have inflation when men are idle and plants are idle?  There can be speculative excesses when surplus funds bid up stocks or real estate, but inflation in the generally accepted sense can only come about by increasing the means of payment in the hands of people who are willing to spend faster than we can increase production" (Marriner S. Eccles, the chairman of the Board of Governors of the Federal Reserve System, November 22, 1935).

Inflation exists in a country whenever the supply of money and of bank deposits circulating through checks, so-called deposit currency, increases relatively to the demand for media of exchange in such a way as to bring about a rise in the general price level (Dr. Edwin W. Kemmerer).

An increase in the general level of prices growing out of an increase in expenditures while goods available for purchase are not correspondingly increased in amount (Dr. James Harvey Rogers)."

The above demand-pull concept of inflation stresses aggregate excess monetary demand as the causal factor.  According to this view, inflation can be controlled by applying conventional monetary and fiscal restraints on the money supply; even if business activity should be dampened in the process, the result will be relative stability in real terms.  Such control of the money supply, in this view, will be effective whether the proximate cause of inflation is excessive money supply or cost-induced rise in prices, as the latter also must be "financed" by money supply.  A variant of demand-pull theories is the Keynesian view that spending decisions, not the money supply per se, are the primarily causative factors of demand-pull inflation.

A second major concept of inflation in recent years in the United States is the cost-push view of inflation.  According to this view, prices have risen persistently in recent years (creeping inflation) in the face of a relatively stable money supply because of "autonomous" upward advances in wages, beyond labor productivity, especially in labor union-dominated industries, and higher costs for other factors of production.  (On the other hand, organized labor's view is that the "new" inflation is caused by deliberate increases in "administered" prices by management, unjustified by increases in wages or other costs.).

One group of cost-push theorists believes that cost-push inflation can be restrained by several restrictive monetary and fiscal policies causing business recession and substantial unemployment, but that this is too high a price to pay for stability.  Hence, as the late Dr. Sumner H. Slichter proposed, we should adjust to creeping inflation as inevitable and counteractive by policies designed to maintain maximum output, productivity, and full employment.  Another group's remedy for cost-push inflation would be to seek flexibility in prices and wages by rigorous application of the antitrust laws to business and even labor, in an effort to break up "administered" pricing and wage fixing, an approach deemed unrealistic by Slichterian group in view of the "political facts of life."

Still another concept of the nature of creeping inflation in the United States is factor price inflation.  This kind of inflation can occur without either an excess aggregate demand or an autonomous cost push (Dr. Charles L. Schultze, Recent Inflation in the United States, 1959).  This "originates in excess demand in particular sectors of the economy and spreads via cost increases to other sectors in which demands are not excessive, and indeed to those in which there is unused capacity and unemployment."  The boom in business investment and the substitution of fixed costs and breakeven points, so that even at lower operating rates, price increases attempt to recapture the higher fixed costs in particular sectors of industry.  In this view, conventional aggregative monetary and fiscal policies, by restricting already low aggregate demand in these sectors, would worsen the situation; instead, selective monetary and fiscal measures aimed at particular sectors where demand for factors is excessive would be necessary to control this type of selective inflation.

Incomes Policy.

During the 1960s, the U.S.S experienced both a demand-pull and a subsequent cost-push inflation.  In 1965, the full employment economic policy of the early 1960s led the economy to a full utilization of its resources.  This led to price increases.  In effect the economy was becoming overheated with labor shortages in key industries.  In an attempt to prevent wages from rising at a faster rate than productivity, the Johnson administration re-emphasized the wage guideposts originated in 1962.  The purpose of the guideposts for wages was to keep the annual rate of increase of total employee compensation per manhour worked equal to the national trend rate of increase in output per manhour.  Wage increases, however, outstripped rise in productivity throughout the latter half of the 1960s, leading to a serious rise in the pace of cost-push inflation.  The GNP price deflator began to rise soon after unemployment fell below 4% at the end of 1965.  Demand kept rising rapidly after the end of 1965, reducing the unemployment rate below 4$ and pushing the pace of inflation still higher.  Under those circumstances, "the proper course of policy was clear" (Council of Economic Advisers, Annual Report, 1971) restrictive policy to restrain inflation, which would carry little if any cost in the form of rise in unemployment.  But by early 1970, rising unemployment rates began to accompany rising inflation rates.  The dilemma of policy as of early 1971 was concisely stated by the Council of Economic Advisers as follows.  Confining the economic expansion to a pace that would keep unemployment in the neighborhood of 5.5% to 6% would permit a significant decline in the rate of inflation during 1971 and 1972, but allowing so high an unemployment rate to persist for so long a time would be inconsistent with the Employment Act of 1946, and "undesirable even if there were no act."  On the other hand, trying to restore full employment (a $4 unemployment rate) would entail risks on the inflation side.

The Council of Economic Advisers in its 1971 Annual Report reported widespread public support for direct price and wage controls, "even if the full consequences that these controls would have in distortions and black markets" were not perceived.  But the council concluded that "short of an emergency of a kind which does not exist, mandatory comprehensive price and wage controls are undesirable, unnecessary, and probably unworkable."

On August 15, 1971, the President of the U.S. announced a 90-day price-wage freeze, which was extended October 7, 1971, into the subsequent three phases of compulsory price and wage controls, the first in the peacetime history of the U.S., details of which are given in INCOMES POLICY.


This term is more aptly descriptive of credit expansion and a general rise in trade and prices on a real basis that occurs during a period of revival or recovery following a condition of recession or depression.  The condition of inflation should be reserved for that final phase of expansion when the economy reaches full employment of resources and prices continue upward in speculative excesses of bidding for goods and services, commodities, stock prices, etc., "pure inflation," in a splurge of aggregate demand relative to given available supplies of factors, output, and inventories.

Stagflation occurs when the economy has slowed down but inflation persists.  The U.S. economy has experienced stagflation several times in recent decades.

The terms "currency inflation" and "credit inflation" refer to the nature of the expansion in money supply creating a condition of pure inflation.  Credit inflation is a condition of excessive expansion of commercial bank credit, resulting in excessive volume of bank deposits relative to supply of factors, output, and inventories.  Currency inflation is a more primitive type of inflation of the money supply caused by deliberate increase in the currency supply or tinkering with the money unit.  Modern inflations have been credit inflations, i.e., expansions in the volume and velocity of bank credit and bank deposits, constituting the bulk of the effective money supply of modern credit system.  Both types of inflations may be effectively controlled by conservative monetary and fiscal policies; the "revival of monetary policy" in recent years, for example, refers to the greater effectiveness of restrictive monetary policy when bank credit is deeply involved in financing an inflation.

Currency manipulation undertaken deliberately by the federal government, as an artificial means of coercing spending, was last tried in the U.S. in the early years of the Franklin D. Roosevelt administration in an extraordinary attempt to stimulate recovery from the severe 1932 depression.  This manipulation was intended to raise commodity prices, ease the burden of public and private debt, decrease the claims of creditors in terms of commodity prices considered abnormally low in comparison with prices at the time the credits were extended, prevent further bankruptcies and permit unfreezing of frozen bank assets, protect gold (or other metallic) reserves, and stimulate demand for the nation's products (by lowering the exchange rates of the currency) in world markets.  The general objective was to force up the general price level by deliberate alteration of the money side of the equation of exchange, either by increasing the quantity of money, impairing its quality (denying its redeemability, lowering the standard monetary metallic content of the unit, and introducing fiat money or greenbacks), coercing an increase in velocity of circulation, or all three.  The grave calculated risk involved was loss of general confidence in the dollar.  That a risk involved was loss of general confidence in the dollar.  That a rampant flight from the dollar and a raging currency inflation did not occur was due to the fact that the Roosevelt administration was more conservative monetarily than its actions bespoke; for example, the gold profit of $2 billion resulting from devaluation of the dollar was not fed to the credit system, the $3 billion authority to issue greenbacks under the Thomas Amendment of 1933 was never used, and the monetary nationalization of silver was subsequently repealed.

In the era before the modern credit systems developed, the common form of currency manipulation was debasement of the coinage.  A sovereign, hard pressed for funds and not willing or able to impose heavier taxes, had only to substitute baser coins for those outstanding or reduce their metallic content.  The assignat inflation of the French Revolution, usually regarded along with the German currency inflation culminating in 1924 as the most disastrous in history, was a deliberate paper money inflation.

Types of Currency Manipulation.

Changes in the currency unit designed to produce inflationary consequences include the following:

  1. Suspension of redemption in basic monetary metal (gold).  This may also mean an embargo on gold exports.  Usually, suspension of gold payments involves loss of both rights.  It does not however, necessarily prevent the maintenance of a freegold market in the country that suspends gold payments.  It does mean that gold will command a higher price in terms of the currency no longer redeemable in gold, such higher price depending on the intensity of the demand for gold as a means of flight from the currency and on the market's judgment of the basic worth of that currency in terms of gold.

  2. Devaluation, i.e., lowering of the gold (or other standard metal) content of the monetary unit and seizure by the government of the resulting "write-up" or profit on gold stocks.

  3. Introduction into the monetary system of other monetary metals, such as silver, through BIMETALLISM (without a definite ratio of coinage with the previously monometallic standard metal) or through SYMMETALLISM.

  4. Issuance of fiat or irredeemable paper money having only legal tender power as its element of value, usually without limitation as to size of issue.

Suspension of gold payments is an extraordinary procedure for protecting gold reserves or temporarily stimulating export trade and may be initiated as a defensive measure without inflationary intent.  England's suspension of gold payments on September 21, 1931, was designed in furtherance of these ends.  Another major purpose of England's suspension of gold payments was to experiment with MANAGED CURRENCY, a policy of releasing the currency unit from the anchor of a fixed gold price, and allowing the currency unit to seek lower levels in the foreign exchange markets, protected against sharp or sudden fluctuations by operations of the EXCHANGE EQUALIZATION FUND.

Strictly speaking, therefore, the mere suspension of gold payments, without other changes in monetary practice, is not, ipso facto, an inflationary step.  It may or may not lead to inflation, and it may or may not lead, after a period of trial and de facto stabilization, to a revaluation of the monetary unit at a new but lower gold par value.  Experience with managed currency in the 1930s, however, indicated that any temporary advantage derived thereby internationally by a nation is soon vitiated by defensive measures by other countries of the same type, leading in turn to countermeasures and further retaliation, establishment of EXCHANGE RESTRICTIONS, trade barriers, etc., so that the end result is reduced international trade and financial relations.  A basic aim of the INTERNATIONAL MONETARY FUND for the post-World War II was the stimulation of such relations by establishment of par values for currency units, removal of exchange and trade restrictions, and an ending of manipulative paraphernalia of managed currency in its international aspects.  Domestically, any exercise of monetary and fiscal policy is management, but this is conventional and expected in modern credit system.

Devaluation, like suspension of gold payments, does not per se assure a price rise automatically.  Devaluation is the statutory adoption of a new monetary unit of less metallic weight (and value) than that which preceded it.  France, Belgium, and Italy are examples of countries that devalued their units in the years 1924-1928 by from 75% to 80% after being off gold a number of years.  The inflation in these countries occurred previous to devaluation so that actual devaluation was intended to stabilize prices at the higher levels.  Led by the 30.%% devaluation of the pound sterling, 28 countries by October 18, 1949 had devalued their currencies, including most Western European nations, countries in the sterling area, and Finland, Canada, Argentina, and Uruguay.  The immediate reason for this devaluation of the pound sterling was the heavy loss in monetary reserves of the United Kingdom.  In contrast to the previous wave of devaluations in the 2930s, this series of devaluations was motivated primarily by the dollar balance-of-payments problem, and most countries devalued to approximately the same extent as the United Kingdom, thus maintaining exchange values relative to the pound sterling, but like the UK assuming new positions relative to the dollar.  The devaluations were accompanied by adoption of policies designed to control inflation in the devaluing countries but at the same time maintain the competitive advantage in selling to dollar markets.  Devaluation provides new pars in foreign exchange, affords the government an opportunity to utilize the gold profit, and provides a basis for controlled credit expansion.

The crudest and most direct method of achieving inflation, whether voluntarily by intent or involuntarily through inability to meet obligations, is by the issuance of fiat or irredeemable paper money.  Issuance of irredeemable paper is considered the grossest form of debasement of the currency, a deliberate injection of additional claims for goods or serves of the economy without justification of commensurate increase in supply of goods and services.  The deliberate expansion in the money supply that will be accompanied by discrimination against the fiat currency will cause prices to rise and purchasing power to decline.  If the issue of fiat paper money continues, the rise in prices and depreciation in purchasing power will be aggravated, leading to the necessity for additional issue, causing utter worthlessness of the currency.  This will ruin the creditor classes, owning claims to fixed sums of money that will now be pensioners, annuitants, insurance policy owners, bank depositors, and all holders of claims in currency units.  The continental currency of our preconstitutional government, the inflation in France in the years 1790-1796, and the German paper money inflation of 1920-2924 are the frequently cited examples of paper money hyperinflation that developed to the ultimate extreme of worthlessness.  Our Civil War greenback history furnished an example of a paper money inflation that was limited and controlled.

Continental Currency Inflation.

The American Revolutionary War was financed largely by the printing of continental dollars on the authorization of the Continental Congress, with the "faith of the Continent" as the only backing.  The Continental Congress had no power to tax and could only lay levies upon the states for revenues that were progressively more difficult to collect; thus the Congress was obliged to resort to additional issues of continentals for payment of federal expenses.  Over a five year period, 1775-1779, 40 issues aggregating $241,552,780 were resorted by the Congress.  Redemption of the continentals was placed by the Continental Congress upon the states, but instead of honoring redemption of the continentals, the states issued paper money of their own, aggregating $209,424,776 in the period 1775-1789, including additional issues after the continentals became worthless in 1781.

One of the early histories tells the story in these words.  "During the summer of 1780 this wretched Continental currency fell into contempt.  As Washington said, it took a wagon load of money to buy a wagon load of provisions.  At the end of the year 1778, the paper dollar was worth 16 cents in the northern states and 12 cents in the south.  Early in 1780 its value had fallen to two cents, and before the end of the year it took ten paper dollars to make a cent.

"In October, Indian corn sold wholesale in Boston for $150 a bushel, butter was $12 a pound, tea $90, sugar $10, beef $8, coffee $12, and a barrel of flour cost $1,575.  Samual Adams paid $2,000 for a hat and a suit of clothes.  The money soon ceased to circulate, debts could not be collected, and there was a general prostration of credit."

The final result of this inflation is best summed up in the old saying, "not worth a continental," which has come down to even modern times as an expression of worthlessness.

French Assignat Inflation.

The French assignats that were issued between 1790 and 1796 are an outstanding example of deliberate inflation.  The French revolutionary government was confronted with the problem of both raising revenue and overcoming a condition of business depression.  In response to the demands of the inflationists, the Constituent Assembly in April, 1790, authorized the issuance of assignats to the amount of 400 million livres, to be legal tender and to bear interest at 3%.  the currency was to be secured by church lands recently seized.

At the beginning, the effect was to relieve the Treasury of some of its burdens and to stimulate trade.  As soon as the assignats began to circulate, however, they depreciated to the extent of about 5%.  The 400 million livres of paper were soon exhausted, and there was an immediate agitation for the issuance of additional currency.  It was even claimed that the first issue had been a success.  Mirabeau, a leading inflationist of the day, advocated that currency be issued equal to the amount of the whole national debt and insisted that such action would bring prosperity to the nation.  The Assembly in September, 1790, by a vote of 508 to 423, approved the issuance of additional assignats up to a total of 1.2 billion livres.  This issue bore no interest and was payable to bearer but provided that as fast as the assignats were paid in for land they should be burned.

In the latter stages of the issuance of assignats, the printing presses were run t the will of the executive authority, blanket authorization being given for the re-issuance of such amounts as might be needed.  Within a year, the discount on assignats ran from 18% to 20%, and within two years it amounted to 44%.  About that time there was a temporary rise in their value, but in 1795 a rapid depreciation commenced.  By February, 1796, it required 288 paper francs to equal one gold franc.  Prices of various necessities soared, that of sugar rising 69 times and soap 44 times.  Finally the populace joined in a public burning of the printing press machinery on which the assignats had been printed.

In October, 1795, a new government was established, the Directory.  It tried to restore order out of the currency chaos by issuing in February, 1796, a new kind of paper money called mandates, secured only by choice public lands.  One mandate was made worth 30 assignats.  The mandates immediately depreciated to 30% of face value, then fell to 15% and finally to 5%.  On July 16, 1796, the inevitable happened; the Directory decreed that all paper could be accepted at its real value, which meant at nothing.  The people cased even to compute the depreciation after that.  When Bonaparte took the consulship, the largest loan available in the land would not meet the government's expenses for a single day.

Unable to do business in such rapidly depreciating money, the market women of Paris had marched on the Assembly and made an appeal, famous among economists, that "laws should be passed making paper as good as gold."  The Assembly's actions included the following:  in April 1793, a forced loan of 1 billion livres was levied upon the rich; in July of that year, the estates of the nobility were confiscated, and these lands, estimated at 3 billion livres, were also pledged behind the paper money to make it more valuable.

In 1793, 6 years in prison was made the penalty for selling gold at more than its nominal value in paper.  Six months later, selling assignats at less than face value was made worth 20 years in prison.  Two years later, the guillotine was provided for any Frenchman who made investments in a foreign country.

Napoleon Bonaparte saw enough of paper money inflation in the years 1790-1796 to convince him of its fallacious and dangerous nature.  When he took the consulship, conditions were appalling.  The government was bankrupt, the troops were unpaid, the further collection of taxes appeared impossible.  Nevertheless, when asked at his first cabinet meeting what he intended to do, Napoleon replied:  "I will pay cash or nothing!"  ("cash" meaning specie), and he carried out that promise to the letter.  "While I live," he declared, when he was hard pressed on another occasion, "I will never resort to irredeemable paper."

German Post-World War I Inflation.

Germany was involved in budgetary difficulties after World War I.  Its national expenditures had increased fivefold during the war period, and its national debt, sixfold.  The paper money in circulation had increased from less than 3 billion marks at the beginning of the war to 29 billion at the end of November, 1981.  Wholesale prices in Germany more than doubled during the war period.  Considering the large expansion of currency, the rise in prices up to the time of the Armistice was moderate.

The German government had borrowed from the Reichsbank during the war by the process of discounting Treasury bills.  This was done to an increased extent as it became necessary to meet deficits in the postwar period.  By the time the stage of hyperinflation was reached toward the end of 1923, the volume of Treasury bills held by the Reichsbank totalled nearly 200 quintillion marks.

What happened during 1922 and 1923 was unlike anything that had ever occurred in the world's monetary history.  Paper marks depreciated more rapidly than the continental currency of the U.S. in Revolutionary War days, or the assignats of France, also in the latter part of the eighteenth century.  The expenditures of the German government increased from 145 billion marks for the year ending March 31, 1921, to more than 8 trillion marks two years later, and to 49 quadrillion marks the next year.  It was impossible to keep up with expenditures by levying more taxes.  Currency in circulation, which amounted to 252 billion marks in August, 1922, increased to 2 trillion marks in January, 1923, to 28 quadrillion marks in September, 1923, and finally reached a total of 497 quontillion marks at the end of 1923.

By November 20, 1923, one gold mark was regarded as equal to 1 billion paper marks.  New Rentebank notes that were issued at about that time as an intermediate step toward stabilization were exchanged at the rate of one for 1 billion paper marks.  Subsequently when the Reichsbank was re-organized in October, 1924, it issued new gold reichsmarks, one of which was equivalent to 1 trillion old paper marks.

During the inflationary period the gold value of the mark as quoted in foreign exchange dropped from an original par of 23.82 cents to about one-half cent in December, 1921; one-hundredth of a cent in December, 1922; and three-trillionths of a cent in December, 1923.

The business of accumulating and investing capital in Germany was completely demoralized by the inflation.  No one wanted to keep money in the banks.  In 1922, all savings in Germany amounted to only 3 billion goldmarks, against 20 billion reported by the savings banks alone two years earlier.  Speculation was rampant, resulting in excesses in various field.  How much of this capital was remunerative may be judged from the fact that dividend payments 1922, measured in the gold value, were only one-fiftieth of what they had been before the war.

Russian Post-World War I Inflation.

Russia was plunged into currency inflation by efforts to finance governmental deficits through the issuance of fiat money.  Early in World War I, the Russian Treasury was allowed to discount its short-term obligations at the state bank to any extent desired, previous restrictions being removed.  The currency was on an irredeemable paper basis.  As early as 1916, there was only paper money in circulation.  The government obtained enormous amounts from the bank.  Between January 1, 1917, and January 1, 1923, the quantity of money in circulation increased two hundred thousand times, while prices rose ten million times.  The depreciation was more rapid than the rate of issuance of currency.  A new Soviet state bank issued notes to meet deficits of the Treasury during 1922 and 1923.  Finally in 1924, a new ruble was issued in exchange for 50 billion of the old depreciated rubles.

Types of Price Changes.

There are two basic types of price changes:

  1. Specific price levels:  price changes of a specific commodity or item, such as a car or house; and

  2. General price level:  price changes of a group of goods and services.

In a technical sense, inflation refers to changes in the general price level.  When the general price level increases, the dollar loses purchasing power - the ability to purchase goods or services.  The opposite situation is referred to as deflation.  Holding monetary assets and liabilities during periods of inflation or deflation results in purchasing power gains or losses.  Monetary items are assets and liabilities that are fixed in terms of current dollars and cannot fluctuate to compensate for the change in the general price level.  Monetary assets include cash, receivables, and liabilities.

Changes in the general price level can affect, adversely or otherwise, almost every business decision.  Changes in the general price level can affect organizational planning, controlling, and evaluating functions:

  1. Is any of the budgeted or reported net income due to inflation?

  2. Did the company lose or gain purchasing power from inflation due to holding monetary assets and liabilities?

  3. How did inflation affect the financial statements during the period?

  4. Were changes in the general price level taken into consideration when budgets were prepared?  When dividend policy was determined?  When analyzing financial statements?  When evaluating performance of investment centers?  When selecting a source or method of financing?

A price index is used to measure changes in price levels.  A price index is a series of numbers, one for each period, representing an average price of a group of goods and services, relative to the average price of the same group of goods and services at a base period.  The consumer price index for all urban consumers, published by the Bureau of Labor statistics of the Department of Labor in the Montly Labor Review, is perhaps the most widely used price index.  Current cost information is needed to deal with changes in specific prices.  Replacement costs are commonly used in current cost systems and for decisions involving specific prices.

The appended table shows the purchasing power of the dollar:  1950 to 1987, for producer and consumer prices.


These examples of currency hyperinflation are not intended to be alarmist, but their lesson is plain, particularly illustrated by the experience of Germany, a financially most advanced nation with a modern credit system:  the problem originates with budgetary deficits of the government; an easy solution therefor is instead of forcing the Treasury to finance in the open market.  Although there were extenuating circumstances in the German post-World Ear I situation, direct financing of Treasury deficits through direct financing by the Treasury through the Federal Reserve banks is authorized by Congress only for renewable periods and with limits on such direct financing.  In practice, the Treasury resorts to such financing to tide it over low tax collection periods.  But even though conventionally financed, persistent federal budget deficits monetize the debt and add to inflationary pressures by increasing the money supply through the banking system.


CAPAS, P. and LIPSEY, R.E.  "The Financial Effects of Inflation."  National Bureau of Economic Research.  

Back to Information