Inflation is an increase in the cost of goods, services and wages. Inflation of 2% means that everything in your society is 2% more expensive this year than it was in a year with 0% inflation.
This is when your inflation rate rises above 0%. A 'healthy' rate of inflation is around 3%. Anything above that is bad, and below it means that your economy is underperforming.
One of the most widespread theories of inflation is also the most straightforward: inflation is an increase in the supply or velocity of money at a rate greater than the expansion in the size of the economy.
Different people and organizations are hurt by inflation versus deflation. Large debtors like inflation because it reduces their effective debt. For example, if Joe pays $100k for a house at 8% interest with inflation at 3%, he's effectively paying 5% interest on the loan. If inflation jumps to 10%, he's happy, he's now making 2% on $100k instead of losing 5%. However, Joe's bank hates this; they were making 5% but are now losing 2% on the loan!
With deflation, the opposite occurs. Joe pays $100k at 8% with inflation of 3%. Inflation drops to 0 and then goes negative to be 5% deflation. Joe finds that instead of making 3%, he is losing 5% due to deflation alone. Overall, his effective interest rate has shot up to 5%+8%=13%. Joe's bank loves this situation, though, since they're making 13% instead of 5%.
There are a number of methods which have been suggested to stop inflation. Central Banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations (i.e., using monetary policy). High interest rates (and slow growth of the money supply) are the traditional way that Central Banks fight inflation, using unemployment and the decline of production to prevent price increases.
There are several effective ways to fight inflation, including:
- Decreasing Domestic Demand for Commodities
- Decreasing Social Services
- Increasing Taxes
- Decreasing Production or Deactivating Industries
- Increasing Migration