In October 1923, a loaf of bread in Weimar Germany cost 200 billion marks. A month earlier, it had cost 2 billion. A year earlier, it had cost 163. Two years earlier, it had cost less than 1 mark.

This was hyperinflation — the complete breakdown of a currency's ability to store value. Workers were paid twice a day so they could spend their wages before the afternoon price increase. People burned banknotes as fuel because the paper was worth more as kindling than as money. The German middle class, who had saved conscientiously in government bonds and bank deposits, saw their savings wiped out entirely.

Germany's hyperinflation is the extreme case. But inflation in less catastrophic forms is a constant feature of modern economic life — one with winners and losers, multiple causes, and a set of policy tools that central banks use to control it. Most developed countries target 2% annual inflation; significant deviations above or below that target signal something is wrong.

Understanding how inflation works is understanding one of the most important forces shaping the value of your savings, the cost of your mortgage, and the health of the economy you live in.

"Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." — Milton Friedman, A Monetary History of the United States (1963)

Key Definitions

Inflation — The rate at which the general price level of goods and services rises over time, reducing the purchasing power of money. Typically expressed as an annual percentage change in a price index (CPI or PCE). Moderate inflation (2-3%) is considered normal; high inflation (double digits) disrupts economic planning; hyperinflation (50%+ per month) destroys the currency.

Consumer Price Index (CPI) — The most commonly used measure of inflation. Tracks the prices of a representative basket of goods and services that typical urban consumers purchase, weighted by spending patterns. The basket includes housing, food, transportation, medical care, recreation, education, and other categories. Published monthly by the Bureau of Labor Statistics (US) and equivalent agencies in other countries.

Core CPI — CPI excluding food and energy prices, which are more volatile. Core CPI is used by central banks to identify underlying inflation trends, filtering out short-term commodity price swings that may not reflect persistent inflationary pressure.

PCE (Personal Consumption Expenditures) deflator — The Federal Reserve's preferred inflation measure. Similar to CPI but broader in coverage and adjusts weights for consumer substitution (when beef prices rise, consumers buy more chicken — PCE adjusts for this, CPI does not). Typically runs slightly below CPI.

Demand-pull inflation — Inflation caused by excess demand for goods and services — "too much money chasing too few goods." Occurs when economic growth is strong, unemployment is low, and consumer and business spending is high relative to the economy's productive capacity. Post-COVID inflation in the US (2021-2023) had a significant demand-pull component: stimulus checks, pent-up savings, and strong consumer spending met constrained supply.

Cost-push inflation — Inflation caused by rising production costs passed through to consumer prices. Energy price spikes (oil shocks) are classic cost-push drivers — higher energy costs increase production costs for virtually all goods and services. Labor cost increases can also be cost-push. The 1973-1974 OPEC oil embargo triggered a severe cost-push inflationary episode in the US, contributing to the "stagflation" — simultaneous inflation and stagnation — of the mid-1970s.

Built-in inflation (wage-price spiral) — Inflation driven by expectations: workers expect prices to rise, demand higher wages; businesses raise prices to cover higher wage costs; which validates workers' inflation expectations and generates further wage demands. Wage-price spirals are self-reinforcing and particularly difficult to break without significant economic pain. The US experienced a severe wage-price spiral in the 1970s.

Monetary inflation — Inflation resulting from excessive money creation — expanding the money supply faster than economic output. Milton Friedman's famous statement reflects his view that money supply growth is the ultimate driver of sustained inflation. Weimar Germany's hyperinflation was caused by the government printing money to pay war reparations and government debts.

Deflation — A negative inflation rate — falling prices. While falling prices sound beneficial, deflation is considered more dangerous than moderate inflation. Deflation encourages consumers to defer purchases (prices will be lower tomorrow), reducing demand, cutting business revenues, leading to layoffs, further reducing demand — a deflationary spiral. Japan's "Lost Decade" (1990s-2000s) was characterized by persistent deflation and economic stagnation despite near-zero interest rates and repeated fiscal stimulus.

Real interest rate — The nominal interest rate minus the inflation rate. If a savings account pays 4% interest and inflation is 3%, the real interest rate is 1% — your real purchasing power grows by only 1% per year. If inflation exceeds the nominal interest rate, real interest rates are negative and holding cash erodes purchasing power.

Purchasing power — The quantity of goods and services that can be bought with a unit of currency. Inflation reduces purchasing power: if prices rise 3% and your income doesn't, you can buy 3% fewer goods and services with the same money. Compounded, 3% annual inflation halves purchasing power in approximately 24 years (by the Rule of 72: 72 / 3 = 24 years).

How Inflation Is Measured

The CPI Basket

The Bureau of Labor Statistics (BLS) constructs the CPI by tracking prices on approximately 80,000 items in 87 urban areas monthly. Items are grouped into eight major categories with weightings that reflect average consumer spending patterns:

CPI Category Weight (approx.) Notes
Shelter (housing costs) 34% Largest single component; includes rent and "owners' equivalent rent"
Food (at home + away) 14% Groceries plus restaurant meals
Transportation 15% Vehicles, fuel, public transit, vehicle maintenance
Medical care 8% Out-of-pocket health costs; does not include employer-paid premiums
Energy 7% Electricity, natural gas, fuel oil
Recreation 6% Entertainment, sporting goods, pets
Education & communication 6% Tuition, internet, phones
Other goods and services 10% Personal care, tobacco, financial services

Source: Bureau of Labor Statistics, 2024 weights.

The shelter component is particularly important — and particularly controversial. The BLS measures housing costs using owners' equivalent rent (OER): a survey asking homeowners what they think they could rent their home for. This proxy lags actual housing market prices significantly (typically 12-18 months), which caused measured CPI inflation to lag both the 2021-2022 run-up in actual rents and the subsequent 2023-2024 cooling of the rental market.

Limitations of CPI

CPI is not a perfect measure of inflation as individuals experience it:

Substitution bias: CPI uses fixed consumption weights. If beef prices rise sharply and consumers switch to chicken, CPI continues to measure beef at its old weight — overstating the cost of living increase. The PCE index partially addresses this.

Quality adjustment: When a laptop computer becomes twice as powerful at the same price, that is a price decrease in quality-adjusted terms. The BLS uses hedonic quality adjustment to account for quality improvements, which some critics argue results in understating true inflation in rapidly-innovating categories.

Individual variation: The average basket may not reflect any individual's actual spending. An elderly person spending heavily on medical care experiences inflation very differently from a young renter in a city with rapidly rising housing costs.

Asset prices: CPI excludes asset prices (stocks, bonds, real estate values). Periods of low measured CPI inflation can coexist with substantial asset price inflation — critics argue the 2010s featured suppressed consumer price inflation alongside significant asset inflation driven by quantitative easing.

What Causes Inflation?

The Money Supply Foundation

Money is a medium of exchange, a store of value, and a unit of account. Its value — how much it can buy — depends on its quantity relative to the quantity of goods and services available for purchase.

The quantity theory of money, formalized by Irving Fisher in 1911, states:

MV = PQ

Where:

  • M = Money supply
  • V = Velocity of money (how often money changes hands)
  • P = Price level
  • Q = Real output (goods and services produced)

If V and Q are roughly constant, increasing M increases P — more money, higher prices, inflation. If Q (output) grows proportionally with M, prices stay stable. If M grows much faster than Q, inflation rises.

Modern central banks manage this relationship. The Federal Reserve, European Central Bank, Bank of Japan, and other central banks control short-term interest rates (which influence money supply and credit growth) and, in extraordinary circumstances, the money supply directly (quantitative easing).

One complication: the velocity of money (V) is not constant. During the COVID-19 pandemic, despite massive increases in M2 (broad money supply), velocity collapsed as households saved rather than spent the transfers they received. The immediate inflationary effect was muted. When spending resumed in 2021 with supply chains still disrupted, velocity recovered — contributing to the inflationary surge.

The 2021-2023 Inflation Episode

The US experienced its highest inflation since the early 1980s following COVID-19, peaking at 9.1% CPI in June 2022. The causes were multiple and interacting:

Supply disruptions: COVID-related factory closures (particularly in Asia), shipping bottlenecks, port congestion, and semiconductor shortages constrained the supply of goods precisely when demand surged. The average transit time for a shipping container from Shanghai to Los Angeles increased from 24 days pre-pandemic to over 70 days at the peak of the disruption (Freightos, 2022).

Demand surge: Massive fiscal stimulus ($5+ trillion in COVID relief spending) combined with accumulated savings from the pandemic (people couldn't spend on travel and services) created a demand wave for goods. Personal saving rates, which averaged 7-8% pre-pandemic, jumped to 33% in April 2020 as government transfers arrived and spending options disappeared.

Energy prices: Russia's invasion of Ukraine (February 2022) disrupted European natural gas supplies and global oil markets, triggering energy-driven cost-push inflation globally. European natural gas prices increased by over 300% in 2022; Brent crude oil peaked at over $125 per barrel.

Housing market: Ultra-low interest rates in 2020-2021 drove housing prices up sharply. The Case-Shiller national home price index rose 20.6% in the year ending March 2022 — the largest annual gain in its history. Shelter costs (which have the highest weight in CPI at ~34%) began rising with a 12-18 month lag, contributing to "sticky" inflation that proved resistant to interest rate increases.

"We now understand better how little we understand about inflation. The pandemic has revealed how unpredictable these forces can be, and how much uncertainty we face." — Fed Chair Jerome Powell, September 2022

This episode challenged the prevailing consensus. Many economists expected the inflation surge to be "transitory" — a temporary mismatch between supply and demand that would resolve as supply chains normalized. Fed Chair Powell famously used the word "transitory" to describe the 2021 inflation. When inflation proved more persistent, the word became a symbol of forecasting failure. Post-mortems by economists including Olivier Blanchard (2023) and Lawrence Summers argued that fiscal stimulus had been excessively large for the economic context, while others emphasized the unpredictable nature of the supply-demand mismatch.

Wage-Price Dynamics

When labor markets are tight (unemployment low, workers have bargaining power), wages tend to rise. Rising wages increase both consumer spending power (adding to demand-pull pressure) and business costs (adding to cost-push pressure). If wage increases exceed productivity growth, businesses must raise prices to maintain margins.

The classic Phillips curve describes the inverse relationship between unemployment and inflation: low unemployment is associated with higher inflation pressure, and high unemployment with lower. Named after economist A.W. Phillips, who documented this relationship in the UK from 1861-1957, the curve became a cornerstone of postwar policy thinking. The 1970s stagflation — when high inflation and high unemployment coexisted — appeared to break the Phillips curve relationship, leading economists to reformulate it as a relationship between unemployment and unexpected inflation, incorporating inflation expectations as a key variable.

The 2022-2023 US experience showed partial wage-price dynamics: real wages (wages adjusted for inflation) actually fell during the peak inflation period as price increases outpaced wage growth, which limited the full spiral effect — workers' purchasing power declined rather than feeding a full wage-price loop.

How Central Banks Fight Inflation

Interest Rate Policy

Central banks' primary tool is the short-term interest rate — in the US, the federal funds rate, which is the overnight lending rate between banks. When the Fed raises this rate:

  • Consumer borrowing costs rise: Mortgage rates, car loan rates, credit card rates all increase with a lag. Consumers borrow less and spend less.
  • Business borrowing costs rise: Companies borrow less for investment. Capital expenditure slows.
  • Dollar strengthens: Higher US interest rates attract capital from abroad, pushing up the dollar. A stronger dollar makes imports cheaper, directly reducing some consumer prices.
  • Asset prices fall: Higher discount rates reduce the present value of future cash flows. Stock prices and real estate prices typically fall when rates rise sharply.

Collectively, these effects reduce demand — cooling the "too much money chasing too few goods" dynamic. With lower demand, businesses have less pricing power and inflation declines.

The lag between rate changes and their effect on inflation is typically 12-18 months. This means central banks must act preemptively — raising rates based on forecasts of future inflation — and risk overtightening (causing recession) if they judge poorly.

The Fed's 2022-2023 Rate Cycle: The Federal Reserve raised the federal funds rate from near-zero (0.25%) in March 2022 to 5.25-5.50% by July 2023 — the fastest rate-tightening cycle in 40 years. Inflation fell from 9.1% (June 2022) to approximately 3% (mid-2023) without producing the severe recession many economists had predicted — a "soft landing" that surprised most forecasters. The Fed's ability to tighten this aggressively was partly enabled by the unusual nature of the inflation (substantially supply-driven) and partly by the strong underlying demand that allowed the economy to absorb higher rates.

The Taylor Rule

Economist John Taylor (1993) formalized a rule describing how central banks should set interest rates:

i = r + π + 0.5(π − π) + 0.5(y − y*)**

Where:

  • i = nominal federal funds rate
  • r* = natural rate of interest
  • π = current inflation
  • π* = inflation target (typically 2%)
  • y = current output (log)
  • y* = potential output (log)

The Taylor Rule suggests raising rates aggressively when inflation exceeds target and when the economy is above potential output. It provides a benchmark for evaluating whether central bank policy is appropriately tight or loose. During the 2021-2022 inflation surge, the Taylor Rule — applied mechanically — would have called for a federal funds rate of 8-10%, far higher than the Fed actually implemented, suggesting the Fed was significantly behind the curve and contributed to the inflation persistence (Clarida, 2022).

Forward Guidance

Central banks communicate their intentions to markets, which affects expectations. When the Fed signals future rate increases, borrowing rates across the economy rise immediately — before the Fed has actually raised rates — because bond markets price in the expected future policy path. Forward guidance is a powerful tool that allows central banks to move financial conditions without immediately adjusting rates.

Inflation expectations anchoring is related: if households and businesses believe the central bank will succeed in keeping inflation near 2%, they will set wages and prices accordingly — making the 2% target self-fulfilling. If expectations become "unanchored" — if people stop believing the central bank will control inflation — the wage-price spiral dynamic becomes much harder to stop without severe tightening. Maintaining credibility is therefore one of the most important assets a central bank has, and protecting it explains why central banks sometimes tighten more aggressively than strict economic analysis requires.

The Volcker Disinflation

The most dramatic modern example of successful central bank inflation fighting is the Volcker disinflation of 1979-1982. When Paul Volcker became Fed Chair in 1979, US inflation was approximately 11% and rising. Volcker raised the federal funds rate to an unprecedented 20% — accepting a severe recession (unemployment reached 10.8% in December 1982) to break entrenched inflationary expectations.

It worked. Inflation fell from over 14% in 1980 to under 4% by 1983. The cost was enormous: the 1981-1982 recession was the worst since the Great Depression, destroying manufacturing employment and causing widespread economic hardship. But it demonstrated that determined monetary policy could break even deeply entrenched inflation — at sufficient economic cost.

"My first priority is to reduce inflation. I know there will be unemployment. I know there will be corporate losses. I hope to make them as small as possible — but that is a necessary cost." — Paul Volcker, congressional testimony, 1979 (paraphrased from contemporaneous reports)

The Volcker episode established the modern framework of inflation targeting — explicit central bank commitments to numerical inflation targets, backed by credible willingness to raise rates aggressively if targets are breached. New Zealand was the first country to formally adopt inflation targeting in 1990; the UK followed in 1992; the Fed adopted an explicit 2% inflation target only in 2012, though it had operated effectively as an inflation targeter for decades before.

Winners and Losers from Inflation

Inflation redistributes wealth between different groups:

Group Effect of Inflation
Debtors (e.g., mortgage holders) Benefit: real value of debt falls; fixed payments represent less real purchasing power
Creditors / savers Hurt: real value of savings erodes; fixed interest income buys less
Workers with flexible wages Neutral if wages keep pace; hurt if wages lag inflation
Workers with fixed wages Hurt: real wages fall
Governments with debt Benefit: inflation reduces real burden of government debt
Pension holders (fixed) Hurt: purchasing power of fixed pension payments falls
Commodity producers Often benefit: commodity prices typically rise with inflation
Homeowners Often benefit: property values and rents typically rise with inflation
Landlords Often benefit: rental income rises with inflation; fixed-rate mortgage debt erodes in real terms
Tenants Often hurt: rental costs rise; income may not keep pace

This distribution helps explain why inflation generates such political heat: it benefits some groups substantially (debtors, tangible asset holders) while harming others (savers, fixed-income recipients). Historically, inflation has been associated with political instability because its effects fall disproportionately on those with less ability to hedge — the elderly on fixed incomes, workers without strong union representation, and those without financial assets.

Research by Coibion, Gorodnichenko & Kueng (2012) found that inflation was significantly more harmful to lower-income households than upper-income households in the US, because lower-income households hold more of their wealth in cash (which erodes with inflation) and less in real assets (which often appreciate). This inflation inequality — the distributional incidence of inflation varying across income groups — is increasingly recognized as a policy-relevant dimension of inflation beyond its aggregate effects.

The Inflation-Growth Tradeoff

Moderate inflation is generally considered beneficial: it provides monetary policy with room to maneuver (nominal interest rates can't fall below zero, but negative real rates require positive inflation), encourages spending and investment over hoarding, and provides wage flexibility (it's easier to hold nominal wages constant than to cut them, so inflation effectively enables real wage cuts when needed). The 2% inflation target widely adopted by central banks reflects a rough consensus about this optimal zone.

Very low inflation (below 1%) is problematic because it reduces monetary policy space and risks tipping into deflation. The zero lower bound on nominal interest rates means that when inflation is very low and the economy weakens, central banks may run out of conventional room to stimulate — as Japan discovered in the 1990s and the US and Europe came close to in 2008-2015.

Deflation is the opposite of inflation — falling prices — and is considered significantly more dangerous than moderate inflation. When prices are falling, debtors face rising real debt burdens (the opposite of the inflation benefit above), consumption is deferred (why buy today if prices will be lower tomorrow?), and nominal interest rates cannot fall below zero to offset deflationary pressure. Japan's experience of secular deflation from the mid-1990s through the 2010s — the "Lost Decade" that stretched into two — is the canonical warning case.

High inflation above 5-6% begins to distort economic decision-making: firms spend resources protecting against inflation rather than producing; long-term contracts become unworkable; the informational content of prices — the signal that guides efficient resource allocation — is degraded by background noise. Economies with chronically high inflation (Argentina, Venezuela, Turkey in recent years) struggle to attract long-term investment and face recurring currency crises.

Hyperinflation: When Inflation Becomes Catastrophic

Hyperinflation is conventionally defined (following Phillip Cagan's 1956 paper) as inflation exceeding 50% per month — roughly 12,875% annually. At this rate, prices double approximately every 51 days.

Hyperinflations share common causes: typically a government printing money to finance spending it cannot tax or borrow, combined with a collapse of confidence in the currency that accelerates the velocity of money and amplifies the price increases.

Weimar Germany (1921-1923): Germany had financed World War I with debt, expecting to pay it off with war reparations from the losers. Instead, Germany was the loser, with enormous reparations obligations. When Germany defaulted and France occupied the Ruhr (1923), the government printed money to pay striking workers. At peak inflation, prices doubled every 3.7 days. The economic devastation of the German middle class — whose savings were wiped out entirely — is frequently cited as a contributing factor to the political radicalization of the 1920s.

Zimbabwe (2007-2009): The government of Robert Mugabe printed money to finance fiscal deficits after the land redistribution program collapsed agricultural export earnings. By November 2008, Zimbabwe's monthly inflation rate had reached 79.6 billion percent. The Zimbabwe dollar became essentially worthless; the country eventually abandoned it and adopted US dollars and South African rand. A new Zimbabwe dollar introduced in 2019 required a redenomination at a rate of 100 trillion old dollars to one new dollar.

Hungary (1945-1946): The worst hyperinflation in recorded history. In July 1946, daily inflation reached 207%, meaning prices doubled every 15 hours. The Hungarian pengő was replaced by a new currency (the forint) at an exchange rate of 400 octillion (4 × 10²⁹) pengő to one forint — the largest redenomination in history.

Venezuela (2016-present): Chronic mismanagement of oil revenues, price controls that destroyed domestic production, and fiscal deficits financed by money creation produced inflation that exceeded 1,000,000% in 2018 by IMF estimates. The Venezuelan bolivar was redenominated multiple times; many transactions shifted to US dollars despite their non-official status.

The mechanism is the same in each case: once confidence in the currency collapses, everyone rushes to spend money as quickly as possible (velocity increases), which validates the expectation of further inflation, accelerating the spiral. Only the credible introduction of a new currency or a fundamental fiscal commitment can stop it.

Inflation in Historical Context

A long-run perspective on inflation reveals how historically unusual modern experience is.

From approximately 1800 to 1914, the US and UK operated under the gold standard — where money was convertible to gold at a fixed rate. Long-run inflation under the gold standard was close to zero: prices in 1914 were roughly similar to prices in 1800. The price level could fall as well as rise, and deflationary episodes were common during recessions.

The abandonment of the gold standard — fully completed by the US when President Nixon ended dollar-gold convertibility in 1971 — freed governments to expand the money supply without constraint. This enabled the large fiscal deficits of the 20th century (particularly World War II financing) but also created the potential for inflation that did not exist under the gold standard constraint.

The 20th century saw both the worst inflations in history (Weimar, Hungary, Zimbabwe) and the long "Great Moderation" from roughly 1985-2020, during which inflation in developed economies was remarkably stable and low — a period increasingly credited to improved central bank credibility and the global disinflationary effects of globalization (which kept goods prices low through cheap manufacturing imports). The COVID-19 pandemic inflation represented the first major test of that framework since the Volcker era, and the outcome — inflation controlled without severe recession — was broadly reassuring about the toolkit central banks have developed.

References

  • Fisher, I. (1911). The Purchasing Power of Money: Its Determination and Relation to Credit, Interest and Crises. Macmillan.
  • Friedman, M., & Schwartz, A. J. (1963). A Monetary History of the United States, 1867-1960. Princeton University Press.
  • Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195-214. https://doi.org/10.1016/0167-2231(93)90011-L
  • Bureau of Labor Statistics. (2024). Consumer Price Index. US Department of Labor. https://www.bls.gov/cpi/
  • Cagan, P. (1956). The monetary dynamics of hyperinflation. In M. Friedman (Ed.), Studies in the Quantity Theory of Money. University of Chicago Press.
  • Bernanke, B. S. (2015). The Courage to Act: A Memoir of a Crisis and Its Aftermath. W. W. Norton.
  • Board of Governors of the Federal Reserve System. (2023). Monetary Policy Report. Federal Reserve. https://www.federalreserve.gov/monetarypolicy/mpr_default.htm
  • Blanchard, O. (2023). Fiscal policy under low interest rates. MIT Press.
  • Clarida, R. H. (2022). The Federal Reserve's new framework: Context and consequences. In Reassessing Constraints on the Economy and Policy. Federal Reserve Bank of Kansas City.
  • Coibion, O., Gorodnichenko, Y., & Kueng, L. (2012). Innocent bystanders? Monetary policy and inequality in the US. NBER Working Paper 18170. https://doi.org/10.3386/w18170
  • Phillips, A. W. (1958). The relation between unemployment and the rate of change of money wage rates in the United Kingdom, 1861-1957. Economica, 25(100), 283-299. https://doi.org/10.1111/j.1468-0335.1958.tb00003.x
  • Freightos. (2022). Container Freight Rate Index. Freightos Baltic Index. https://fbx.freightos.com

For related concepts, see how central banks work, how interest rates affect the economy, and how recessions happen.

Tags

inflation economics central banks monetary policy Federal Reserve

Frequently Asked Questions

What is inflation?

Inflation is the rate at which the general price level of goods and services rises over time, eroding the purchasing power of money. If annual inflation is 3%, something that cost \(100 last year costs \)103 this year. Moderate inflation (2-3% annually) is considered normal and healthy in most economies. High inflation (double digits) disrupts economic planning. Hyperinflation (hundreds or thousands of percent annually) destroys the currency and economic activity.

What causes inflation?

Inflation has several causes. Demand-pull inflation occurs when demand for goods and services exceeds supply — too much money chasing too few goods. Cost-push inflation occurs when production costs rise (raw materials, wages, energy) and businesses pass these on as higher prices. Built-in (wage-price spiral) inflation occurs when workers demand higher wages in expectation of higher prices, and businesses raise prices to cover wage costs. Monetary inflation — excessive money creation — was historically a primary cause; modern central banks manage money supply to prevent it.

How do central banks fight inflation?

Central banks primarily fight inflation by raising interest rates. Higher interest rates make borrowing more expensive, reducing consumer spending (mortgages, car loans, credit cards) and business investment. Lower demand puts downward pressure on prices. Central banks also use forward guidance (signaling future policy intentions) and, in extreme cases, quantitative tightening (selling assets to reduce money supply). The Federal Reserve raised rates from near zero to over 5% between 2022 and 2023 in response to post-COVID inflation.

Why do central banks target 2% inflation rather than 0%?

A 2% inflation target provides a buffer against deflation — falling prices — which is considered more dangerous than moderate inflation. Deflation causes consumers to delay purchases (prices will be lower tomorrow), reducing demand and potentially causing a deflationary spiral. It also increases the real burden of debt. A small inflation target keeps the economy away from deflationary risks, gives central banks room to cut rates during recessions, and allows relative price adjustments without requiring nominal wage cuts.

What is the CPI?

The Consumer Price Index (CPI) is the most commonly used measure of inflation. It tracks the prices of a representative 'basket' of goods and services that typical households purchase — food, housing, transportation, medical care, recreation, etc. The basket composition and weights are updated periodically to reflect actual spending patterns. CPI inflation compares this basket's cost today versus a year ago. Core CPI excludes volatile food and energy prices to show underlying inflation trends.

What is hyperinflation and when does it happen?

Hyperinflation is extremely rapid inflation, conventionally defined as exceeding 50% per month. It typically occurs when governments print money to cover spending deficits — typically during wars, political crises, or post-war reconstruction periods. Famous examples: Weimar Germany (1921-1923, prices doubled every 3.7 days at peak), Zimbabwe (2007-2009, estimated 89.7 sextillion percent annual inflation), Hungary (1945-1946, the worst case in recorded history). Hyperinflation destroys savings, trade, and economic activity.

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