Understanding Inflation
Inflation is the general, sustained and self-reinforcing rise in the price level within an economy. Mankiw presents it as one of the most important macroeconomic phenomena to master, as it directly affects purchasing power, interest rates, wages, and all economic decisions made by agents.
Last updated: 9 July 2026
Definition
DefinitionInflation refers to the sustained increase in the general price level within an economy. It does not concern an isolated price increase for a single product, but an overall movement: when we speak of 3% annual inflation, it means that on average, the basket of goods and services consumed by households costs 3% more than a year earlier.
The main measurement tool is the Consumer Price Index (CPI). The inflation rate is calculated as: π = (CPI_t − CPI_t-1) / CPI_t-1 × 100. The national statistical institute (INSEE in France, the BLS in the United States) records each month the prices of several thousand goods and services grouped into a basket representative of household consumption.
A distinction worth making: disinflation is merely a slowdown in the pace of price increases (inflation remains positive), whereas the two true extreme cases are deflation (a generalized decline in prices) and hyperinflation (price increases exceeding 50% per month).
Why it matters
Controlling inflation is at the heart of central banks' mandates: it is the ECB's primary objective (price stability), and one of the US Fed's two objectives, along with maximum employment. Moderate inflation, around 2%, is considered optimal by most central banks in advanced economies. This rate is low enough not to disrupt economic decisions, while being high enough to avoid the risk of deflation.
The costs of inflation include: "shoe-leather costs" (agents seek to hold as little money as possible), "menu costs" (firms must frequently revise their prices), tax distortion (taxes are levied on nominal rather than real gains), confusion in price signals, and the arbitrary redistribution of wealth between creditors and debtors.
Key points
Demand-pull inflation: aggregate demand for goods and services exceeds the economy's production capacity. Excess demand pushes prices upward. Mankiw illustrates this with "too much money chasing too few goods"
Cost-push inflation: rising production costs (raw materials, energy, wages) are passed on to selling prices. The 1973 oil shock is the most cited historical example
Inflation expectations: if economic agents anticipate high inflation, they adjust their behavior (wage increase demands, preemptive price hikes), which becomes self-reinforcing. Hence the importance of central bank credibility
The short-run Phillips curve suggests a trade-off between inflation and unemployment, formalized as π = πᵉ − β(u − uₙ) + ε, where πᵉ is expected inflation, u the unemployment rate, uₙ the natural rate, β the sensitivity, and ε a supply shock. In the long run, this trade-off disappears as πᵉ adjusts
Concrete example
ExamplesIn the eurozone, the ECB targets 2% annual inflation. In 2022, inflation reached 10.6% in October, its highest-ever level, due to the energy shock linked to the war in Ukraine and post-Covid bottlenecks in global supply chains. The ECB responded by raising its key rates from 0% to 4.5% between July 2022 and September 2023 — the fastest increase in its history. By 2024, inflation had fallen back to around 2.5%, illustrating the effectiveness (and the lag) of restrictive monetary policy.
Mankiw anecdote
MankiwMankiw uses the example of German hyperinflation during the Weimar Republic (1923): at its peak in October 1923, prices doubled approximately every 3.7 days (source: Hanke & Krus, "World Hyperinflations," 2012), workers were paid twice a day and spent their wages immediately. The absolute record remains Hungary in 1946, with prices doubling every 15 hours. He also recalls Zimbabwe's hyperinflation in 2008 (79.6 billion % per month) to illustrate the quantity theory of money: money printing without productive counterpart mechanically leads to the destruction of the currency's value.
Further reading
ProgressionThe role of inflation expectations in price dynamics is explored in depth in the explanation "Rational Expectations and the New Classical Macroeconomics" (ch. 14, Advanced level), which explains how central bank credibility determines the anchoring of expectations and the cost of disinflation.
📊 Courbe de Phillips
Market impact
MarketsInflation above expectations prompts central banks to tighten monetary policy by raising key interest rates. This rate increase penalizes long-duration assets (fixed-rate bonds, growth stocks) and tends to strengthen the national currency. Gold has historically served as a hedge against monetary erosion during periods of high inflation. The bond market is the first to be affected: yields rise and the prices of existing bonds fall.