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Economic Theory

real GDP, nominal GDP can adjust only if the price level changes. Hence,
the quantity theory implies that the price level is proportional to the money
supply.
Because the inflation rate is the percentage change in the price level,

this theory of the price level is also a theory of the inflation rate.
Thus, the quantity theory of money states that the central bank, which

controls the money supply, has ultimate control over the rate of inflation.
If the central bank keeps the money supply stable, the price level will be
stable. If the central bank increases the money supply rapidly, the price
level will rise rapidly.

5. Inflation. Types of inflation

A lot of people worry about inflation. Most people associate inflation
with price increases on specific goods and services. The economy is not
necessarily experiencing inflation, however, every time the price of a cup
of a coffee goes up. We must be careful to distinguish the phenomenon of

inflation from price increases for specific goods. Inflation is an increase in
the average level of prices, not a change in any specific price.
Suppose you wanted to know the average price of fruit in the

supermarket. Surely you would not have much success in seeking out an
average fruit – nobody would be quit sure what you had in mind. You
might have some success, however, if you sought out the prices of apples,
oranges, cherries, and peaches. Knowing the price of each kind of fruit,

you could then compute the average price of fruit. The resultant figure
would not refer to any product but would convey sense of how much a

typical basket of fruit might cost. By repeating these calculations every
day, you could then determine whether fruit prices, on average, were
changing. On occasion, you might even notice hat apple prices rose while
orange prices fell, leaving the average price of fruit unchanged.

The same kinds of calculation are made to measure inflation in the
entire economy. We first determine the average price of all output – the
average price level – then look for changes in that average. A rise in the

average price level is referred to as inflation.
In economics, deflation is a decrease in the general price level of
goods and services. Deflation occurs when the inflation rate falls below
0 % (a negative inflation rate). Inflation reduces the value of currency over

time, but deflation increases it. This allows more goods and services to be
bought than before with the same amount of currency.

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