Inflation is a measure of the rate at which the general level of prices for goods and services is rising and subsequently, purchasing power is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
When the inflation rate is too high, it can cause problems for the economy. For example, high inflation can lead to uncertainty and volatility in financial markets, as investors and consumers are unsure about the future purchasing power of their money. This can lead to a decrease in spending and investment, which can slow down economic growth.
On the other hand, when the inflation rate is too low, it can also cause problems. This is because low inflation can lead to deflation, which is a general decline in prices. Deflation can be harmful to the economy because it can lead to a decrease in demand and spending, as consumers may postpone purchases in the hopes of getting a better deal in the future. This can lead to lower economic growth and even a recession.
In order to maintain a healthy level of inflation, central banks use a variety of tools to manage the money supply and interest rates. For example, they may increase or decrease the interest rate in order to encourage or discourage borrowing and spending. They may also engage in open market operations, which involve buying or selling government securities in order to expand or contract the money supply.
Overall, inflation is a critical aspect of the economy and central banks must carefully manage it in order to keep the economy running smoothly. Too much or too little inflation can lead to problems, so it is important for central banks to strike the right balance.