Inflation occurs when there is a sustained increase in the general level of prices. This means that it isn’t a one-off increase in prices, or a situation where prices are only rising in certain sectors of the economy. When inflation is happening, money loses its value, as its purchasing power is reduced. Currently, inflation in the UK is around 2% a year, which is lower than it has been in the past. For example, the inflation rate averaged 15% between 1973 and 1981, and 6% between 1981 and 1990 (Begg, p.274).

Inflation can cause a number of problems for an economy, so it can be said that there are costs of inflation. The costs of inflation include the menu costs, which are the costs which occur when firms need to change prices, and the shoe leather costs, which occur when people try to reduce their cash balances, because money quickly loses its value during times of inflation. Another cost of inflation is the effect it has on the distribution of wealth in an economy. Inflation can cause a redistribution of wealth from savers to borrowers, because the real value of debts (the nominal va

The Cambridge version of the Quantity theory uses the following equation:

Keynesian theories of inflation also look at the demand for money, but these theories have a different view of the effect of money on the economy. According to the Keynesians, there are different reasons for holding money, so that it is possible that a rise in the money supply could also lead to a rise in the demand for money, with people holding the extra cash. This means that a rise in the money supply doesn’t always cause inflation.

It is important to note that both versions of the Quantity theory assume that the economy is at full employment.

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