Inflation is the aggregate level at which prices for goods and services are increasing. When inflation occurs, it means that the purchasing power of consumers and businesses is declining, unless they can increase their income by an offsetting amount. Inflation also reduces the value of savings. If the inflation rate is higher than the return on investment that a person or business is experiencing, then there is a net decline in investment. Inflation has an especially pernicious impact on those with fixed incomes, since their purchasing power gradually declines over time.
For example, if inflation is 3%, then the price of an item that cost $1.00 one year ago now costs $1.03. As just noted, inflation is considered an aggregate amount, which is the average change in prices for a selected set of goods and services. In reality, the inflation rate for a specific item may be much higher than the reported aggregate inflation rate, while the prices of other items may have declined during the same period of time.
Inflation may be caused by a constriction in supply. For example, when there is a shortfall in the amount of gasoline in comparison to the demand for it, the price of gasoline will increase (unless prices are controlled by order of the government). Inflation may also occur when a loosening of credit results in individuals and businesses spending so much that excessive demand forces an increase in prices.
A minor level of year-over-year inflation is considered to be optimal, usually in the range of 2-3%. This is the target level that most central banks use as one of the goals of their monetary policies.
When prices are increasing at an extremely fast rate, it is called hyperinflation.