There are two things which are meant by inflation, the first being the primary cause of the second. The first is an increase in the money supply. This is the straightforward meaning of “inflation,” it’s like more air being blown into a balloon—the balloon gets bigger. The second meaning is a universal increase in prices. An increase in the amount of money without an increase in the amount of goods and services to buy with them means that more money is chasing the same amount of goods and services, so the prices of them will rise until an equilibrium is reached.
How It Happens
The main cause of inflation is the creation by a government of money faster than the increase of goods and services. (The latter is, generally, caused by increases in economic productivity, chief of which is an increase in population.) Colloquially this is referred to as governments “printing money,” though it’s been many decades since the majority of money existed as printed currency. This is possible because virtually all people use what is called a “fiat currency,” that is, a currency which exists because a government said that it does. This is a reference to the latin translation of the first words of God after creating the heavens and the earth, when the earth was a formless void and darkness was over the deep: fiat lux. (“Let there be light,” is the common English translation.)
Prior to fiat currencies, which were widely adopted in the 1900s, precious metals tended to be used as currencies. These do increase, though their increases are limited by the amount of them that can be found. That said, while it is far harder to inflate a currency through mining precious metals, it has happened in history, though usually only on a local scale.
Why It’s Bad
If a government announced a date on which it would double the money supply and on that date doubled the money supply instantly and instantly handed the money out uniformly to people according to how much they already had, such that everyone received an extra dollar for every dollar he had, everyone would double their prices and other than the math for transactions being slightly harder and everyone selling anything facing the inconvenience of printing up new price tags, nothing would change. That is not, however, how governments do it.
What they universally do, because it is a fallen world, is to give themselves the money and not tell anyone that they did. They then spend this in order to be able to buy more than what the taxes they brought in would allow them to. This slowly filters into the economy, raising prices first in the places where they are buying things, then rippling out as those people buy from their suppliers. (Since governments rarely do this exactly uniformly, it also has a tendency to create economic bubbles where increased demand gets met with increased production and then demand falls off, but that’s a story for another day.) If they stop making the new money, eventually these ripples go throughout the economy, everyone has more money, prices are increased, and a new equilibrium is reached. But people are impacted; the people who have not yet received income increases have to pay more before they receive more, and often have to dip into their savings to make up the difference. Anyone who has saved is penalized for this savings, because they receive nothing extra for their savings and their savings is now worth less. Thus governments inflating the currency is a kind of stealth taxation. (This is why it was an excellent idea, when it became clear that the government’s response to COVID was to create massive amounts of new money, to make any large purchases of durable goods with one’s savings, locking in that value before the stealth taxation hit. E.g. buying a weight set, a new car, a new water heater, re-roofing one’s house now rather than in a year, etc.)
Other Causes of Universal Price Increases
There is another causes of universal price increases besides inflation: a contraction in the amount of goods and services available for purchase while the supply of money stays the same. This can be caused by the population shrinking, but that has been (so far) pretty uncommon in human experience. Not unheard of, but uncommon.
A more common cause of the contraction in goods and services are wars: wars consume large fractions of the productive capacity of people and literally throw the results away. Granted, they often throw them away for military purposes, as in the shooting of bullets or the dropping of bombs. Still, bullets and bombs are not economically productive. Further, soldiers at war are not part of the economy, and thus their labor is removed from the economy.
Another cause of a contraction in goods and services is the expansion of the regulatory state. Regulators do not produce anything (besides regulation). People who are employed as regulators are, therefore, not contributing to economic production and the more people who are shifted from the economy to the regulatory state, the smaller the pool of laborers and the fewer goods and services there will be to purchase. (This is not a value judgement on regulation; experience has shown that some regulation is necessary for the common good; it just must be understood that regulation is in no sense free.)
Another cause of a contraction in goods and services is the limitation of the resources to produce them. For example, if energy policy reduces the amount of energy available to the economy, fewer goods and services will be able to be produced. This can be effected either through the direct limitation of energy production or by the taxation of energy production.
Chris Lansdown 