Depending on whom you listen to, inflation will either clean your teeth or knock them out. Former United States President Ronald Reagan described it as being "as violent as a mugger, as frightening as an armed robber and as deadly as a hit man." Karl Otto Pohl, former president of the German Bundesbank, said: "Inflation is like toothpaste; once it's out [of the tube], you can hardly get it back in again."

In fact, most of the time, inflation -- the phenomenon of rising prices -- is neither of the above. Keeping prices ticking up slowly and predictably has become one of the most important roles -- if not the most important role of central banks and governments when managing their economies. But inflation can have a nasty tendency to get out of control.

Levels of Inflation

Inflation is usually expressed on an annual basis. Thus, a 3 per cent inflation rate means that prices across the economy as a whole are 3 per cent higher than 12 months earlier.

Among the most telling of all economic statistics, inflation can help illustrate whether an economy is in good health, overheating or slowing down sharply. Too high and an economy risks becoming trapped in an inflationary spiral -- when prices rise exponentially -- or even hyperinflation; the difference between the two depends on the magnitude of price rises. Hyperinflation, which afflicted Germany in the 1920s and Zimbabwe during the first decade of the new millennium, involves price rises of at least 50 per cent -- and often far higher -- in a single month. Weimar Germany at one point had to resort to issuing banknotes of 100 trillion marks as hyperinflation peaked in 1923.

Even lower inflation of around 20 per cent can be highly damaging, particularly when, as in the US and UK in the 1970s, it comes alongside weak economic growth or recession. The result is commonly known as stagflation (stagnant growth and high inflation), and in the US and UK it pushed up unemployment and bankruptcies for many years. Inflation, in short, has the power to wreck once proud and healthy economies.

Causes and Effects

Inflation tells us something about both social and economic conditions. By comparing how fast the cost of living is increasing with the speed at which households' incomes are rising, one can calculate the rate at which a society's standard of living is improving. If inflation outpaces families' wages, their standard of living is falling: people cannot afford to buy as many goods as they would otherwise have done. But when wages are rising faster than inflation, people have more money in their pockets after paying for their weekly shopping bill: their standard of living improves.

When an economy is growing fast, employees receive generous pay increases, meaning they will spend more on goods and services. Prices will tend to rise in response to this increase in demand, whether it be for houses or haircuts. Likewise, if the economy slows, demand will follow suit and prices will come down, or will at least rise at a slower rate.

The price of goods is affected not just by demand but by the amount of money people have at their disposal. If the money supply grows (either because more money is printed or because banks are lending out more), there will be more money chasing the same volume of goods, which will push the price up. The debate over how precisely to influence this process was one of the major intellectual battles of the 20th century, between monetarists and Keynesians.

Always Inflation?

A question frequently asked is whether prices always have to rise: can't they just stay still? In fact, they can freeze, and at various points in history have done so. Although inflation is not theoretically necessary for economies to function, politicians have tended, particularly in the past century or so, to encourage a little bit of inflation in their economies, for a number of reasons.

First, and most importantly, inflation encourages people to spend rather than save, because it slowly erodes the value of the money in one's pocket. A certain degree of this forward momentum is essential in modern capitalist economies, since in the long run it encourages companies to invest in new technologies. However, inflation also erodes debt, so indebted governments have in the past all too often allowed it to bubble ever higher, effectively reducing the amount of money they owe.

Similarly, inflation levels are usually analogous to interest rates, and people are accustomed to positive rather than negative interest rates. There have been few examples in history of banks charging customers to save and paying them to borrow (as would happen in a world of negative interest rates), and only in times of crisis when it was essential to encourage people to spend rather than save.

Finally, people are inherently used to rising wages. It is human nature, people strive to improve themselves, and often find it difficult to stomach a pay freeze each year, even if prices in the shops are more or less static.

Inflationary Spirals

Prices can sometimes rise exponentially in what is commonly called an inflationary spiral. The higher inflation goes, the more discontent it causes among workers, who see their standard of living deteriorating. They demand higher wages, and if they succeed they spend their extra cash, which in turn prompts shopkeepers to raise their prices. This pushes inflation still higher, which sends employees back to their bosses for more pay rises.

The fundamental problem with excessive inflation -- or for that matter deflation -- is that it can dangerously destabilize economies. When businesses and families feel insecure about how fast prices are rising or falling, they put off investing and saving, and normal life grinds to a halt. This is why governments and central banks are determined to keep prices ticking along at a predictable rate. Should they fail, then -- as Ronald Reagan rightly pointed out -- people are left to face a hugely unpleasant experience.