Inflation—the general rise in the prices of goods and services—is one of the differentiating characteristics of the U.S. economy in the post-World War II era. Except for 1949, 1955, and 2009, the prices of goods and services have, on average, risen each year since 1945. The cumulative effect of this inflation is staggering: the price level has risen more than 1,000% since the end of World War II. Inflation rose in the 1960s, peaked in the 1970s (it was 13.3% in 1979) and early 1980s, and has been generally low but positive since then. During the last two recessions (2001 and 2007 to 2009), policymakers have been more concerned about the threat of deflation (falling prices) than inflation. Prices fell in 2009, but have risen at a low and stable rate since. Prices did not persistently rise in the pre-World War II period. On the eve of that war, in 1941, the U.S. price level was virtually the same as in 1807. During the periods from 1846 to 1861 and 1884 to 1909, the United States experienced a near constant price level. And in the 15 years from 1865 through 1879, the price level either remained constant or declined. The principal periods of inflation between 1800 and 1941 were associated with wars and the discoveries of gold and silver both here and abroad (and with increased efficiencies in extracting both metals). Inflation can be defined as a sustained or continuous rise in the general price level or, alternatively, as a sustained or continuous fall in the value of money. Several things should be noted about this definition. First, inflation refers to the movement in the general level of prices. It does not refer to changes in one price relative to other prices. These changes are common even when the overall level of prices is stable. Second, the prices are those of goods and services, not assets. Third, the rise in the price level must be somewhat substantial and continue over a period longer than a day, week, or month. There has been practically no period in American history in which a significant change in the price level has occurred that was not simultaneously accompanied by a corresponding change in the supply of money. This has led to a widely held view that, in the long run, "inflation is always and everywhere a monetary phenomenon resulting from and accompanied by a rise in the quantity of money relative to output." Although this view is generally accepted, it is, in fact, consistent with two quite different views as to the cause of inflation—whether it is caused by "demand-side" factors influencing overall spending or "supply-side" factors influencing overall production—at any given time. In one view, inflationary pressures begin to rise when spending in the economy outpaces the economy's production. Monetary policy can be used to keep spending in line with total production, albeit imperfectly and with lags between implementation and results. Thus, a more rapid rate of money growth plays an active role in inflation and results either from mistaken policies of the Federal Reserve or because the Federal Reserve subordinates itself to the fiscal requirements of the federal government. Examples of Federal Reserve policies that are likely to produce inflation are those that fix rates of interest too low or those that support unrealistic foreign exchange values of the dollar. According to this view, the control of inflation rests with the Federal Reserve (Fed) and depends upon its willingness to limit the growth in the money supply. The relationship between changes in the money supply and changes in inflation is not stable, however. Thus, as a practical matter, economists are divided on whether inflationary trends can best be predicted by looking at the relationship between spending and production, using measures such as the output gap, or by looking at measures of monetary policy, such as growth in the money supply. Economists who are proponents of the Fed's recent use of "quantitative easing" tend to point to measures such as the large output gap to predict that deflation is a greater risk than high inflation. Some economists who are concerned that quantitative easing will lead to high inflation tend to point to the rapid growth in the portion of the money supply controlled by the Fed (called the monetary base) since 2008. To date, the overall money supply has grown more quickly than it had in recent decades, but not at a pace commensurate with the growth in the monetary base, and inflation has remained low. Nevertheless, the increase in the monetary base has the potential to be inflationary in the future, as the output gap declines. An alternative view comes in several versions. They have in common a belief that the major upward pressure on prices comes from external price shocks, which unlike overly stimulative money growth would produce a fall in real output. One candidate is the attempt by organized labor to obtain increases in real wages. Other activities include the monopolistic pricing behavior of OPEC, major crop failures, or changes in the terms of international trade produced by a decline in the foreign exchange value of the dollar. The decline in real output that these activities produce will, in general, lead to rises in unemployment. To prevent unemployment from increasing, in one version of this alternative, the Federal Reserve is seen to pump up demand by increasing the growth of money and credit. In the process it ratifies the rise in the price level. Thus, in this version, while a growth in the money supply is necessary to ratify the upward movement in the price level, it is not the cause of the rise in prices. It is interesting to speculate what would happen if the Federal Reserve refused to expand demand in the face of the rise in unemployment. Presumably, after a protracted period, the additional unemployment would lead to a fall in wages, costs, and other prices. Over the longer run, output would return to its previous level or growth path, the price level would fall back to its previous level, and only relative prices and wages would be different. Thus, while the Federal Reserve has the power to curb inflation, it is unlikely to exercise this power in the face of a large run up in unemployment. In another extreme variant, what the Federal Reserve does is really irrelevant. Should it refuse to expand what is conventionally called money to pump up demand in the presence of these developments that reduce output, money substitutes under the guise of credit will emerge that will allow demand to grow and the price increases to be ratified. This variation, interestingly, precludes excessive money growth from causing inflation, for it also holds that the Federal Reserve cannot force too much money on the economy. Inflation, then, cannot be a case in which too much money is chasing too few goods. The first two explanations for inflation find many adherents among American economists, whereas the third is more common among some British economists. In most years, inflation tends to rise when unemployment falls, and vice versa. Economic theory explains this relationship in terms of a full employment rate of unemployment, also called the natural rate of unemployment or the non-accelerating inflation rate of unemployment (NAIRU). Whenever the actual unemployment rate is above the full employment rate, total spending in the economy will fall, and the resultant slack will cause the inflation rate to fall (since there is less demand for goods and services). As the inflation rate falls, the expected rate of inflation should also fall if economic agents believe the government is sincere in its efforts to end inflation (i.e., that the government will not reverse its policy in the face of rising unemployment). As inflationary expectations fall so will wage demands, and falling wage demands will bring about a lower unemployment rate (since employers will demand more labor when labor costs fall). Ultimately, the economy will move back to full employment at a zero inflation rate or a stable price level. Thus, the important steps in the sequence are (1) convincing government policy to reduce the inflation rate to zero; (2) tolerating an above normal rate of unemployment; and (3) adjusting inflation expectations and wage demands to the lower rate of inflation. In practice, policymakers have shown a preference for stimulating the economy before inflation hits zero, so that unemployment returns to the full employment rate faster. As a result, most recessions have featured a falling but still positive inflation rate. The relationship between inflation and unemployment points to one reason that inflation can be temporarily costly in practice. Because inflationary expectations have not fallen until unemployment has risen, efforts to reduce the rate of inflation have often been associated with economic downturns. For example, the double-digit inflation of the early 1980s was reduced only through an economic downturn during which the unemployment rate rose to double digits (10.8% in late 1982) for the first time since the Great Depression of the 1930s. It is argued that a higher inflation rate in the late 1980s was a major reason why the Fed tightened monetary policy, which was also an important factor causing the recession of 1990-1991. Economists believe that expectations of future inflation play an important role in the relationship between inflation and unemployment. To illustrate why, consider the example of tightening monetary policy (raising short-term interest rates) to reduce the inflation rate. Higher interest rates reduce spending on interest-sensitive goods, such as business investment spending, consumer durables, and housing. As spending on these goods declines, so will employment in the sectors producing these goods. If inflation expectations are low, the overall decline in spending and employment will put downward pressure on prices, as discussed in the previous section. But if inflation expectations are high, prices will respond less quickly to the same decline in spending and employment. As a result, spending and employment would have to fall further and longer to produce the same decline in prices. Whether inflation expectations are high or low will depend importantly on the perceived credibility of the Fed's commitment to maintaining low inflation.