Money does weird things doesn't it? Things used to be cheaper, you can exchange your dollar for a bajillion bulungi bulungs, things will cost way more in the future. Why does this happen, and how true are these tropes? Read more to find out.
Money in Economics
Both inflation and exchange rates are results of using money. People who study how money works (economists, financial people, historians) define it as something that fills three roles:
- A medium of exchange: Money is used to buy and sell things. You give money to someone, they give you a good or service. Or you get paid money to give someone else a good or service. Other ways to do this exist: favors can be owed, barter used, or economies can run as gift based economies (as an example). But favors can be hard to keep track of in too big a society, and keeping track of bartered goods can get complicated. Well accepted money simplifies this process enormously.
- A measure of prices/unit of account: Money is used to compare prices. How many cows is a yoga class? How many knives is fixing a roof worth? It is possible to use a single good to do this(roof fixing costs x standardized knives, cow costs y standardized knives, etc.), but money also works well.
- A store of value: You can be paid something now, save the money, and spend it later. Societies can keep track of debts or owed favors, but money makes the process much simpler. Value/wealth can be stored as other goods, or investments like stocks and bonds, these are not usually counted as money since they do not fill the other roles and are less easily tradeable. (Less "liquid" in finance terms)
All of these properties obviously relate: using money to pay for things means measuring prices in it make sense, money can only store value because it can be exchanged for useful things, etc. However, some things fill some but not all of these roles: durable goods or investments can store wealth but are not used to measure prices or in day to day trades, bartered goods are used in trades but often not to store wealth or measure prices. Sometimes the boundary gets blurry, certain types of bank accounts store money with limitations, so whether they count as money or another type of investment is up in the air. Different measurement methods have different standards,
For this useful notes, some other properties of money are important:
- It has value because people using it agree it does. This could be because it is made of something valuable (precious metal currencies), because you have to pay taxes using it, because someone will give you precious metals for it (some banknotes and paper currency originally worked this way), or just because everyone around you uses it so you do as well. If people take the money for payment and expect to use it in the future to buy things, it has value. If not, the money doesn't.
- Related to this, money is assumed to have value only for its role in transactions and saving. Money is not a useful good on its own that people would want outside these two roles. Most modern money is like this, stored as electronic deposits or paper money that would be far cheaper than face value if printed or computer coded differently, but with coins and precious metal money in the past this is not necessarily true. In economics this leads to a separation of the "real" economy, the physical production and use of goods and services, from the "monetary economy", whatever is happening with money. (In measurement, you get "real" and "nominal" measures of things, described later on this page.)
- In modern times, almost all money is produced by governments, either through printing cash or minting coins, or by typing some things in a computer. The total amount of money can be controlled relatively closely by governments. This was also true through most of history, coinage was often used to demonstrate power of a ruler or government and closely controlled in addition to its economic role. There are, however, occasional exceptions such as individual banks having their own currencies at times. (Where the word "banknote" comes from.)
- It is assumed in this useful notes that each economy mainly uses 1 currency of its government's choice, unless said otherwise. Unless a country has very untrustworthy money, this is generally a good assumption, though some border regions, areas with visitors, or areas without trusted currencies, multiple currencies are in use, either from the bordering countries or any place with trustworthy money.
Weirdly, some very abstract theoretical fields of economics ignore money completely. Some are models of an entire economy, modeling the production and use of goods: exchange within this highly simplified economy is ignored, so money can be ignored also. Theoretical models of how markets work (highly theoretical, instead of producing cars, doctor visits, or even food, health care, etc., they just go with good 1, good 2, raw material 1, etc.)can ignore money by measuring prices using a base good like the knives above: only the ratio matters, not the actual numbersnote . in most field of economics, money fills the same role it fill in day to day life: you get paid in in, spend it, budget it, etc. Only the specific subfield of monetary economics studies the things described in this useful notes.
What is inflation, and how does creating money cause it?
Inflation is a general increase in prices of most goods in an economy. This is different from an increase in prices of a single good, in an ideal situation where nothing changed apart from inflation, all prices would increase at the same rate. (How to measure it in an actual economy is described later.) General price decreases are called deflation, they are rare in modern times, more common before the early 1900's. If you flip "price increase" to "price decrease" or think "negative inflation", most of what is written here applies just fine.
Another common way to describe inflation is a decrease in the value or purchasing power of money. This is the same as a general increase in prices, looked at from a different direction.
One simple but generally accurate explanation for how inflation is caused is "too much money chasing too few goods". This gets at the most common cause of inflation: an increasing amount of money per economic activity in an economy. One of the strongest correlations in economics is money supply growth to inflation rate minus economic growth rate. Generally, an economy with certain prices and a certain amount of production seems to require a certain amount of money to function: less money than this and prices drop, more money and prices rise.
How does this process work? Imagine one day you wake up, and all money stored on people has doubled. Cash in your wallet, under the sofa, piggy banks, money suitcases, or any other place you store it has doubled. Your checking and saving accounts, or any other such places, have doubled as well, as has all of the above for everyone else. Awesome, Free Money!
What to do with this money? There's a lot of options, but overall the extra cash will either be saved or spent. Saved money is eventually spent: If directly invested (like buying stocks) the money goes to others who will spend it, if saved in a bank, it will be loaned out and spent by whoever took out the loan.
When the money is spent, sellers will see an increase in demand. To make more money, sellers have a couple ways of responding: increase prices or put more things up for sale. Since the increase in prices would apply to just about everything for sale, this is inflation. If sellers try to sell more, they’ll need to produce more to keep up, which means buying raw materials, hiring more people, buying more equipment or running it harder, which means maintenance, and in general using more of whatever is needed for production. This increases demand for those raw materials, leading to increased prices and increased production, leading to more demand for raw materials and labor, which also see price increases and increased production (or time spent working and employment, time spent working can be treated the same as a physical raw material or equipment used to produce things in economic analysis) and the cycle continues for anything needed to produce those goods.
In this magical money situation, technology, production methods, people’s skill, and other such characteristics of this economy haven’t changed, so this economy hasn’t gained an ability to produce more. Any increased production comes from using resources (including people’s work time) more intensely. However, if the economy wasn’t underproducing before the magical money increase, people were probably producing and working about as much as desired under the circumstances. To produce or work more, there must be some expected reward, such as higher wages or increased profits. If prices for goods someone produces, or wages, increase faster then things people receiving these things are buying, that gives a reason to produce more. If the opposite is the case, people will want to produce or work less. Increased spending by producers or workers, if competing for goods, means increased prices for the things they buy, which will make raw material and wage or finished good prices increase at a more similar rate.
Since conditions of this economy haven’t changed: technology is the same, people want the same sort of things, etc., economists expect the economy to settle on about the same buying and selling it had before, and for all prices and wages to increase at about the same rate. If this is the case, then the prices will double, in proportion to the magical doubled amount of money that started the whole thing. If they less then double, then people with “extra” money (bank accounts, cash, etc. increased by more then the price increase) will have “extra” money, and wat to spend some of it, starting the process again or keeping to going until everything equalizes, If prices more than double, people will feel pinched, with less cash/bank accounts/etc. And won’t spend as much, leading to a reverse cycle until prices drop. If prices double, then people’s bank accounts and cash can buy about the same amount of money as before, and the economy effectively acts the same as before.
In the above money doubling scenario, the economy won’t be ‘’exactly’’ the same as before the magic doubling, people lucky with cash or savings to be doubled will be better off. However, in practice, money tends to circulate around an economy, so the effects of changing the amount of money will spread around as well. In actual economies, money usually enters through government spending, or loans or investments purchased or made from a central bank using the created money. These methods amount to a central bank making loans to others in an economy, which effects interest rates used for loans and saving, so in practice central bank actions are described as changing the interest rate rather then adding or removing money, and central banks will target this easier to measure number rather then a more fuzzy to define money supply. When you hear about, say, the U.S. federal reserve lowering or raising interest rates, it is at the same time adding or removing U.S. dollars from the world's economy.
What else affects Inflation? How is it managed? Also, monetary policy.
Changing the amount of money in an economy is the main way to cause inflation, especially ridiculously high inflation. But there are some other ways to cause it.
If an economy produces less but keeps the same amount of money inflation will occur. People will have the same amount of money in bank accounts, investments, cash, etc, and will be attempting to spend some of it, but in an economy with reduced production ability, that same amount of money will be competing for fewer goods, sellers will respond with higher prices. Inflation of this sort happened after the Black Death, in areas effected, the same amount of coins were attempting to buy in economies with lots of dead people, who in the absence of raising the dead as working zombies could obviously not do any work to produce what they had. More recently, COVID-19 Pandemic produced similar effects, as freight, workplaces, and other production activities shut down or operated at reduced intensity as a way to keep the disease under control.
Other sources of demand increases can cause inflation, such as increased government spending, increased demand for a country’s exports, or similar. The mechanism is the same as described in the above money doubling scenario. However, demand increases that don’t come with money being added to an economy are self limiting: increased spending relies on loans, decreased savings, and/or decreased spending on something else. Loans and decreased savings mean money is not being invested or saved and loaned out to be spent somewhere else. Opposites of these effects: decreased money supply, increased productivity, decreased demand, produce deflation.
Expectations, agreements, and cultural factors play a big role in price changes. If people expect others to increase prices, they often react by demanding higher wages, or raising prices on things they sell, which creates a Self-Fulfilling Prophecy. Price collusion seems to have contributed to increases during COVID based inflation, many businesses experienced higher profits, with than would be expected from COVID conditions alone. Inflation in some countries has been stopped by getting big unions, big businesses, and central banks to agree to certain actions, getting the rest of the country to follow.
In modern times, controlling the amount of money in an economy is mainly the responsibility of central banks. Controlling price increases is a major part of their job, but changing the money supply also has a role in managing recessions. In the magical money doubling scenario, if the economy was not producing as much as it could (unemployed people, machines idle, etc.), increased production to satisfy the increased demand from people with doubled money could hire unemployed people, reactivate idle equipment, etc., and bring that economy back to full production. A doubled money supply would still almost certainly result in big price increases, but central banks can on a smaller scale add money to an economy to stay out of a recession, or reduce the effects of one, in a similar way.
Sometimes people will suggest using precious metal currency or returning to a gold standard (Paper money is used, but the amount in circulation is based on the amount of gold a government has stored, so that paper can be exchanged for gold at a constant rate. Other materials could also be used ion place of gold) to keep inflation under control. This would limit price increases, but comes with other disadvantages, which is why it is rarely used. Precious metal prices and available amounts change over time as well (new deposits are found, new techniques to exploit deposits found, they can be stolen, used for day to day uses, etc.), which may not match up with other events in an economy and cause difficult to predict inflation and deflation as a result. Adjusting the money supply can't be used to deal with recessions as described above.
The one you've been waiting for: Why do prices tend to increase over time? And when and why does inflation get absurdly high?
If properly predicted and/or low, inflation isn’t too much of a problem. Longer term contracts can take it into account with cost of living increases, interest rates on loans, bank accounts, and other investments can change to match the rate of price increases, these and similar changes can account for inflation and mean that economic activity stays about the same as it would have without price changes. The main cost is that keeping cash or other non interest paying money stores is costly, that money buys less over time, some costs also come from having to update prices more often.
Before the 1940s to 950s in many richer countries, inflation and deflation were both common, prices tended to change somewhat randomly. After this time, prices tend to increase slowly year to year in these same economies, apart from unusual events. Much of this comes from more control by central banks, which tend to use monetary policy to keep recessions and strong inflation under control. Prices decreasing over time encourage people to keep money instead of saving or investing it, this means a lower demand for goods and lower employment and production. Low steady inflation instead encourages people to keep money circulating, while giving central banks room to add or remove money from an economy if needed. If kept low and steady, the costs of inflation aren’t too high.
Given how exponential growth works, even low steady inflation will noticeably increase prices over decades, thus a stereotypical old person telling you How much they could buy for a nickel when they were a kid. Wages ad salaries increase along with goods prices, so this person couldn’t actually buy more stuff overall, they were paid a lot less, in a less productive economy the amount and quality of goods buyable on some standard salary will have been less, but it is true that the same amount of dollars, euros, etc. buys a lot less decades ago.
What if things don’t go to plan, and inflation is much higher than a planned low, steady rate? What could cause this? One possible source is attempting to stimulate an economy too much, to use too much extra spending or money increases to increase production and employment. In the magical money increase above, production and sales would increase at first, but go back to normal as effects of increased money spread through the whole economy and producers compete for raw material prices. Attempts to repeatedly push an economy to produce more by increasing demand for goods when an economy is producing about as much as it can produce will instead cause increasing prices.
Contributing to further price increases are people’s expectations. If prices and contracts are planned out expecting a certain level of price increases, and a central bank doesn’t add enough money to support these increases, people in an economy can buy fewer goods with the amount of available cash. Fewer goods will be demanded, which leads to less production and increased unemployment. To continue stimulating an economy, pushing people to produce as much as possible, a central bank would have to add enough money to beat people’s expectations. But once this money circulates, it causes prices to increase even further, and people to expect higher future prices, requiring even more money to be added to an economy in the future and leading to more price increases. Modern economic management has largely learned to avoid this cause of high inflation, but it was important historically and has occasionally happened in more recent times.
The most absurd cases of hyperinflation are usually caused by governments printing money to pay costs. Unusually this printing is set off by some combination of bad events and longer term problems, which a government spends money to respond to. Governments have a few ways to get money: raising taxes or fees, taking out loans or selling bonds, selling things for immediate money. But if a country’s government isn’t well organized, or if it can’t or doesn’t want to raise money in these ways for other reasons, it may go to printing money instead to pay bills. But printing money in this way adds a lot of money to an economy, and as described above this causes prices to increase. If the cause of this spending was something that reduced productivity in an economy (such as wars or political instability), this will also have increased prices. The increased prices mean the money printing government must print even more money over time to buy the same amount it needed, and this extra money causes prices to rise even more. Which requires even more money printing to cover expenses, resulting in a vicious cycle. People learn to expect price increases and demand more money, further increasing the amount of money printing needed, fuelling more inflation.
Because inflation and money creation aren’t limited by physical processes, they just require more digits or different writing on a piece of paper or some electronic signals, so at its highest inflation can reach ridiculously extreme rates. The most recent famous example, zimbabwe hyperinflation in the 2000’s, needed prices to be shown in a logarithmic graph, and it still appeared as an exponential looking curve in that graph. Germany and Hungary in the early 1900’s produced images of people hauling wheelbarrows of cash, or of prices increasing so quickly they even over the course of a day or few hours, sellers would feel a need to demand more money. Paper money with 10-20 zeros, or equivalent written in words, has been produced in episodes of hyperinflation,
High inflation is a pain, it makes money difficult to use and constantly adjusting to increasing prices, which may be updated at different times, makes effective management difficult. Ending periods of high inflation generally takes special actions: simply cutting the production of money while people expect high inflation leads to sharply reduced production, recessions, and high unemployment as described above, which are obviously high costs on their own to pay to cut inflation. Generally, some sort of highly visible steps are taken that both directly cut inflation, and also let people in an economy know what is going on. New currencies are perhaps the most common way to do this, a government creates a new currency that the old one can be traded for, it is either implied or stated outright that this currency’s prices will be better controlled. Some governments might officially use foreign currencies, or promise a fixed exchange rate with a foreign currency, the foreign currency is more stable and will keep the inflated country’s one under control. If a country has a few major business, unions, or similar, they can all agree to keep prices stable for a short time to establish inflation at a lower rate, with a central bank as part of these negotiations keeping the amount of money stable.
Inflation in RPG's
Inflation in the actual world is well and good, but this is a wiki for media. Well, lucky you, there is a type of media that lends itself very strongly to having inflation: multiplayer RPGs. Very differently from Real Life, money is constantly generated by individuals in the economy, by a mix of direct loot from enemies, and from selling Shop Fodder to merchants with an infinite store of money to buy whatever the endless stream of adventurers wants to get rid of. Since these games are mostly based around fighting, and items should in theory be accessible to just about everyone, most common items are one time purchases or low cost, as a result little money is actually destroyed from the economy by base gameplay.
The result is usually fast growth in the amount of money in game, resulting in ridiculously high prices. A steadily increasing supply of money means, not surprisingly, that almost anyone in the game long enough has gobs of money to spend, and prices for non fixed goods in game currency can get ridiculously high. This may make it difficult for newer players to access some items in the game, and create a big split between sections of the economy.
To avoid a big split between newer and longer time players, or to just generally keep prices lower, game designers need a way to remove money from a game economy, thus the Money Sink. For a money sink to work well, it must be some combination of cost and regular purchase, which destroys large amount of money regularly to keep up with money creation. Some common examples of money sinks are:
- Expensive vanity items: Expensive, obviously, usually not much better or the same as regular items for gameplay, but cool in some way.
- Auction fees: Takes a percentage out of all trades by players on an auction house. The money exchanged between players remains, but the auction fee is destroyed. Simulates an actual exchange (if usually much more expensive), and the money removed scales with prices, so if prices inflate, so does the money destroyed in the auction house.
- Consumables: temporary items that are often expensive. Players will buy them for gameplay boosts to help just that little bit more, and because they are used up, they will be bought over and over. If traded in an auction house, will also destroy auction fees.
- In theory, repairs on expensive items could serve this role. In practice, using items and combat are the main source of fun, so designers would likely not make them too expensive, reducing gold sinks effectiveness.
Not inflation of prices, but closely related, is MUDflation. The person who chose that name was clearly familiar with inflation, because the metaphor is a close analogy and follows similar logic: A game adds items with better stats, with better stats characters desire more challenges, which are added to the game. With greater challenges are usually expected better stats on loot, which required more challenges, etc., leading to an increase in stats with no actual gameplay changes (because the higher stats for player characters are balanced by higher stats of stuff to fight against) Not too far off from increased money supply leading to increased demand for goods, higher prices, more money needed to continue stimulate an economy, etc. leading to higher numbers but about the same amount of goods and services physically produced.
Exchange Rates
If money in one country is fun enough, money in multiple countries must be even more fun. Exchanging currency comes into play whenever money moves between countries: the most common reasons are international trade and international investment, but gifts/family remissions, reparations, robberies, or a number of other examples can also apply.Currency exchange can be thought of as a market, where instead of a good or service, one type of money is the thing being bought or sold, and the "price" is the amount of some other type of money exchanged for it. As in other markets, the exchange rate will adjust to the point where all sellers can find buyers, for currency exchange, this means all currency exchanged away can find someone who wants to receive it. Exchange rates are usually given between two currencies (dollars/Euro, Pesos/Renminbi, Ruritanian Rurits/Bulungian Bulungs, etc.), in theory, bulungs per dollar, Rurits per dollar, or rurits per bulung (or any other combination) don’t have to have consistent exchange rates, and different sites of exchange could in theory have different rates for the same currencies, in the same way that different stores or online marketplaces can have different prices. In practice, in modern financial markets, any such differences provide a chance to make money, and the resulting trades increase or decrease demand for these currencies in a way that equalizes everything and causes them to move consistently.
Like any market, anything that increases desire for a currency will increase its price, requiring more of other currency to buy it. Anything decreasing desire will do the opposite. Foreign currencies are used to buy goods from another country (tourism, foreign student university tuition, media subscriptions, and other services like these are included along with physical goods being traded), invest in that country, or if money is gifted from one place to another using different currency. If any of these things increase, people will want to buy more of that country’s money, as in any supply and demand situation, said people will be willing to offer more foreign currencies to get the country they want, people with main country’s currency to offer will want more foreign money to do the exchange, which increases the value of the main country’s money compared to foreign money, which is what a higher exchange rate is. The opposite happens if people buy less, invest less, or send less gifts to a particular country.
Exchange rates over time will track inflation, meaning that Ridiculous Future Inflation will lead to Ridiculous Exchange Rates if one type of money inflates far faster than another. If one type of money inflates faster, and exchange rates stayed the same, people using the inflated money could exchange their large amounts of inflated money for foreign currency, and use that foreign currency to buy a lot more stuff then the inflated money could at home. /going the other direction, people using the non inflated currency couldn’t get enough of the inflated currency to buy much, so if the inflated country was exporting or selling useful goods, it would sell a lot less. The combination of these decisions would greatly increase demand for the less inflated currency, and decrease demand for the inflated currency, which would cause the inflated currency to lose value compared to the uninflated one in currency exchanges, until the exchange rate was sch that relative prices of goods would be about the same as they would have been if oth currencies saw the same inflation rate. In practice, inflation will be spotted quickly be financial markets, and resulting trades to make money or by central banks to control currency will keep everything in step very quickly.
The main effect of exchange rates are exactly as you experience them in day to day life. A foreign currency getting more expensive makes buying things using that currency more expensive, the opposite if foreign money gets cheaper. This changes how easy it is for a country to export goods, anything that reduces a currency’s value makes it harder for a country to export, the opposite if its money gets cheaper. A country receiving lots of outside investment, increased exports and/or prices of one or a few export goods, or lots of gift money flowing in will tend to have more difficulty exporting other goods, and/or will tend to import more, this is one reason countries often to specialize in certain goods, such as oil exporters often have little other industry unless carefully managed. It will also make that country more expensive to visit.
Something that looks like ridiculous foreign exchange, but isn't, is being able to buy a lot of services or a lot of cheap goods in poorer countries. The effect is exaggerated in media, but can happen. The actual reason is simply that if a country is poor, and people in it as well, they will be willing to work for less money, and a lot of the “cheap stuff” someone can buy are services or other goods that can take advantage of low labor costs. The same sort of political dysfunction, wars, poor management, etc. that lead to inflation will also make a country less economically productive, and/or being poorer makes it harder to have a good administration, leading to high inflation, which means the two results can get blurred in people’s minds. Goods and services that aren’t the sort of things a visitor can buy will usually require something richer countries have that poorer ones don’t, such as better technology, institutions, raw resources, education, etc. Richer countries by definition produce more, it is these more complex goods that are cheaper/better to make in richer countries, and how different countries don’t equalize in income very quickly as industry moves continuously to whichever has cheaper labor at the moment.
Controlling Exchange Rates
Remember those paragraphs above about how central banks control recessions and inflation? Well, things just got a lot more complicated, especially for smaller countries that trade a lot. For some of these places, everything written earlier in this useful notes gets thrown out.
There are a few tools to control exchange rates, all working either by changing the amount of exports and imports, or by changing investments crossing a border. Central banks can directly buy or sell foreign currencies. They can also directly buy and sell investments from other currencies (usually government bonds): buying foreign investments increases demand for the foreign currency and increases supply of the home currency, depreciating the home currency and appreciating foreign ones. Doing the reverse has opposite effects. Governments can directly control exports and imports, and foreign investment: usually these controls are for some other purpose, but they affect exchange rates also. Manipulating interest rates directly affects exchange rates: higher interest rates make a country more worthwhile to invest in, increasing demand for the currency and appreciating it (or the opposite if interest rates decrease.)
Most tools to control an exchange rate also affect other parts of an economy, and adjusting interest rates and money supply as described earlier affects exchange rates. Large countries and countries with little foreign trade aren’t affected as much: if you are in the United States like probably most readers of this site, you’ll hear news about the federal reserve doing things to avoid a recession or inflation with exchange rates not mentioned. But smaller countries with lots of trade are much more affected by exchange rates, so equivalent readers in Singapore, Dubai, or similar reading about their central bank would hear about exchange rates as the major focus. Changes in interest rates change how rewarding it is to invest in a country, lowered rates to stimulate an economy make it less rewarding, less outside investment flows in, and exchange rates are lowered. To buy or sell foreign currency, a central bank must put more of its money into circulation or remove it, which affects inflation. Export and import controls, or capital controls that limit outside investment, obviously affect individual industries in a country, and might make it more or less productive, or increase or reduce demand for goods and cause price, employment, and production changes.
Keeping exchange rates constant has the benefit of simplifying accounting and trade for everyone involved, but actually doing this requires constant activity, since events are always happening that affect exchange rates, and these interventions can cause their own side effects. In practice, most countries let exchange rates do what they do, as long as no major changes occur. A major change in the exchange rate suggest some other financial or economic event, which likely would require intervention anyway. Some might maintain fixed exchange rates for other purposes, such as to control inflation as mentioned earlier on this page. Countries heavily focused on manufacturing exports, such as China or Germany, will often attempt to keep their currencies lower valued, to make their goods relatively cheap for others to buy as a way of supporting their own industries.
Measurements
You’ve now got lots of wonderful information about how inflation and exchange rates work, but didn’t this useful notes say “if nothing else changes” quite a few times? How does all this work when other things are changing? Also, how do you even measure all this, especially when prices are changing for all sorts of other reasons?
Measuring exchange rates is simple to do: just go to a currency exchange, see how much it costs to buy one currency with another, bam, done. Inflation is trickier: Inflation measurements need to capture a general increase or decrease in all prices together, but in any economy prices are changing all the time for a variety of other reasons, in different amounts and in different directions. Figuring out how to “average” all the increases is important to both measure what is happening in an economy and test economic models. To do this, inflation is usually measured using a "market basket" approach: take a representative collection of things for sale, add up the total cost, and see how much that total cost changes over time. A TV Tropes market basket, for example, might consist of a months maintenance and fuel for one Alleged Car, a months worth of Unconventional Smoothie ingredients (say, 40 pounds of blueberries, 40 bars of chocolate, 80 bananas, 40 boxes of pencils, and 10 rolls of aluminum foil), plus a month's rent for a "Friends" Rent Control apartment or Volcano Lair. Add together the cost of these goods each month or year, and if you want to calculate a rate, calculate the percentage change in the total cost of all this month to month, year to year, or whatever other time period you are interested in.
In the United states, there are a few such indexes using different collections of goods. Consumer Price Index is probably the most well known, here a collection of goods that is roughly what a "typical"/"normal" household would buy. Other indexes include the GDP deflator (measuring a sample of all goods in the economy) and Billion Price Index (using goods from online sellers). In practice, these tend to mostly track each other, a good signal for economic theories. Measurements for other countries will use other collections of goods. A tricky part of these sorts of measurements is working out quality differences, or when a good simply doesn’t exist at a particular point in time. A “computer” for an individual household didn't exist in the 1950’s, and will be much more powerful today then, say, the 1980s, so the price has in a sense decreased a lot more in that time then what raw data might show. Representative samples of goods will also change over time with technology, cultural, and other changes. Working out how to do this is the job of statisticians and economists who put together these indexes. In practices, most of these indexes agree pretty closely, which suggests economic theories/models of inflation work pretty well, and that measurements are accurate.
Inflation and exchange measurements aren’t just useful for their own sake, they are also important for accurately making other types of comparisons. This is a media wiki, so you may be familiar with box office returns listed raw and in constant dollars. This reflects the fact that movies will make more money simply due to inflation increasing prices for everything, but if you want a good measure of the success of a movie based on how many people saw it, were willing to spend on it, etc., to effectively compare two movies as if they were released under the same conditions, you need to compensate for/cancel out inflation in some way. The same goes for comparing prices or spending in different countries, to properly do it you need to account for exchange rates.
To calculate things in constant dollars, divide the raw dollar number by your inflation index value in whatever year that dollar number is from. Then, multiply by the inflation index value for the year you have chosen as a “base” year, as in “adjusted to (year)” or “box office in (year) dollars”. One such measurement is “real GDP” which roughly speaking measures the value of all production in an economy in a year. “Nominal GDP’ is measured by adding up the total value of final goods sold in an economy, or equivalently for reasons not described here, all income from various sources (taxes, salaries, rent, profits, etc.). It roughly measures how much an economy produced in a year, but to properly compare year to year inflation needs to be taken into account, inflation will increase the number without necessarily producing more stuff.
Similar comparisons are done for countries with different currencies. One number may be larger or smaller, but this doesn’t say anything about the actual amount of goods. One common way to do this is to use exchange rates, take amounts of something in one country’s currency, multiply by the exchange rate with a comparison country’s money, and get two directly comparable numbers. The other method is something called purchasing power parity, take a collection of representative goods, see how much of different currencies it takes to buy that collection, use the ratios between these amounts as a substitute exchange rate. Exchange rate and purchasing power usually track each other closely, but not exactly. These can be used to accurately compare GDP's to measure how much stuff different countries produce, compare prices to tell how expensive or cheap some item is in different places, or a variety of similar uses.
