What causes inflation to go up?

A question from Yahoo Answers:

What causes inflation to go up?

Why do prices go up each year, how can we stop it!

Let’s start at the end; why do you want to stop inflation? Inflation pushes savers to invest; without inflation, savers might just hoard money…

Also, there are more important things than inflation (most notably, unemployment). In the pre-euro years, many European central banks (most notably, Germany’s Bundesbank) were known as tough inflation fighters; but their countries were known as places where unemployment tended to stay in double digits. By cracking down on inflation, those central banks increased unemployment…

As to why prices go up, recall the Hume-Fisher equation of exchange:

MV = PQ,

where M is money supply,
V is money velocity,
P is price level, and
Q is real GDP

If you rewrite the equation:

P = MV / Q

you can easily see that prices can go up for three reasons: (1) an increase in money supply, (2) an increase in money velocity, and/or (3) a decrease in real GDP.

In practice, expansion of the money supply is the most significant source of inflation. Every once in a while, when inflationary expectations run high, you can see money velocity increase; people spend money fast in anticipation of it losing value…

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