question: How does inflation work? And how do business know when to adjust their prices to that? I guess banks don't shout out:"We just printed another 1b$ that will be in circulation soon, so make sure to increase your prices accordingly"?
comment: To understand inflation, you first need to understand the difference between money/currency & wealth. We create wealth all of the time. Let's say you pay $1 million to mine materials out of the ground & you sell those materials for a profit. That profit is new wealth that you created. Then someone could buy a bunch of materials & pay workers to create a product that they'll also sell with a profit, creating even more wealth. We create wealth with human work (physical or intellectual) & from natural resources. Now, if you continue to create wealth, but your amount of currency stays the same, then the value of that currency will increase. People will want to trade more currency than there is, so currency will become rare & the value of that currency will increase over time. That's deflation & it's bad because it becomes more profitable to keep your money rather than invest it. And without investment, you can't create as much wealth. So, the solution is to print more currency as wealth increases in your country. The ideal goal would be to print the exact amount of currency as your country creates in new wealth. The problem is that it's hard to estimate the exact amount of wealth that'll be created, so you can't print the exact amount of currency you need. The value of your currency depends on the law of supply & demand. Your production of currency is the supply of that currency. And the amount of wealth you create is the demand. If you over-produce your currency, then you have a higher supply, so your demand/the value of your currency decreases over time. If you under-produce your currency, then it's what's said above: you'll have a lower supply of currency than the demand (wealth), so your currency will increase in value. So, now you have a choice. You know you can't produce the exact right amount of currency, so you can either over-produce currency, which creates inflation, or under-produce currency, which leads to deflation. The solution is that a little bit of inflation is better than a little bit of deflation, because a little bit of deflation still incentivizes people to keep their money, while a little bit of inflation incentivizes people to invest their money, & investment is an engine of economic growth.
passages: BULLET::::- Under inflation targeting, open market operations target a specific short-term interest rate in the debt markets. This target is changed periodically to achieve and maintain an inflation rate within a target range. However, other variants of monetary policy also often target interest rates: the US Federal Reserve, the Bank of England and the European Central Bank use variations on interest rate targets to guide open market operations.
   In the United States, however, the Federal Open Market Committee (FOMC) focuses on core inflation—namely the "personal consumption expenditures price index". However, President of the Federal Reserve Bank of St. Louis James B. Bullard explained that the FOMC still takes headline PCE into account, and that since 2008 (in the wake of the financial crisis) the FOMC has included forecasts for both types of inflation in its semiannual "Monetary Policy Report" for the United States Congress. He emphasized that "the Fed's main concern is long-run headline inflation and the prices people actually pay."
  
  Section::::See also.
   Higher interest rates reduce the economy’s money supply because fewer people seek loans. When banks make loans, the loan proceeds are generally deposited in bank accounts that are part of the money supply. Therefore, when a person pays back a loan and no other loans are made to replace it, the amount of bank deposits and hence the money supply decrease. For example, in the early 1980s, when the federal funds rate exceeded 15 percent, the quantity of Federal Reserve dollars fell 8.1 percent, from US$8.6 trillion down to $7.9 trillion.
   The inflation rate will not be known in advance. People often base their expectation of future inflation on an average of inflation rates in the past, but this gives rise to errors. The real interest rate ex-post may turn out to be quite different from the real interest rate (ex-ante real interest rate) that was expected in advance. Borrowers hope to repay in cheaper money in the future, while lenders hope to collect on more expensive money. When inflation and currency risks are underestimated by lenders, then they will suffer a net reduction in buying power.
   When the Federal Open Market Committee wishes to reduce interest rates they will increase the supply of money by buying government securities. When additional supply is added and everything else remains constant, the price of borrowed funds – the federal funds rate – falls. Conversely, when the Committee wishes to increase the federal funds rate, they will instruct the Desk Manager to sell government securities, thereby taking the money they earn on the proceeds of those sales out of circulation and reducing the money supply. When supply is taken away and everything else remains constant, the interest rate will normally rise.
   One of the Fed's main roles is to maintain price stability, which means that the Fed's ability to keep a low inflation rate is a long-term measure of their success. Although the Fed is not required to maintain inflation within a specific range, their long run target for the growth of the PCE price index is between 1.5 and 2 percent. There has been debate among policy makers as to whether the Federal Reserve should have a specific inflation targeting policy.
  
  Section::::Measurement of economic variables.:Personal consumption expenditures price index.:Inflation and the economy.
   During a January 2009 speech, Fed Chairman Ben Bernanke described the strategy of lending against various types of collateral as "Credit Easing" and explained the risks of inflation as follows: "Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary. The Fed's lending activities have indeed resulted in a large increase in the excess reserves held by banks. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as you would expect, this measure of money has risen significantly as the Fed's balance sheet has expanded. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate."
   If inflation is 10%, then the $110 in the account at the end of the year has the same purchasing power (that is, buys the same amount) as the $100 had a year ago. The real interest rate is zero in this case.
  
  The real interest rate is given by the Fisher equation:
  
  where "p" is the inflation rate.
  
  For low rates and short periods, the linear approximation applies:
  
  The Fisher equation applies both "ex ante" and "ex post". "Ex ante", the rates are projected rates, whereas "ex post", the rates are historical.
  
  Section::::Market rates.
   In managing the rate of inflation or deflation, information and expectations play an important role, as explained by Jeffrey Lacker, President of the Federal Reserve Bank of Richmond: "If people expect inflation to erode the future value of money, they will rationally place a lower value on money today. This principle applies equally well to the price-setting behavior of firms. If a firm expects the general level of prices to rise by 3 percent over the coming year, it will take into account the expected increase in the costs of inputs and the prices of substitutes when setting its own prices today."
   Open market operations are one tool within monetary policy implemented by the Federal Reserve to steer short-term interest rates. Using the power to buy and sell treasury securities, the Open Market Desk at the Federal Reserve Bank of New York can supply the market with dollars by purchasing U.S. Treasury notes, hence increasing the nation's money supply. By increasing the money supply or Aggregate Supply of Funding (ASF), interest rates will fall due to the excess of dollars banks will end up with in their reserves. Excess reserves may be lent in the Fed funds market to other banks, thus driving down rates.
   The Czech National Bank (CNB) is an example of an inflation targeting central bank in a small open economy with a recent history of economic transition and real convergence to its Western European peers. Since 2010 the CNB uses 2 percent with a +/- 1pp range around it as the inflation target. The CNB places a lot of emphasis on transparency and communication; indeed, a recent study of more than 100 central banks found the CNB to be among the four most transparent ones.
   In the United States, as of 2006, the Federal Reserve sets an interest rate target for the federal funds (overnight bank reserves) market. When the actual federal funds rate is higher than the target, the Federal Reserve Bank of New York will usually increase the money supply via a repurchase agreement (or repo), in which the Fed "lends" money to commercial banks. When the actual federal funds rate is less than the target, the Fed will usually decrease the money supply via a reverse repo, in which the banks purchase securities from the Fed.
   Prices are influenced by various factors such as corporate investment, household consumption and international prices of raw materials. Meanwhile, among the various policy instruments to bring about price stability, the monetary policy of a central bank, which adjusts the quantity of money in circulation, is the most effective.
  
  For these reasons, the responsibility for price stability is given to central banks in most countries. The Bank sets and announces an inflation target for a certain period and strives to meet this target. The 2016–18 target is consumer price inflation of 2.0%.
  
  Section::::Organization.
  
  Section::::Organization.:Monetary Policy Committee.
   As a result, market interest rates are generally held around the Reserve Bank's OCR level. The practical result, over time, is that when market interest rates increase, people are inclined to spend less on goods and services. This is because their savings get a higher rate of interest and there is an incentive to save; and conversely, people with mortgages and other loans may experience higher interest payments.
   Section::::Controlling inflation.
  
  Although both fiscal and monetary policy can affect inflation, ever since the 1980s, most countries primarily use monetary policy to control inflation. Central banks such as the U.S. Federal Reserve increase the interest rate and slow or stop the growth of the money supply. Some central banks have a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.
   Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate the overnight federal funds rate in the U.S. and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target. With interest rates near zero, debt relief becomes an increasingly important tool in managing deflation.
   Under this policy approach the target is to keep inflation, under a particular definition such as the Consumer Price Index, within a desired range.
  
  The inflation target is achieved through periodic adjustments to the central bank interest rate target. The interest rate used is generally the overnight rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.
  
  As the Fisher effect model explains, the equation linking inflation with interest rates is the following:
   Since February 2000, the Federal Reserve Board’s semiannual monetary policy reports to Congress have described the Board’s outlook for inflation in terms of the PCE. Prior to that, the inflation outlook was presented in terms of the CPI. In explaining its preference for the PCE, the Board stated:
   During the period that John Crow was Governor of the Bank of Canada—1987 to 1994— there was a worldwide recession and the bank rate rose to around 14% and unemployment topped 11%. Although since that time inflation-targeting has been adopted by "most advanced-world central banks", in 1991 it was innovative and Canada was an early adopter when the then-Finance Minister Michael Wilson approved the Bank of Canada's first inflation-targeting in the 1991 federal budget. The inflation target was set at 2 per cent. Inflation is measured by the total consumer price index (CPI). In 2011 the Government of Canada and the Bank of Canada extended Canada's inflation-control target to December 31, 2016. The Bank of Canada uses three unconventional instruments to achieve the inflation target: "a conditional statement on the future path of the policy rate", quantitative easing, and credit easing.
   In most developed countries, central banks are not allowed to give loans without requiring suitable assets as collateral. Therefore, most central banks describe which assets are eligible for open market transactions. Technically, the central bank makes the loan and synchronously takes an equivalent amount of an eligible asset supplied by the borrowing commercial bank.
  
  Section::::Theoretical relationship to interest rates.
  
  Classical economic theory postulates a distinctive relationship between the supply of central bank money and short-term interest rates: 
  
  like for a commodity, a higher demand for central bank money would increase its price, the interest rate.
   The Federal Reserve System implements monetary policy largely by targeting the federal funds rate. This is the interest rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed. This rate is actually determined by the market and is not explicitly mandated by the Fed. The Fed therefore tries to align the effective federal funds rate with the targeted rate by adding or subtracting from the money supply through open market operations. The Federal Reserve System usually adjusts the federal funds rate target by 0.25% or 0.50% at a time.
   A core assertion of rational expectations theory is that actors will seek to "head off" central-bank decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or economic actors will make bets that the central bank will expand the money supply rapidly enough to prevent recession, even at the expense of exacerbating inflation. Thus, if a central bank has a reputation as being "soft" on inflation, when it announces a new policy of fighting inflation with restrictive monetary growth economic agents will not believe that the policy will persist; their inflationary expectations will remain high, and so will inflation. On the other hand, if the central bank has a reputation of being "tough" on inflation, then such a policy announcement will be believed and inflationary expectations will come down rapidly, thus allowing inflation itself to come down rapidly with minimal economic disruption.
   When financial information is presented in nominal (low inflation), the change in the balance sheet of monetary equivalent to the cash flow generated or invested in such items, however, when inflation is significant and requires the expression of the financial statements in pesos of purchasing power, the change in constant pesos of monetary balance involves not only the cash flow or profit erosion that inflation (monetary effect) resulted in the effect created or invested in these items.
  
  The change in monetary items going to represent cash flow generation and use of resources in pesos.
  
  Section::::See also.
   "The rate at which the central bank lends money can indeed be chosen at will by the central bank; this is the rate that makes the financial headlines." Henry C.K. Liu explains further that "the U.S. central-bank lending rate is known as the Fed funds rate. The Fed sets a target for the Fed funds rate, which its Open Market Committee tries to match by lending or borrowing in the money market ... a fiat money system set by command of the central bank. The Fed is the head of the central-bank because the U.S. dollar is the key reserve currency for international trade. The global money market is a USA dollar market. All other currencies markets revolve around the U.S. dollar market." Accordingly, the U.S. situation is not typical of central banks in general.
   BULLET::::8. Money Supply (M2) — The money supply measures demand deposits, traveler's checks, savings deposits, currency, money market accounts, and small-denomination time deposits. Here, M2 is adjusted for inflation by means of the deflator published by the federal government in the GDP report. Bank lending, a factor contributing to account deposits, usually declines when inflation increases faster than the money supply, which can make economic expansion more difficult. Thus, an increase in demand deposits will indicate expectations that inflation will rise, resulting in a decrease in bank lending and an increase in savings.
  