The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation.
Long-Run and Short-Run Concerns: Growth, Productivity, Unemployment, and Inflation
(Part D)
by
Charles Lamson
 |
Inflation
Ups in the business cycle often, but not always, seem to encourage inflation. Why is inflation a problem? If you understand that wages and salaries, as well as other forms of income increase along with prices during periods of inflation, you will see this question is more subtle than you might think. If my income doubles and the prices of the things I buy double, am I worse off? I can buy exactly the same things that I bought yesterday, so to the extent that any well-being depends on what I am able to buy, the answer is no. However, incomes and prices do not all increase at the same rate during inflations. For some people, income increases faster than prices; for others, prices increase faster. Some people benefit from inflations, others are hurt. This post focuses on the problem of inflation: its measurement, its costs, and the gains and losses experienced during inflationary periods. Defining Inflation What is inflation? Not all price increases constitute inflation. Prices of individual goods and services are determined in many ways. In competitive markets, the interaction of many buyers and many sellers---the operation of supply and demand---determines prices. In imperfectly competitive markets, prices are determined by producers' decisions. (This is the core of microeconomic theory.) In any economy, prices are continuously changing as markets adjust to changing conditions. Lack of rain may dry up corn and wheat fields, reducing supply and pushing up the price of agricultural products. At the same time, high levels of production by oil producers may be driving down the price of oil and petroleum products. Simultaneously, the United Auto Workers may be negotiating a contract with the Ford Motor Company that raises (or lowers) wage rates.  When the price of one good rises, that price increase may or may not be part of a larger inflation. Remember, inflation is an increase in the overall price level. It happens when many prices increase simultaneously. We measure inflation by looking at a large number of goods and services and calculating the average increase in their prices during some period of time. Deflation is a decrease in the overall price level. It occurs when many prices decrease simultaneously. It is useful to distinguish between a one-time increase in the overall price level and an increase in the overall price level that continues over time. For example, the overall price level could rise 10 percent in a single month and stop rising, or it could increase steadily over some years. Economists often use inflation to refer only to increases in the price level that continue over some significant period. We will refer to such periods as periods of sustained inflation. Price Indexes Price indexes are used to measure overall price levels. We discussed how these indexes are constructed in part 101 of this analysis. The price index that pertains to all goods and services in the economy is the GDP deflator. As we saw in part 101 the Bureau of Economic Analysis (BEA) does not use fixed weights to construct the GDP deflator. Many other price indexes are constructed using fixed weights. The most popular fixed-weight price index is the Consumer Price Index (CPI). The CPI was first constructed during World War II as a basis for adjusting shipbuilders wages, which the government controlled during the war. Currently, the CPI is computed by the Bureau of Labor Statistics (BLS) each month, using a bundle of goods meant to represent the "market basket" purchased monthly by the typical urban consumer. The quantities of each good in the bundle that are used for the weights are based on extensive surveys of consumers. In fact, the BLS collects prices each month for about 71,000 goods and services from about 22,000 outlets in 44,000 geographic areas. For example, the cost of housing is included in the data collection by surveying about 5,000 renters and 1,000 homeowners each month.  Remember from part 101 that a fixed-weight price index like the CPI does not account for consumers' substitution away from high-priced goods. Changes in the CPI somewhat overstate changes in the cost of living. In response to the fixed weight problem, in August 2002 the BLS began publishing a version of the CPI, called the "Chained Consumer Price Index," which uses changing weights. The Chained Consumer Price Index still differs in important ways from the GDP deflator. The CPI covers only consumer goods and services whereas the GDP deflator covers all goods and services produced in the economy. Also, the CPI includes prices of imported goods, which the GDP deflator does not. Other popular price indexes are producer price indexes (PPIs), once called wholesale price indexes. These are indexes of prices that producers receive for products at all stages in the production process, not just the final stage. The indexes are calculated separately for various stages in the production process. The three main categories are finished goods, intermediate materials, and crude materials, although there are subcategories within each of these categories.  One advantage of some of the PPIs is that they detect price increases early in the production process. Because their movements sometimes foreshadow future changes in consumer prices, they are considered to be leading indicators of future consumer prices. The Costs of Inflation If you asked most people why inflation is "bad," they would tell you that it lowers the overall standard of living by making goods and services more expensive. That is, it cuts into people's purchasing power. People are fond of recalling the days when a bottle of Coca-Cola cost a dime and a hamburger cost a quarter. Just think about what we could buy today if prices had not changed. What people usually do not think about is what their incomes were in the "good old days." The fact that the cost of a can of Coke has increased from $0.10 to $1.19 does not mean anything in real terms if people who once earned $5,000 now earn $25,000. Why? The reason is simple: people's income from wages and salaries, profits, interest, and rent increases during inflation. The wage rate is the price of labor, rent is the price of land, and so on. During inflation, most prices including input prices tend to rise together, and input prices determine both the incomes of workers and the incomes of owners of capital and land. Inflation Changes the Distribution of Income Whether you gain or lose during a period of inflation depends on whether your income rises faster or slower than the price of the things you buy. The group most often mentioned when the impact of inflation is discussed is people living on fixed incomes. If your income is fixed and prices rise, your ability to purchase goods and services falls proportionately. Who are the fixed income earners?  Most people think of the elderly. Many retired workers living on private pensions receive monthly checks that will never increase. Many pension plans, however, pay benefits that are indexed to inflation. The benefits these plans provide automatically increase when the general price level rises. If prices rise 10 percent, benefits also rise 10 percent. The biggest source of income for the elderly is social security. These benefits are fully indexed; when prices rise---that is, when the CPI rises---by 5 percent, social security benefits also increase by 5 percent. Effects on Debtors and Creditors It is also commonly believed that debtors benefit at the expense of creditors during an inflation. Certainly, if I loan you $100 to be paid back in a year, and prices increase 10 percent in the meantime, I get back 10 percent less in real terms than what I loaned you. Suppose we had both anticipated prices would rise 10 percent. I would have taken this into consideration in the deal that I made with you. I would charge you an interest rate high enough to cover the decrease in value due to the anticipated inflation. If we agree on a 15 percent interest rate, then you must pay me $115 at the end of the year. The difference between the interest rate on a loan and the inflation rate is referred to as the real interest rate. In our deal, I will earn a real interest rate of 5 percent. By charging a 15 percent interest rate, I have taken into account the anticipated 10 percent inflation rate. In this sense, I am not hurt by the inflation---I keep pace with inflation and earn a profit on my money, too---despite the fact that I am a creditor.  On the other hand, an unanticipated inflation---an inflation that takes people by surprise---can hurt creditors. If the actual inflation rate during the period of my loan to you turns out to be 20 percent, then I as a creditor will be hurt. I charged you 15 percent interest, expecting to get a 5 percent real rate of return, when I needed to charge you 25 percent to get the same 5 percent real rate of return. Because inflation was higher than expected, I got a negative real return of 5 percent. Inflation that is higher than expected benefits debtors; inflation that is lower than expected benefits creditors. Administrative Costs and Inefficiencies There are costs associated even with anticipated inflation. One is the administrative costs associated with simply keeping up. During the rapid inflation in Israel in the early 1980s a telephone hotline was set up to give the hourly price index. Store owners have to recalculate and repost prices frequently, and this takes time that could be used more efficiently. Increased Risk and Slower Economic Growth When unanticipated inflation occurs regularly, the degree of risk associated with investments in the economy increases. Increases in uncertainty may make investors reluctant to invest in capital and to make long-term commitments. Because the level of investment falls, the prospects for long-term economic growth are lessened.  Inflation: Public Enemy Number One? Economists have debated the seriousness of the costs of inflation for decades. Some, like Alan Blinder, say, "Inflation, like every teenager, is grossly misunderstood and this gross misunderstanding blows the political importance of inflation out of all proportion to its economic importance." Others, like Philip Kagan and Robert Lipsy argue, "It was once thought that the economy would in time make all the necessary adjustments [to inflation], but many of them are proving to be very difficult. . . . For financial institutions and markets, the effects of inflation have been extremely unsettling." No matter what the real economic cost of inflation, people do not like it. It makes us uneasy and unhappy. In 1974, President Ford verbalized some of this discomfort when he said, "Our inflation, our public enemy number one, will unless whipped destroy our country, our homes, our liberties, our property, and finally our national pride, as surely as any well-armed wartime enemy." In this belief, our elected leaders have vigorously pursued policies designed to stop inflation.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 422-427* end |
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