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Inflation

Inflation



Including:
Definition of Inflation
Price Indexes
The Effects of Inflation on Interest Rates
The Consequences of Inflation
Causes of Inflation
The Relationship between Inflation and Unemployment
Hyperinflation
Deflation


The subject of inflation is very important in the study of economics. Inflation affects many aspects of the economy, and involves many different concepts.

You do not need to possess a degree in economics in order to understand many of the effects of inflation. Almost everybody has had to learn to deal with the consequences of inflation at some point in their lives. But misconceptions still exist. It would be helpful to know what the inflation rate means, as well as the causes of inflation.



The definition of inflation would be a good starting point:


Inflation: A sustained rise in the average level of prices.



Not all prices change at the same time or by the same amount. The inflation rate measures average, not individual, price changes.


Inflation represents a decline in the purchasing power of the currency. As prices rise, the same nominal value of the currency will be worth less in terms of the amount of goods and services that it can be used to purchase. An alternative definition of inflation would be:


Inflation: A sustained decline in the value of the currency.




Price Indexes

It would be impossible to track the price changes and quantities sold for every good and service in a complex economy. Besides, different price indexes are used to measure the degree that inflation affects different groups of people. Therefore, only prices and quantities for something considered to be a "typical" bundle of goods are included in the calculations. The inflation rate measures average price changes over time. This is done by assigning a number, called a price index, to the average price level for each time period (usually one year). The percentage change in the price index from one year to another would indicate the level of inflation.

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Consumer Price Index (CPI)

The U.S. Bureau of Labor Statistics (BLS) publishes various CPI measurements. The most widely-used ones are:
CPI-U
CPI-W

For these measurements, price changes over time are tracked for of a fixed “typical” bundle of goods purchased by an “average” household.

CPI-U
The “U” stands for “all urban consumers”. The bundle of goods used in this measurement is designed to mirror the spending pattern of a “typical” urban consumer.

CPI-U is the measurement that is typically used whenever you see a report such as “a $4,000 car in 1965 would be worth $30,150.22 in today’s dollars”. In case you want to calculate the effects of inflation on a specific dollar amount between two different time periods, here is a link to the BLS Inflation Calculator.

CPI-W
The “W” stands for “urban wage earners and clerical workers”. The bundle of goods used in this measurement is designed to mirror the spending patterns of that demographic group.

CPI-W is the measurement most often used in labor negotiations as well as calculating cost of living adjustments (COLAs) for fixed income benefits (such as Social Security).

CPI measurements are far from perfect.

In reality, there is no such thing as a “typical” household purchasing a “typical” bundle of goods. Households purchase a wide variety of goods and services.

Different demographic groups (according to age, geographic location, ethnicity, etc.) tend to have different spending patterns. CPI-W is designed to mirror the spending patterns of “urban wage earners and clerical workers”, yet it is used to determine COLAs for retirees’ Social Security benefits. Retirees and others living on fixed incomes tend to have far different spending habits than the demographic group used for CPI-W calculations. For example, Social Security beneficiaries tend to spend a larger share of their incomes on necessities with relatively large price increases – medicine, healthcare, home heating, etc. – while younger workers tend to spend a larger share of their incomes on items from decreasing-cost industries, such as electronics.

There is an upward bias in the method for calculating CPI-U and CPI-W called the substitution effect. In the economy, there are literally millions of prices for goods and services. In any time frame, some of these prices will remain the same. Some of these prices will increase. Some of these prices will decrease. The increases and decreases in prices will be at various rates of change. According to the law of demand, when prices change, consumers will spend less money on items with large price increases, and will purchase lower-cost items instead. CPI measurements are based on a fixed bundle of goods, but consumers do not purchase a fixed bundle of goods.

Another upward bias involves product quality. Prices change over time, but so does quality. Advances in technology are incorporated in product design; new features are added. When consumers pay a higher price for a product, a portion of the price increase might be for “getting more”. But CPI measurements consider all price increases to be due to a decrease in purchasing power for a given quantity of currency.

COLAs are based on last year’s inflation. This means that adjustments to fixed incomes are always a year behind.

Chained-CPI (C-CPI-U)

A switch from CPI-W to C-CPI-U as a method for calculating COLAs for Social Security and other fixed-income benefits has been proposed.

Chained-CPI uses a floating bundle of goods rather than a fixed bundle of goods. The only reason for a Chained-CPI is to correct for the upward bias of the aforementioned substitution effect. In other words, a switch from CPI-W to C-CPI-U is designed to lower the future benefits paid to Social Security recipients. Such a switch assumes that under the current system, people living on Social Security have had their purchasing power increase every year due to the method of adjusting for inflation. This assumption ignores all of the other known problems with CPI measurements, including the different spending patterns for different demographic groups.

Producer Price Index (PPI)

Formerly known as the Wholesale Price Index (WPI), the PPI measures the prices received by producers. This is considered to be a leading economic indicator, because it measures price changes at an earlier stage than CPI does. If the PPI increases, it can be expected that an increase in the CPI will soon follow.



The Effects of Inflation on Interest Rates



When inflation is present, the borrower receives money that is worth more than the money that is paid back. In order for such a transaction to take place, both the borrower and the lender will have to agree on the terms. This can occur as long as the effects of inflation are built into the contract.

When the inflation rate is included as part of the stated interest rate, the lender will be compensated for the loss of purchasing power during the time that the loan is outstanding, or during the time that control over the money is transferred from the lender to the borrower. By including the inflation rate in the stated interest rate, the contract can be mutually acceptable to both the borrower and the lender, despite the loss of purchasing power over time.

The stated interest rate, which includes the adjustment for inflation, is called the nominal interest rate. The effective interest rate, after the effects of inflation are discounted, is called the real interest rate. The formula for this is:

Real Interest Rate = Nominal Interest Rate Minus Inflation Rate

Including the inflation rate in the nominal interest rate will mean that neither the borrower nor the lender can gain a windfall profit at the other's expense simply because of inflation.

The problem with that concept is that the contract involves payments to be made in the future. In order to include the inflation rate in the nominal interest rate, the future inflation rate must be known. Since it is impossible to know with certainty what the future inflation rate will be, the rate of inflation must be forecast. This is accomplished using the concept of expected, or anticipated, inflation.

The anticipated inflation rate is the expected rate of inflation over the length of the contract. As long as the actual inflation rate turns out to be equal to the anticipated inflation rate, inflation will not redistribute wealth between the parties to the contract. Each party will receive a perceived benefit from the transaction.

However, when the actual inflation rate differs from the anticipated inflation rate, wealth is redistributed between the parties simply because of the existence of inflation.

When the actual rate of inflation is greater than the anticipated rate of inflation, the borrower ends up paying back the loan with money that is worth less than contracted for. In that case, the borrower gains at the expense of the lender. Wealth is redistributed from the creditor class to the debtor class.

When the actual rate of inflation is less than the anticipated rate of inflation, the opposite occurs. The borrower ends up paying back the loan with money that is worth more than contracted for. In that case, the lender gains at the expense of the borrower. Wealth is redistributed from the debtor class to the creditor class.

It should be worth noting that this analysis holds for all contracts involving interest rates. This means that the debtor class includes households with outstanding personal loans, homeowners with outstanding mortgages, corporations with outstanding bonds, and governments with outstanding bonds. The creditor class includes banks and other financial institutions, as well as investors in corporate and government bonds.

For example, when the actual rate of inflation is greater than the anticipated rate of inflation, wealth is redistributed from the investor class to the taxpayer class, in the case of the government's debt. When the actual rate of inflation is less than the anticipated rate of inflation, wealth is redistributed from the taxpayer class to the investor class. And in the case of foreign ownership of bonds, wealth can be transferred from one country to another.



The Consequences of Inflation



Three categories of the consequences of inflation are: redistribution, uncertainty, and inefficient resource allocation.


Redistribution
Inflation causes a redistribution of wealth due to changes in real interest rates, as discussed earlier on this page.

Inflation also causes redistribution to occur when specific wages and prices do not adjust with the rate of inflation - for example, retirees whose pension payments are fixed at a specific level. The term "fixed income".
The effects of redistribution can be minimized if wages and prices are indexed for inflation. That is, if the payments are adjusted based on changes in a relevant price index.

Uncertainty
Inflation creates uncertainty regarding the future profitability of investments. This is especially true during times when the inflation rate is high. High inflation rates tend to be volatile. This can cause risk aversion to investments that could otherwise create future economic growth.

Funds get reallocated from long term to short term projects. Funds also get reallocated from interest-sensitive investments, ones that could produce economic growth, to inflation hedges such as gold and real estate. As a result, long term economic growth is decreased.

Inefficient Resource Allocation
Long term contracts become riskier in times of high inflation. The market for long term bonds is decreased in favor of short term investments. Labor contracts and wage scales are set for shorter periods. Holding money becomes risky, because money balances depreciate in value. All of this requires that more time be spent on financial transactions, making less time available for productive activities.

The costs associated with this inefficient resource allocation are called the shoe-leather costs of inflation.



Causes of Inflation



Inflation can be caused by forces that work on aggregate demand, called demand-pull inflation; or by forces that work on aggregate supply, called cost-push inflation.


Demand-Pull Inflation
The aggregate demand / aggregate supply model shows that the price level increases whenever aggregate demand increases (the AD curve shifts rightward). This can be a permanent situation due to continual increases in the money supply and government spending. Wars generally create demand-pull inflation because of government borrowing to finance war efforts.


Cost-Push Inflation
The aggregate demand / aggregate supply model shows that the price level increases whenever aggregate supply decreases (the AS curve shifts leftward). This is not a permanent situation, because the general trend is for aggregate supply to shift rightward. Occasionally it can shift leftward due to a supply shock: a sudden decrease in aggregate supply. Examples are weather related reductions in the production of basic foods, and sudden large cutbacks in oil production.

A supply shock results in both higher prices and lower output. In this case, both high inflation and high unemployment can occur at the same time. This is called stagflation, and occurred in many industrialized nations during the 1970s.


The Money Supply and Inflation
Perhaps you have heard people say that inflation is always caused by an over-supply of money, created by government action. Perhaps you already believe that to be true. Many people do. In that case, the above explanations for the causes of inflation can be interpreted in terms of the underlying supply of money.

Consider the following situation:

Suppose that the world supply of oil was suddenly reduced drastically, as it was in the 1970s. This would be a classic case of supply shock. The aggregate supply curve shifts leftward, resulting in both higher inflation and higher unemployment.

Now also suppose that the government decides to intervene with stimulus monetary and/or fiscal policies in order to reduce unemployment. In this case, the government believes that the best short run policy would be to stimulate output and employment. Expansionary government policy to deal with the situation will shift the aggregate demand curve to the right.

This will create more output and lower unemployment, but will also magnify the inflation problem. So, how does the situation coincide with the belief that inflation is always caused by an increase in the underlying money supply? The initial inflationary pressures had nothing to do with the money supply, but the government response did.

Some people will look at the government's reaction first, and say that the money supply caused this inflation. Most economists would not agree with that assessment.



The Relationship between Inflation and Unemployment



A discussion of a trade-off between inflation and unemployment, including the Phillips Curve, is found in the Unemployment section of this site.



Hyperinflation



Hyperinflation is a situation in which the rate of inflation accelerates to the point where the entire economy breaks down. Nobody wants to receive currency in exchange for goods and services because the currency will soon lose its value. It will be worth less than the value of the goods and services that it was exchanged for.

In an attempt to prevent that from happening, people will rush to spend the money before it loses its value. This increases current demand, drastically decreases long term investments, and makes the hyperinflation situation worse.

Hyperinflation, despite being talked about a lot, has actually occurred relatively infrequently in recorded world history. In each case, it has happened during times of political instability, and was created by unstable governments printing a very large quantity of money instead of collecting taxes. Typically in these situations, the government is either unwilling or unable to collect taxes to prevent hyperinflation from occurring.

The response to hyperinflation is that the currency is replaced by a new currency. Often, because of the underlying instability, the government is also replaced.

The chances of hyperinflation occurring without a civil war or an overthrow of the government contributing to the causes of hyperinflation are remotely small in the industrialized world.

Is there a specific rate of inflation that defines hyperinflation? I have not seen a number that economists tend to agree with, but it would be very high. The number that I have seen quoted most often is an inflation rate of 50% per month, or higher. But I don't believe that the economics profession has defined hyperinflation with a specific number.



Deflation



Deflation is defined as a period of time in which the price level decreases. Alternatively, it can be defined as a period of time in which the value of the currency rises.


During periods of deflation, businesses may have difficulty making payments on their investment obligations. They sell goods and services at deflated prices, but have to make principle and interest payments based on pre-deflated values of the currency. Real interest rates are higher than nominal interest rates.


As a result, businesses and farms are more likely to become bankrupt.