Inflation: Not What You Think it is

Inflation: Not What You Think it is

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

Why do people tend to think of inflation as an evil? Do we have to live with this evil, in a world where we can complain about the problem but in the end we just put up with it, or can we find policies to support which will eliminate this evil? What exactly are the problems in our lives that are caused by inflation?

Well, let’s look at some specific problems. With inflation, we lose purchasing power. Our incomes don’t go as far as they used to. Our real incomes fall, our wealth is depleted, and more people end up below the poverty line. When our incomes rise due to a cost of living increase, the increase tends to be based on last year’s inflation rate. Our expenses, especially living expenses, continue to go up while our incomes are based on old inflation statistics. Our cost of living adjustments (COLAs) are inadequate anyway, never covering our increases in living expenses, even when discounted for a one year delay in receiving the COLAs. An increase in utility expenses by themselves might be more than the entire increase in pay we get to cover inflation. The same thing can be said about many other expenses – food, fuel, and medicine are some of the ones many of us think of first. We might have to choose between these necessities in our monthly budgets.

Meanwhile, businesses and individuals find it harder to receive credit. Banks don’t want to lend money if they know that they will be paid back in money that is worth less than it was worth at the time of the loan. Debt will redistribute wealth from creditors (banks, bond investors, etc.) to debtors (borrowers, bond sellers including the government, etc.) due solely to the existence of inflation. Business costs increase, access to funds to invest in business decreases, and as a result businesses lay off more employees. Long term contracts involving payment become riskier than short term agreements, creating a redistribution of resources.

Did I come up with a good description of the evils of inflation? I did not intend to make a comprehensive list of all of the problems associated with inflation, and perhaps you can come up with more. Perhaps you can make a better list than I did. But did I at least do a decent job of summarizing and highlighting the main problems we face with inflation?

If you say yes, then take another look. None of the problems I listed above are examples of inflation. They are things that we always associate with inflation, but they are not examples of inflation. In order to understand this point, go back to the definition of inflation:

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

Prices in this definition include wage rates. Wage rates are prices paid by someone to someone else. Wages are costs as well as income. Interest rates are also prices. Interest is the cost of credit. In the economy, different prices change by different amounts, at different times, and not always in the same direction. Inflation occurs when the average of all of these prices rises. Inflation does not occur simply because one price rises, or because some prices rise. Inflation only occurs when the average of all prices rise. The inflation rate is the rate by which this average price level changes, not the rate by which individual prices change. A one-time rise in prices is not inflation either; the rise must be sustained over time.

So what problems are created by a sustained rise in the average level of prices? None of the problems that I listed, as real as all of them are, falls into this category. Inflation means that over time, people have to get used to big numbers that mean the same thing that small numbers used to mean. Inflation means more time and expense associated with the process of changing prices. – But the bigger problems that I listed above? Inflation does not cause those problems.

None of those problems would exist if all prices moved together at the same time, in the same direction, at the same rate. The inflation rate could be exactly the same, but the problems would not exist. As long as every price change is equal to the average price change, these problems do not exist.

Think about that: the inflation rate could be exactly the same, but the problems would not exist. The definition of inflation depends on the average price change. According to this definition, inflation does not cause these problems. The problems are all caused by individual price-change variances from the average price change.

What difference does this truth make? Am I not just parsing words by emphasizing the definition and not the reality of inflation? Are not all of these problems at least side effects of inflation, with the same underlying cause?

It makes a huge difference when it comes to policy decisions. If the policy focus is on the average level of prices, and not on the variances from this average, then the problems listed above will not get solved and more problems might be created as unintended consequences. If the policy focus is on the individual variances, then the problems can be addressed directly.

Say, for example, that politicians want to deal with the fact that senior citizens face increasing poverty because COLAs on retirement income such as Social Security do not cover the increasing cost of maintaining the same living standard because increases in the cost of food and medication more than eat up the increase in income. Politicians see the increase in poverty, decide that it is due to inflation, and as a result they make policy decisions designed to lower the rate of inflation. This policy does nothing to fix the problem that it is designed to attack. The problem lies in the formula and timing of the COLAs relative to the specific price changes that seniors on fixed incomes tend to be affected by. In the meantime, a policy of lowering the inflation rate could have unintended consequences on the economy. Remember that the inflation rate is an average of the rate of change of many different prices in the economy, all of which change at different rates, and sometimes in different directions. When the average is lowered, so are some or all of its various components. More prices go down, and deflation becomes a potential problem. Deflation means that businesses sell their products at a lower price level than the one that existed whenever they purchased raw materials. During periods of deflation, the number of business and farm bankruptcies increases. Real interest rates become higher than nominal rates. Unused production capacity, including unemployment, tends to be higher whenever inflation is very low or negative.

On the other hand, if politicians saw the same problem for what it really is, then they would have an opportunity to address the problem directly. The Social Security income of a senior citizen is indexed by inflation. But the formula that is used does not reflect the spending patterns and necessities of typical seniors. Using several different inflation indexes that are designed for specific purposes, including one for senior citizens living on Social Security, would be one way to address this particular problem. Another would be to directly address the specific price increases faced by senior citizens.

The problems listed at the beginning of this essay can be dealt with more successfully with a focus on the specific problems than they can be with a focus on the overall rate of inflation. By the way, the problem with credit relationships redistributing wealth solely because of inflation does not really exist, at least not in the way I worded the problem. Wealth gets redistributed when actual inflation varies from expected inflation, and the redistribution can work either way depending on which direction the actual results vary from the forecasts. This should not be confused with the fact that credit relationships can and do redistribute wealth in ways that are completely unrelated to inflation.

Policies designed to work on the overall inflation rate make sense only when the specific problems being targeted are problems associated with that overall rate. This includes fighting deflation, but it also includes fighting hyperinflation. Under current conditions and policies, deflation has been at times a real problem and currently is a bigger potential problem. We have never experienced hyperinflation in the United States. Hyperinflation would require conditions much different from the ones we face today. Many times throughout American history, we have been subjected to dire warnings about impending hyperinflation that has never materialized.

A version of this essay is included as a chapter in the book Common Misconceptions of Economic Policy by Jerry Wyant. You can purchase this book in paperback form from Amazon and other online book distributors. The list price is $12.99 (only $9.99 using discount code TA9GTK7E when ordering, depending on the distribution channel). Or if you prefer, you can download a digital version on your device (Kindle, Nook, etc.) for $4.99.

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Jerry Wyant