What Everybody Should Know about Inflation

Economics Corner: What Everybody Should Know about Inflation

Inflation is one of the most widely commented-on yet most widely misunderstood topics on the economy. Everybody seems to have a viewpoint. Yet many of the views are based on misconceptions. Everybody who desires to be an informed voter should learn to distinguish between basic truths and well-meaning but misguided thoughts regarding inflation.

For starters, look at each of the following statements. If you agree with any of them, then you should read this essay to the end. Each one of these statements is FALSE.

  1. “Our purchasing power keeps going down because prices keep going up. To fix this problem, we need policies designed to cut the rate of inflation.”
  2. “People on fixed incomes increasingly are forced to live in poverty because inflation keeps eating into their incomes. To fix this problem, we need policies designed to cut the rate of inflation.”
  3. “Inflation is bad. The economy works best for everybody if the rate of inflation is zero.”
  4. “Inflation is always the result of too much money chasing a fixed quantity of goods.”
  5. “Inflation is the biggest threat to our economic well-being. We need to cut the rate of inflation at all costs, or we will end up being destroyed by hyperinflation.”
  6. “Gasoline prices are not counted in the government’s inflation index. If they were, Social Security benefits would be higher.”

Each of the above statements is false. If you agree with any of them, then I hope I got your attention. All of these statements are well-intentioned. Most of them begin with an obvious truth, but end up with a false assumption about the kinds of policies needed to address the obviously true problems. All of these statements rely on a misconception of the nature of inflation. As a result of the misconception, all of these statements suggest a misguided policy – a policy which either doesn’t address the source of the problem, or will create unintended consequences which are worse than the current problem (or both).

In order to understand the widespread misconceptions about inflation, we need to start with a definition of inflation.

Inflation: A sustained rise in the average level of prices

Hopefully, you would agree that this definition is fairly straightforward. With inflation, a given face-value of currency will provide less purchasing power over time. When we look at it from the point of view of declining purchasing power, we can come up with an alternative way of stating a definition for inflation.


Inflation: A sustained decline in the value of the currency

Again, this definition is fairly straightforward. You might notice that either way of stating a definition of inflation is consistent with the “obvious truths” in some of the above false statements. It is true that purchasing power decreases when the same amount of money can buy fewer things. It is true that a fixed income doesn’t go as far when the value of the currency decreases. But if you take a closer look at the definition, you should be able to see that the suggested “solution” of decreasing the rate of inflation doesn’t actually deal with the problems listed.

The rate of inflation depends on changes in the average level of prices. One price change doesn’t equal the rate of inflation.

The average of all price changes equals the rate of inflation.

If every individual price in the economy changed at exactly the same rate as the average, regardless of how high or low that average happens to be, then none of the problems listed above would exist. Suppose, for example, that the rate of inflation is 5%. This means that the average of all price changes in the economy is a 5% increase per year. If every price increased by 5% at the same time, then the purchasing power of our incomes would stay the same. You have to understand that wages for one is a cost to someone else. Wages are factored into the costs of other items. Wages are prices. As long as every price change is identical, wages would also adjust by the same amount. As long as a cost of living adjustment (COLA) for people on fixed incomes keeps up, these people will not have their purchasing power decrease. Yes, the purchasing power for a fixed quantity of currency will decrease. But this will be offset by incomes increasing by an equivalent amount of currency.

The rate of inflation, then, doesn’t cause any of the problems listed. Yet we know that some of these problems do exist. We know that purchasing power decreases. How can this be true, if inflation doesn’t create these problems?

Inflation DOES cause these problems. But the RATE of inflation does NOT.

That is the key to understanding policy implications. The truth is that all price changes do not equal the average. Some price changes are higher than the average, and some price changes are lower than the average. Some prices go up at the same time that other prices go down. These variances from the average affect different individuals and different classes of individuals in different ways. If all price changes equaled the average, then these problems do not exist. But when you have variances from the exact same average price change, these problems exist.

Problems typically associated with inflation, including loss of purchasing power, are not problems that can be fixed through policies designed to change the rate of inflation. The rate of inflation has nothing to do with the problems. If we want to deal with these problems effectively, we need to focus on policies which deal with undesirable consequences of variances from the average rate of inflation. For example, if senior citizens on a fixed income are losing purchasing power because the COLA used for determining benefits isn’t keeping up with the actual expenses that seniors tend to have, policy focus should be on changing the COLA formula, not on trying to lower the overall rate of inflation in the economy.

But wouldn’t the problems go away if prices never changed and the inflation rate was zero?

Whoa there! We could have a zero rate of inflation, with no variances from the average creating these problems; at least in theory. Getting there would require a command economy – an economy in which the government makes every price and production decision. The government could simply freeze all prices. If we were advocating for such an economy – and some people do – then we wouldn’t even need to discuss which types of policies would be effective in eliminating the problems associated with inflation. However, if you believe in the benefits of a market-based economy, or even one that is partially based on market forces, then you don’t want to go there. A free-market economy requires prices to be able to adjust freely. All of the benefits claimed by advocates of a market-based economy – reallocation of resources to improve efficiency, economic growth, technological advances, consumer choices, upward mobility, fair prices due to competition, elimination of shortages and surpluses, etc. – require that prices be allowed to adjust freely. If we fixed prices in order to eliminate inflation, these benefits wouldn’t exist – even in theory.

But still, isn’t lower inflation always better than higher inflation?

One way to visualize the fallacy of this argument is to look at the stock listings in the business section of the newspaper. On a typical day, a stock index might go up or down by 1%, more or less. The newspaper will report the amount of change for the index, and that change (points or percentage) is what the headlines will focus on. But if you look at all of the individual listings, you won’t see the same percentage change for each item. You will see some upticks and some downticks. Some changes will be relatively large, and some prices won’t change at all. The stock index average might be higher than the previous day, or it might be lower. In the long run, stock prices go up. You can’t really see the long run trend by looking at the upticks and downticks on a given day. But you can see that for a typical day, some stock prices go up, and some go down, regardless of which direction the average moves. Individual price changes for goods and services in the economy act in a similar fashion. At any point in time, some prices are going up and some are going down. There are upticks and downticks, so to speak. On the average, prices go up in the long run. It is this long run trend in average price changes, not any individual price change, which defines the rate of inflation.

When the rate of inflation increases, then that means either the number of upticks increased relative to the number of downticks, or that the deviation from the average changed. When the rate of inflation decreases, then either the number of downticks increased relative to the number of upticks, or the deviation from the average changed. Neither scenario, by itself, is necessarily better or worse than the other. “Good” or “bad” depends on other factors. Economic growth can be associated with upward pressure on prices. Economic growth means that more resources are being utilized for production purposes. Whenever additional resources are required, average costs go up. For example, if a business needs more man-hours of labor in order to meet a higher demand for its product, then it will either have to pay more for overtime, or bid up labor costs in order to compete with other businesses for available labor. The labor market becomes a seller’s market.

On the other hand, price decreases are associated with slower economic growth, or even economic contraction. Resources are idled. Labor is laid off. The labor market becomes a buyer’s market.

With lower inflation economic growth tends to be lower, unemployment tends to be higher, and wages tend to be lower. In fact, the policies used by the Fed when it attempts to lower the rate of inflation are policies specifically designed to lower wages and increase unemployment. Monetary policy by the Fed acts on a trade-off between inflation and unemployment. With higher inflation, the opposite tends to be true. It’s all about the reality of price variances from the average and the economic factors which put pressure on prices to either go up or go down.

But aren’t high inflation and hyperinflation real problems in the economy?

Yes, high inflation creates real problems. Hyperinflation creates political revolution. But in today’s economic and political climate, the chances that policy-makers will go along with a “the sky is falling” mentality of those spreading misinformation about inflation is a bigger danger than the chance that we will experience high inflation any time soon. Economists tend to agree that reaching potential economic growth is consistent with an inflation rate of around 3% to 5%.

When the inflation rate is close to zero, there is more danger of deflation than high inflation. Deflation means that small business and family farm bankruptcies increase because debt obligations are harder to meet when the prices of the goods they sell are going down. Think in terms of the visual comparison to stock market tables – deflation means that there are more downticks, or larger downticks, than upticks.

When the inflation rate is above the rate consistent with potential economic growth, the economy is overheating. Since growth requires the use of more resources, an overheated economy is one where the additional cost associated with using more resources outweighs the additional output resulting from the use of these resources.

Despite the rhetoric from many people, the only way that the United States could fall into a state of hyperinflation would be if the entire political system disintegrated into a state of all-out civil war. Too much is now known about the causes of hyperinflation – and there are too many safeguards in place to prevent such an outcome – that it would take the entire collapse of the political and social system BEFORE hyperinflation would even be possible. In that case, the collapse of the political system along with the advent of civil war – and not some economic policy – would be the cause of the problem.

Hyperinflation is associated with an inflation rate of 50% per month, or higher. The United States has never threatened to approach inflation numbers in that range. The last time we had an inflation rate as high as 10% per year was 1981. Most instances of inflation rates this high have been associated with the supply shock of the Arab Oil Embargo of the 1970s. The last time inflation inched above 5% for an entire year was 1990.

Is inflation always caused by “too much money chasing too few goods”?

“Inflation is always a monetary phenomenon” is a common belief. People hear it over and over, assume it must be true, and repeat it. The implication is that the rate of inflation increases proportionally whenever more money is put into circulation, and that the way to eliminate inflation is to hold the money supply steady. Sometimes this claim is accompanied by a mathematical equation purporting to prove that this must be true.

Besides the most obvious example of stagflation – a situation unrelated to the money supply – there isn’t much in the historical data to support this claim (not counting the rare special cases of hyperinflation in other countries). Such a claim ignores the processes involving supply and demand of goods and services which put upward and downward pressures on prices as production increases and decreases.

For more on the relationship between inflation and the money supply, see Economics Corner: What Everybody Should Know About…Money.

Should gasoline prices be included in the price index?

When gas prices go up, they often go up dramatically, and people whose incomes are indexed to inflation definitely have their purchasing power decreased.

However, gasoline prices are extremely volatile. They go up quickly, but they also go down quickly. The long-run trend of gas prices is roughly the same as the long run trend of prices in general. If gasoline prices were included in the price indexes that are used for making policy decisions, including the benefits for people on fixed incomes, then economic policy itself would be volatile. People on fixed incomes would see benefits go up, but they would also see benefits go down. Including gasoline prices in policy decisions would create unstable policy.

But there are other ways to “fix” price indexing that seem to make sense. Currently, Social Security benefits are indexed to something called CPI-W. This index is an estimation of changes in purchasing power based on the spending patterns of “typical” urban wage earners and clerical workers. But people who receive Social Security benefits do not have the same spending patterns as these “typical” workers. “Urban wage earners and clerical workers” as a group spend more money on electronics and other decreasing-cost items. They are more likely to have discretionary income, which makes it easier to substitute low-cost items for high-cost items when prices change. On the other hand, senior citizens who receive Social Security benefits spend more of their money on increasing-cost items such as prescription medication. As a group, they spend a larger share of their incomes on necessities for which fewer low-cost substitutes exist. One way to eliminate the effects of inflation on the purchasing power of senior citizens is to index Social Security benefits to items that senior citizens tend to spend their money on. Another way would be to develop policies which deal directly with the increasing costs of prescription medication.

Is inflation a self-fulfilling prophecy?

There can be a herd-mentality factor in the rate of inflation. If customers expect prices to go up, they might rush to buy, causing prices to go up due to an increase in demand. If businesses expect costs to go up, they might decrease long-term investments, causing prices to go up due to a decrease in supply.

We are not all economists, so why does the news media keep bombarding us with economic statistics and terminology we don’t understand? Should the average American even care about such news stories? When politicians talk about the economy, how do we separate the relevant from the rhetorical? More to the point, you might be asking yourself, “How does this affect me?”

Perhaps talk about the economy sounds like a bunch of gibberish to you. But if you had a basic understanding of the terminology being used – not the dictionary definitions, but what the words in their context should mean to a layman – free of misleading political implications, then such talk would mean more to you than just gibberish. The good news is that you don’t have to be an economist or even a student of economics in order to understand the terminology.

“Economics Corner: What Everybody Should Know About…” series is designed as a layman-friendly explanation of important economics terms and concepts. Created by Jerry Wyant.

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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