Chapter 7:  Inflation

In the final chapter of this module we look at inflation. In macroeconomics we are interested in the average level of prices in the economy, not the price of any particular good or service. Inflation is defined as an increase in the average level of prices in the economy, while deflation would be a decrease in the average level of prices. We focus on inflation because for the past 60 years in the U.S., average prices have risen, not fallen, so deflation is actually rare.
In this chapter we ask

I.  Why is inflation a problem?

Not for the reasons most people think. It may be tempting to say, "because everything is more expensive," but that is not it. Deflation can actually be just as damaging as inflation. The problem with inflation is one of redistribution: inflation makes some people worse off, but it makes others better off. This redistribution is due to three effects:

The costs of inflation go beyond redistribution, and have negative implications for the economy as a whole. If inflation is low, the effects may be small. But in periods of high inflation, known as hyperinflation, the negative effects will cripple an economy. What are the macro implications for inflation? So inflation not only redistributes income, it also reduces the growth of real GDP which has negative implications for employment and standard of living for everyone.

II.  Measuring Inflation

Inflation is measured as the percentage change in a price index. A price index measures the average price level for a set of goods and services, relative to a base year. We will discuss three commonly used price indices.

The Consumer Price Index (CPI) is the most commonly used index for measuring inflation. It is designed to measure changes in the prices of goods and services typically purchased by an urban consumer, so it is also known as a cost-of-living index. So the price of gasoline or milk is included in the CPI, but the price of a forklift is not.
To calculate the CPI the Bureau of Labor Statistics

Example: The price of the market basket between 1996-1999 is listed in the table below
Year
Cost of the market basket
1996
$10, 640
1997
$10, 780
1998
$10, 810
1999
$10, 900

To calculate the CPI for each year we compute

Suppose we choose 1997 as our base year. Now we can calculate the CPI for each year:

The CPI rises over time because the price of the market basket has risen over time. To get the inflation rate for each year, we measure the percentage increase in the CPI:

Note that for the base year, the price index = 100. This is true for any index.

The CPI is used to calculate cost-of-living adjustments (COLAs) under many union contracts, for Social Security recipients, for federal employees, and to adjust federal tax brackets for inflation. Therefore, it is important that this measure be accurate. However there are a couple of problems with the CPI that cause it to OVERSTATE inflation:

Also, the CPI market basket changes over time, making comparisons difficult. For example, a 1970 market basket would not include a VCR, computer, or cellular phone.

The mismeasurement of inflation by the CPI causes COLAs to be higher that actual inflation, which means larger raises for some workers, but higher costs to the federal government and thus taxpayers. A 1996 report suggested this overstatement of inflation to be between .8 and 1.6 percentage points annually.

The Producer's Price Indexes (PPI) are similar to the CPI, except that they measure the prices of raw materials, intermediate goods, or final goods used by producers instead of consumers. Increases in the PPI often precede increases in the CPI, as producers pass price increases along to consumers.

The GDP Deflator is the broadest price index, measuring the average price level of all goods and services included in the GDP. The deflator is simply the ratio of nominal GDP to real GDP. Or in other words, this index deflates nominal GDP to an inflation-adjusted output, real GDP. The GDP deflator differs from the two previous indexes in that

III.  Real vs. Nominal Quantities

Using the appropriate price index, we can convert any nominal quanitity (measured in current dollars) to a real quantity (adjusted for inflation):

Let's consider an example using the minimum wage. Consider the following table of the federal minimum wage between 1980-1998 and the CPI for the same years:
 
Year
minimum wage
CPI
1980
$3.10
82.5
1982
$3.35
97
1984
$3.35
103.7
1986
$3.35
109.4
1988
$3.35
118.1
1990
$3.80
130
1992
$4.25
140.2
1994
$4.25
148
1996
$4.75
156.8
1998
$5.15
163

So the minimum wage has risen $2.05 or 66% over 18 years, but prices have risen as well. Using the formula above we can calculate the real minimum wage, i.e. the actual purchasing power of the minimum wage.
Year
minimum wage
CPI
real minimum wage
1980
$3.10
82.5
$3.76
1982
$3.35
97
$3.45
1984
$3.35
103.7
$3.23
1986
$3.35
109.4
$3.06
1988
$3.35
118.1
$2.84
1990
$3.80
130
$2.92
1992
$4.25
140.2
$3.03
1994
$4.25
148
$2.87
1996
$4.75
156.8
$3.03
1998
$5.15
163
$3.16

Looking at the real minimum wage, we see that it actually peaked in 1980. So someone working for minimum wage is actually worse off, even though the nominal wage has risen, it has not kept up with inflation.

IV.  The Goal of Price Stability

Price stability is synonymous will low inflation (or low deflation).  What is an appropriate goal for price stability?  We know inflation is costly.  Does it follow that our goal should be for zero inflation?  If so, we are doing a pretty lousy job!

Recall that according to the Full Employment and Balanced Growth Act of 1978 the goal of economic policy should be an inflation rate of less than 3%.  Why not zero?  An inflation rate of 0% may require spending cuts that could decrease real GDP and increase unemployment (we discuss this tradeoff later in chapter 16).  Also, given that the CPI overstates inflation, a 3% measured inflation rate is actually less than 3%.

Looking at the percentage change in the CPI below (the red line) we see that inflation has frequently risen above 3%.  Right after WWII, inflation spikes as consumers rush to buy all of the consumer goods not available during wartime.  Throughout the 1950s inflation is fairly tame, but it begins to increase steadily in the 1960s. Inflation was especially a problem between 1973-1982. However, inflation stayed below 3% during most of the 1990s

V.  What causes inflation?

Inflation can come from two sources:  the economy supply curve or the economy demand curve.  Cost-push inflation comes from the supply side.  Basically, a large increase in the price of a very important input causes suppliers to pass along those increases and prices rise.  Examples of cost-push inflation include OPEC oil price hikes in the 1970s, a bad drought the decreases food production, or labor union wage demands.  Cost-push inflation results in one-time price hikes, but not persistent inflation.

Persistent inflation comes from the demand side.  Demand-pull inflation occurs when the economy cannot produce fast enough to satisfy demands of consumers.  In the first half of 2000, economists have been concerned about the emergence of demand-pull inflation as a booming economy and stock market motivate wealthy consumers to spend, spend, spend. Those concerns have decreased in the latter part of 2000, as the stock market ended the year down, GDP growth slowed down, and the unemployment rate inched up slightly.  Holiday retail sales, an important spending indicator, were flat relative to 1999.

Most economists agree that persistent inflation is a demand phenomenon:  "Too many dollars chasing too few goods."  The link between inflation and money is explored later in chapter 15.

FYI: Related Links

The Bureau of Labor Statistics Data on the Consumer Price Index, broken down by city.

The Boskin Report This 1996 report details the causes and consequence of the CPI's overstatement of inflation, along with recommendations for adjusting the CPI.

EconDebate: Should the Fed Pursue a Zero Inflation Policy?