What is Inflation?• Inflation can be defined as the overall general upward price movement of goods and services in an economy. (BLS.gov)• The best measure of prices is the Consumer Price Index or CPI. The Consumer Price Index (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.• The Producer Price Index, PPI, measures the prices paid for intermediate goods.
All of Inflation’s Little Parts• Each month, the Bureau of Labor Statistics gathers 84,000 prices in about 200 categories — like gasoline, bananas, dresses and garbage collection — to form the Consumer Price Index, one measure of inflation.• This graphic shows the components of the CPI broken down into categories for 2007-2008.
Historical Inflation RateFRED data series (CPIAUCSL)0.16 Inflation Rate0.140.12 0.10.080.06 Inflation Rate0.040.02 0 1960 1970 1980 1990 2000 2010 2020-0.02
The DroughtA nation-wide drought will reduce theamount of corn for consumption, Ethanolproduction, feed for cattle, and allproducts in which corn is used. Thesupply curve for corn will shift to the leftwhich will increase prices. When theresources used in a good increases inprice, economists call this cost-pushinflation.Cost-push inflation refers to a general risein prices as aggregate supply shifts to theleft. In a study conducted by HopeJahren, the University of Hawaiiresearcher found that over 500 fast fooditems used corn.According to Soyatech, corn is the mostused food stapleAn increase in the price of corn couldlead to inflation as measured by the CPI.
Gas PricesHigher gas prices can hinder aneconomic recovery . As of thiswriting, gas prices have climbed 30cents over the last five weeksaccording to this CNN Money report.Arguably gas is an input into everyproduct. Gas moves goods along thesupply chain.Gas allows consumers to consumegoods and voluntary exchanges can bemade. These voluntary exchangesallow prices to be driven down to theirmarginal cost.When gas prices are high, theeconomy doesn’t work efficiently.
OilThis cartoon uses a play on words tosuggest that gasoline prices would belower if there were more domesticdrilling for oil. The toon also makes thepoint that higher prices are depletingpersonal savings.These experts believe that drilling will notlower domestic gas prices.The supply of oil on the world market isso enormous that domestic drilling in theUnited States would do little to lower gasprices. (The Washington Times).Gas prices constitute only 5% of aconsumers budget. The smaller amountof a budget that than item consumes themore inelastic the demand. Thiselasticity suggests that changes in gasprices will result in higher prices.
In the Bag?This cartoon suggests that the pricesof basic food items has increaseddrastically because of the 2012drought.This inflation rate calculator showsthat the inflation rate is belowhistorical monthly averages since2002.Remember that inflation is rise in thegeneral price level. Some goods mightbe increasing in price while others aredecreasing. The net effect of theincreases and decreases is the overallinflation rate. There is also thepossibility of CPI bias.The CPI doesn’t reflect the qualityimprovement s, substitution effects, ornew innovations. A Federal ReservePaper explores the bias here.
Higher prices have an income effectand a substitution effect. As foodprices increase in price relative toother goods, consumers have to makeother consumption choices such ashow much to spend onhousing, education, and health care.This cartoon implies that food pricesare high. Since people have got toeat, other goods that satisfy aconsumers wants and needs gowithout fulfillment. In theend, inflation changes consumptionexpenditures on many other goods.This change in demand may result inunemployment in industries thatconsumers substitute away from.Higher prices also rob consumers ofbuying power. Higher prices act like awage cut.
Natural DisastersThe economy isn’t free fromexogenous forces. In this cartoon, thedrought of 2012 has hurt charitablecontributions. This suggests thatinflation hurts lower income earnersharder than higher income earners.
Fiscal PolicyWhen the government cutstaxes, consumers have moredisposable income to spend. Thiscartoon suggests that tax cuts will helpthe economy out of a deep recession.During a recovery, prices rise. Manyeconomists believe that there shouldbe a 2% inflation rate if the economy ishealthy.A small amount of inflation showsthat consumer demand is strong andpresents profit opportunities thatencourage employment andinvestment.
HyperinflationWhen a country experiences rapidlyaccelerating inflation, the country is ina period of hyperinflation.The most notorious case was Germanyfrom 1919 to 1923.More recently, Zimbabwe.
Monetary PolicyThe Federal Reserve Bank canindirectly control inflation through thediscount rate or the Fed Funds Rate.The discount rate is theinterest rate that an eligibledepository institution is charged toborrow short-term funds directly froma Federal Reserve Bank. The federal funds rate is the interestrate at which depository institutionsactively trade balances held atthe Federal Reserve.Raising either the discount or Fedfunds rate contracts the money supplyand brings the average price leveldown.
DebtorsDebtors gain from inflation since theypay back the principal with lessopportunity cost.
Real Money BalancesMoney buys less; the cost of inflationhurts children ; how come the incomeearners wages haven’t kept up?One way to show the effects ofinflation is to divide the nominal wageby the price level. So if the nominalwage rate is $10 and the price level is5, then only $2 of real goods can bepurchased. When prices rise fasterthan income, a families real buyingpower decreases.
Creditors and DebtorsInflation enriches debtors and theexpense of creditors as explained inthis article.
Inflation BullyInflation is a bully. Inflation ispersonified here as shaking down theconsumer. At an annual inflation rateof 8.3 percent, this would beequivalent to a gallon of gasoline thatcost $3.45 costing $3.74. With aninflation rate that high many homeowners with a variable rate would be“upside down.”
MV = PQWhen a nation’s money supplyrises, it’s price level rises too. Infact, Milton Friedman called for amonetary rule in which the moneysupply increased by 3% each year sothat prices would increase equally.In the cartoon, the dollar buys lessforeign goods so the US dollar must berapidly depreciating.If you want to measure the change inprices, you will need to analyze theConsumer Price Index, CPI.
Shoeleather CostsWhen inflation is expected, thenominal interest rate raises throughwhat economists call the Fisher Effect.When the nominal interest rate isrelatively high, people hold less moneyfor transactions. As a result, theymake frequent trips to the bank towithdraw money and in making thetrips, they wear out the leather ontheir shoes.
Distributional EffectsThis cartoon suggests that inflationhurts everyone but the poor are hurtthe most.Earners who are living on a fixedincome are also hurt. Perhaps theseearners live on a pension or incomefrom bonds.
Chopping Block?This father can’t afford two of hischildren so he’s letting them go.Fortunately, families don’t mirrorbusinesses. But the cartoon raises aquestion. How does an income earnerearn enough to provide for his family?In periods of inflation, especially whenwages don’t keep up with prices, thefamily has to make tough choices. ThisChristian Science Monitor articlesuggest that wages do not.Economics is defined as how to satisfyunlimited wants with limitedresources. Economics is often calledthe dismal science for this reason.
StagflationStagflation is an economic malady inwhich there is simultaneousunemployment and inflation.In the United States the most notableperiod of stagflation occurred the1970s due to an adverse supply shockwhen the price oil escalated.The best policy response to a supplyshock is Laissez-Faire since mostsupply shocks don’t last long.
Inflation TaxWhen price rise, buying power falls.Inflation acts like a tax on goods. Thetax isn’t collected at the cash registerbut is a hidden tax as the purchasingpower of the dollar is reduced.When the money supply isincreased, perhaps to monetarize thedeficit, prices increase. As pricesincrease, the buying power of a fixedassets such as a bond falls. So dopeople on fixed incomes.Inflation “taxes” those on fixedincomes. Several links can be foundhere, here, and here.
SeigniorageThe government can earn revenuewhen it prints money to finance thedebt. This is called seigniorage.A well written blog post can be foundhere.To monetarize the debt, the treasuryissues bonds and the central bank usesopen-market operations to buy thebonds. If the government is running alarge deficit, it might resort toseigniorage if it can’t obtain loans fromforeign investors. This might result inhyperinflation.Why is it cheaper the ride the bus thanride the train during hyperinflation?Because you pay at the beginning ofthe ride when use ride a bus.
Business Cycles?This cartoon suggests that policymakers have to balance monetarypolicy to stabilize the economy.Fiscal policy suffers from lags so thatwhen spending kicks the economy hasalready recovered and the effects areinflationary. If contractionary policy isenacted, fiscal policy can send theeconomy into a recession.But, does inflation usually follow arecession? Evidence that someinflation is necessary to boostemployment can be found in the WSJarticle.
DataThe empirical data shows thatsince 1980 a run up on pricesis followed by a recession.Some questions to ask are:Did policy induce therecessions?What social forces contributedto the price declines such ashousing bubbles.This graph is taken fromSeekingAlpha.
• Two other problemsBracket Creep or TaxDistortion associated with inflationWhen an asset is sold, the seller payscapital gains on the amount of the sale are an arbitraryover the purchase price. What if theasset rises in nominal value but the redistribution of wealthreal value, adjusted forinflation, remains the same? and uncertainty about theSay you are taxed on capital gains and future.there is no inflation. If you sell yourhome for no capital gain then there’sno tax. But what if inflation makesthe value of the capital gain$10,000, but the real value remainsconstant. If the tax rate is 30%, thenthe seller pays $300 in taxes simplybecause the nominal value of the assetincreased.
Inflationary FearsIn the late 70’s, inflationary fearsmotivated a raise in the FED funds rate. The FED funds rate is the rate thatbanks loan excess reserves to eachother. When this rate raises, there’sless money for loans and the economycontracts.This cartoon implies that the reactionto any inflationary news roils markets.
Real MoneyInflation makes the nominal value ofmoney worth less. The real value ofmoney is equal to M/P where M is themoney supply and P is the price level.Since people make contract decisionson real income and real buying powerof money, knowing about inflationhelps to make informed decisions.
Inflationary ExpectationsEveryone forms inflationaryexpectations. If inflation has beenrunning at 2% in the past, consumersand investors think that the futureinflation will run about the same.How you view the future determineshow you act today. I believe a self-fulfilling prophecy forms. Theexpectation of higher prices fuelshigher prices.In the late 1970s wage setters beganto form inflationary expectationswhich resulted in the inflationaugmented Phillips Curve.