Next to the unemployment rate, the rate of inflation-the percentage change in the overall price level-is as Rodney's comment suggests the most closely watched economic indicator. Since the 1980s, inflation has overtaken unemployment as the most closely watched indicator of macroeconomic health.
Inflation is a rise of prices in general. It shows, in percentage terms, how much your currency is worth today compared to some earlier or future period.
Deflation is a fall of prices in general.
But don't confuse deflation with disinflation. Disinflation is declining inflation; that is, with disinflation, prices we pay for food and energy and housing and health and the like are on average rising, but the rate at which they are rising is decreasing. An example is 5 percent price inflation one year, followed by 4.6 percent the following year, which is in turn followed by 3.9 percent the year after that. Prices rising at a decreasing rate.
The "in general" in these definitions is important. Inflation refers to the rise in prices of goods and services across the entire economy, not just to the price of a single good or service, as we saw in microeconomics. When the price of a single commodity rises, we speak of a relative price increase. Macroeconomics focuses on price levels in general.
|Speaking Economics: General Price Changes Versus Relative Price Changes|
|When people say that the price of air fare or health care has gone up, economists want to know: "Relative to what?" When the price of a product or service goes up relative to other prices, economists speak of a relative price change. But in macroeconomics, price inflation does not mean that every single price in the economy moves up at the same rate. Or at all. Some prices rise, and by a lot; others rise just a little; still others fall, and maybe, like the price of computing power, by a whole lot. Relative price changes continue to occur even in times of inflation: a failure of the apple crop drives up the price of apples while technological improvements lower the price of cell phones and televisions sets. Inflation is a price rise that represents all goods and services on average.
Problems Caused by Inflation
The main problem caused by inflation is that today's currency-one dollar, one euro, one yuan-buys less than last year's currency of the same amount. And that means that today's wage (paid to workers in an inflated currency) buys less than the same wage bought last year.
Suppose you work at a fast-food restaurant, contracted for $10.00 per hour of work. If general price inflation is rising at the annual rate of 5 percent, your actual pay is worth $9.50 per hour ($10.00 - [$10.00 x 0.05]). It's easy to see: your pay check is fixed in dollars per hours, but when prices are rising, the amount of goods and services your dollars are able to buy in the market is shrinking. For every dollar you earn you only get to enjoy 95 cents of purchasing power.
So inflation is a serious problem for anyone whose income is truly fixed or does not increase at at least the same rate as the rising prices. Inflation especially hurts people who live on pensions that are not adjusted or "indexed" for inflation (in the United States, Social Security benefits are now so indexed; they haven't always been). It also hurts lenders-banks, for example-who receive a fixed interest on the money they lend.
Concept Check 2: Why do some lenders lose in times of inflation? (Answer at end of chapter.)
Another problem is that unanticipated inflation distorts the price signals that markets send out. When you walk into a store and see that the price of beef has gone up, you may think: "Something must have happened in the market for beef-a shift in demand or supply. So maybe I should buy something else - like chicken or fish." After all, that's what prices are supposed to do: inform consumers about changing market conditions, allowing them to economize on each decision. But prices in general may have been going up, with nothing special happening in the market for beef. In that case, unanticipated inflation is distorting the signals that markets send out.
Yet another problem caused by inflation is the danger that it will increase at an accelerating rate and turn into hyperinflation.
Hyperinflation is inflation that is rising at an extremely high rate.
When hyperinflation sets in, the price of food goes up while people are out shopping-for food. In Bolivia, prices increased by 11,750 percent over the year 1985. In dollar terms this would mean that a cup of coffee that cost $1.00 on New Year's Day would cost $117.50 at the end of the year. A $20,000 automobile would cost almost $2.5 million at year's end. Under such conditions people try to spend their money as soon as they get it. In fact, they try to avoid getting money altogether, and search for barter exchange and other forms of asset holding. No economy can function normally under conditions of hyperinflation.
Why Inflation May Not Be a Serious Problem
But is normal inflation-which most economists say lies between 0% and 3% a year-all that bad? A common complaint is that inflation makes everyone poorer. But that cannot be the case. When we pay higher prices, other people must be receiving higher income. Money, by a matter of simple logic, has to travel around the circular flow; a dollar earned is a dollar received, by somebody. The rise of prices in general must imply rising incomes in general.
To keep inflation in perspective, remember two economic proverbs: (1) every coin has two sides, and, as the Dutch say, (2) a forewarned person counts for two.
A coin has two sides. On average, one person's loss is offset by another's gain. To say it another way, your expense is someone else's receipt. When you pay more for pizza, someone else--the pizzeria, the maker of the cheese, the farmer who grew the wheat for the flour--will receive every extra cent you spend. In this respect, inflation cannot hurt everybody. Instead, as we saw above, the hurt is usually unevenly distributed, with those living on a fixed income or bound to a fixed contract being hurt the most.
Concept Check 3: A student replies: "But the pizzamaker who just raised his price still has to pay more for his ingredients. Therefore I will have to pay even more when I buy a pizza. And the pizzamaker will still suffer a net loss." What's wrong with the argument? (Answer at end of chapter.)
A forewarned person counts for two. "Forewarned, forearmed" Cervantes wrote of Don Quixote. Inflation hurts little if at all when people anticipate it and prepare for it. For example, if consumer prices have been doubling year after year in a predictable way, employees will demand a doubling of their wages, and eventually will get it. Landlords will refuse to enter into long-term leases at a fixed monthly rent, and bankers will demand higher interest on fixed-interest-rate mortgages. If something is anticipated, people will adjust their behavior accordingly. If you see another car coming at you along a narrow road, you move to the far side to avoid a crash. It's the car you don't see that causes the accident. Inflation that is anticipated is less harmful than inflation that comes as a surprise.
Maria: So what's all the fuss about? Why do politicians make such a big deal of inflation?
Ziliak: In addition to the problems we've mentioned-hyperinflation, unanticipated inflation, senior citizens and the poor and disabled living on fixed incomes-there's another problem, a moral problem. When the government issues money, it has an obligation to see that the money retains its value. At least that's what most economists believe. By permitting inflation to set in-at some level-the government fails to live up to that obligation. The trick is to figure out the right level for your economy.
Klamer: Inflation is bad enough, but I think unemployment is a much more serious problem. If I had to make a choice I'd choose less unemployment in exchange for a little more inflation.
McCloskey: I prefer lower inflation every time. Unemployment would vanish if we just let the markets work.
Klamer: We disagree!
Finding the Inflation Rate from the Price Index
Like the unemployment rate, the inflation rate must be calculated. We need a measure of the overall, average increase of prices in general. Calculating inflation the way we calculate price change in microeconomics-one good or service at a time-would be impossible if not insane. Think about it for just a moment. The average supermarket in the United States stocks around 40,000 items for sale at any point in time. The task of tabulating the change in price of item number 17,421 versus item number 13,911 is daunting; now imagine repeating that exercise for the many thousands of grocery stores in the nation; and then the tire stores; and the pharmacies; and the so and so forth. And then imagine repeating the exercise across all the permutations: item number 17,421 in the grocery store relative to item number 4 in the tire store, and the like. We think you get the point.
It would be convenient to generate for the macroeconomy a single price level, a price index, let's say, that takes into account the influence on price with respect to quantity and sometimes other characteristics of the commodities being traded. And so economists have done it. (An index, by the way, is a "number" or "indicator," scaled to some other number: 80 degrees Fahrenheit is warm relative to a Fahrenheit scale on which 32 degrees freezes water and 212 degrees boils it.) Price indices are useful like that. Consumers care more about a 10 percent increase in the price of the car they plan to buy than they care about a 10 percent increase in the price of salt. Salt is dirt cheap, if not cheaper. The technical workshop explains how to derive a one such index, the Consumer Price Index (CPI). Roughly, the procedure is to add up the prices of selected goods after weighing each good's price according to the relative importance of the good, so that cars and apartment rentals receive more weight in the index than pencils and chewing gum.
Deriving the Price Index and the Inflation Rate
In deriving a price index, you must first decide which prices to include and how to weigh them. The inflation that matters most to you is the inflation in the prices of the products you most often buy. If your consumption package is significantly different from that of the typical U.S. consumer (you may buy more books than the average person does, for example), then your personal inflation rate will differ from the average inflation rate. (If the price of books goes up less than other prices your personal inflation rate will be lower than the average.)
Let's start by calculating Maria's personal price index --calculating the national price index will prove to be very similar. First she needs to choose a year as the base year -- that is, a year to serve as the benchmark. In that year her price index is taken to be 100, and the quantities of the goods she bought in that year will determine the relative weights to be ascribed to the various prices.
The base year is the point of departure in calculating a price index. The price index for that year is taken to be 100, and the quantities used in the calculation are the quantities consumed during that year.
Maria chooses 1997 as her base year. During that year she consumed the following bundle of commodities:
She looks up the price of each of these commodities and determines her total expenses in the base year. She then looks up the price of each commodity in the current year and determines what she would have spent in 2005 if she had consumed the same bundle of commodities as she consumed in 1997, the base year. Here are the results:
Notice that the quantities of what she consumed in the base year serve as weights. Pizzas are important for her price index, because she bought a lot of them in the base year. Now Maria can calculate her price index for 2005, the current year:
Maria's personal price index for the current year is higher by 5.6 percentage points than it was in the base year. Her personal inflation rate was 5.6 percent.
The general formula for the price index is:
Concept Check 4: The price of haircuts goes up by almost $4 while the price of pizza goes up by less than $3. Which price increase will upset Maria more? (Answer at end of chapter.)
In general, when p1 is the price index in year 1 and p2 is the price index in year 2, the inflation rate will be:
Notice that p1 is not always equal 100. That is because economists, citizens, and policymakers often want to know the rate of inflation from, let's say, 1998 to 2005, not just from the base year of 1997 to the year 2005.
Concept Check 5: If the price index in the third year is 115 (call it p3), what will Maria's inflation rate be in that year, relative to year two (p2)? (Answer at end of chapter)
The weights used in these calculations may need to be adjusted from time to time. When Maria gets a job, her bundle of commodities will probably change significantly. She may eat fewer pizzas and go out to dinner more often. That would make her price index--and consequently the inflation rate she experiences--more sensitive to the price of dinners. The only way to account for such changes is to adjust the weights of her consumption bundle. And to do that requires changing the calculations for the base year.
Notice that these calculations do not take into account changes in the quality of the commodities purchased. The haircut Maria gets in her college town might be better than the one she got back home. The price increase from about $15.00 to $20.00 may be misleading: the higher price may actually be a lower price, considering the improved quality.
To determine the national rate of consumer inflation, the Bureau of Labor Statistics follows essentially the same procedure as the one described in the Technical Workshop. (Since the mid-1990s the BLS has adopted a weighting instrument that changes dynamically in an arithmetic "chain" over time-it's, as they say, "chain-weighted"; here, since we want to emphasize intuition and life-time learning, we speak only of "fixed" price and "fixed" quantity weighting instruments.) The BLS constructs a "market basket" of commodities by surveying a sample of households in urban areas. Interviewers ask each household to list its purchases of specified commodities during the base year. It then calculates the corresponding weights and uses those weights for several years. As the years go by, the market basket becomes less and less representative of what consumers are actually purchasing, and a new survey and a new base year have to be adopted. The result is the Consumer Price Index, abbreviated CPI.
The CPI is a price index based on the relative weights of the commodities consumed by the average consumer.
The official inflation rate is the percentage change in the CPI from year to year:
The CPI is the best available estimate of the inflation rate-or is, anyway, when our attention is fixed on the macroeconomic status of consumption. But, like Maria's inflation rate, the weights ascribed to the contents of the "market basket" become unrealistic as time passes. When gasoline prices went up during the 1970s, gas consumption declined. Yet the weights in the BLS market basket remained unchanged. The result was an overstatement of the inflation rate.
Figure 20.4 Changes in CPI Weightings, 1952 and 2000
As in Maria's price index, the CPI does not reflect changes in the quality of the commodities in the market basket. An automobile manufactured in 2000, for example, is probably of higher quality than one built in 1984. When quality improves, the CPI tends to overstate the rate of inflation.
Finally, because the weights the BLS uses for the CPI are derived from a sample of U.S. households, we cannot be absolutely certain that they are representative of any given household. Yours, for example. Only that they are representative for a statistically average household.
Concept Check 6: Why does your personal inflation rate differ from the CPI? (Answer at end of chapter.)
There are price indices other than the CPI, watched closely by economists, policymakers, and investors. The producer price index, for example, is an index of wholesale prices (that is, the price retailers pay to get the goods they sell). And the GDP Price Deflator is a price index of all goods and services, whether purchased by consumers, businesses, or government. We will encounter the all-important and popular GDP Price Deflator in the next chapter.
Nominal Amounts and Real Amounts
When the price level is changing, the value of the income you receive may not be what it seems. To find out what your income is worth, you need to correct for changes in the price index. In economic language, literal amounts are called nominal amounts and amounts that have been corrected for price changes are called real amounts.
Nominal amounts, (as in nominal income, nominal product, and nominal wage) are amounts that can be literally observed.
Real amounts (as in real income, real output, and real wage) are nominal amounts corrected for changes in the price level.
The general formula for converting nominal amounts into real amounts is just as we did above with the fast-food example:
Say total output in year one is $11,000 billion (that is, 11 trillion dollars) and total output in year two is $11,500 billion. Would you be impressed by this increase of $500 billion in total output? You can't say-not without some additional information. The 4.55% increase is expressed in nominal amounts only. Much or most of it may be due to an increase in prices. So you need to calculate the real amounts. To keep matters simple, assume that year one is the base year. That means that the price index for that year is 100. When you plug that number into the formula above, you find that in the base year nominal and real are the same. So in year one real output is 11,000 billion. How about year two? You look up the price index for that year (in real life, the CPI or the GDP deflator, say, at the BLS or BEA web site) and find that it is 110. So real output in year two is:
The calculation shows that real output actually went down! All the increase in output, plus some more, was due solely to a rise in prices.
Concept Check 7: Your boss just told you she's giving you a 5 percent raise. Should you celebrate or complain? (Answer at end of chapter.)
Inflation in the United States and Other Countries
In 2005 the annual average inflation rate in the United States, measured by the CPI, was about 3.5 percent. Is that a big amount, big enough to worry about? Again, only through comparison with other times and other economies and-ultimately, with other nominal amounts-can we can tell. Figure 20-5 shows the rate of inflation as derived from the CPI from 1960 to 2005.
Figure 20-5. U.S. Annual Inflation Rate, 1960-2005, derived from the CPI. (1982-1984=100)
Caption: The latest spike in inflation occurred in 1980, when inflation reached 13.5 percent. The 3.5 percent price rise experienced in 2005 was low compared with rates during the preceding two decades but somewhat high if compared with rates around the very end of the twentieth century.
Concept Check 8: In public opinion polls people often say that inflation is a more serious problem than unemployment. Do you agree? Why or why not? (Answer at the end of chapter).