Inflation

This is Unit Six of Principles of Macroeconomics: inflation. Unit five counted the people not working; this unit measures the money everyone is paid in. Carry one idea through. Inflation is a rate of change in an average, and almost everything costly about it comes from its being uneven and partly unexpected rather than from the numbers rising. The capstone says exactly that. By the end you will build a price index and compute a rate, choose the index that fits a question, convert nominal to real, say who gains from unexpected inflation, and tell demand-pull from cost-push.

Two entries on what inflation is, and the two things people mistake for it.

What the word means.

MAC 0501 What Inflation Is

Inflation is a general and ongoing rise in the level of prices across an economy, and the inflation rate is the percentage change in that level. Deflation is the same in reverse. Both describe a rate of change, not a level: high prices are not inflation, and low prices are not deflation.

What it is not.

MAC 0502 Not a Relative Price Change

Inflation is a rise in the average level, not a rise in one price. One good getting dearer while others get cheaper is a relative price change: tuition rising while laptops fall tells you about those two markets. A one-time jump that then stops is also not inflation.

Four entries on measuring it: the basket, the index, building one, and getting a rate.

What gets measured.

MAC 0503 The Basket and the Price Level

The price level is the cost of a basket of goods a typical buyer buys, with items weighted by how much is actually bought. A ten percent rise in rent moves the level far more than a ten percent rise in carrots. Without weights the index would treat every price as equally important.

Turning that cost into a number.

MAC 0504 Index Numbers

An index restates the basket's cost so the base year equals one hundred: divide each year's cost by the base year's and multiply by a hundred. Index numbers carry no units. The base year is arbitrary, and changing it changes no inflation rate, because the rate is a ratio between two years.

Building one.

MAC 0505 Building a Price Index

Four steps. Choose the basket: which goods, and how much of each. Price it in the base period and total the cost. Price the same basket, same quantities, in the current period. Divide the current cost by the base cost and multiply by one hundred. The quantities stay fixed, so any change comes from prices alone. A basket of four books at ten dollars and three meals at twenty costs a hundred dollars; at twelve and twenty-five it costs a hundred and twenty-three, so the index is a hundred and twenty-three. Repricing with current quantities measures something else.

Getting a rate out of it.

MAC 0506 Computing the Inflation Rate

The inflation rate between two periods is the change in the index divided by the earlier index, times one hundred. The divisor is always the earlier value, never the later one and never a hundred. An index going from one hundred and seven to one hundred and ten has changed by three, and three over a hundred and seven is about two point eight percent. Subtracting to get three percent is close here and wrong, and at an index of two hundred the shortcut would be wrong by half.

Five entries on the indices themselves, and how to choose between them.

The one most often quoted.

MAC 0507 The Consumer Price Index

The consumer price index prices a fixed basket of what households buy. The basket comes from a survey of household spending, and housing carries the largest weight. Its base period is nineteen eighty-two to eighty-four. When a report gives an inflation rate without saying which index, it usually means this one.

What a fixed basket gets wrong.

MAC 0508 Why a Fixed Basket Overstates

A fixed basket overstates the rise in the cost of living, because buyers substitute away from what gets dearer and new goods enter late. When beef gets dearer people buy chicken, and the fixed basket keeps buying beef. Estimates of the remaining overstatement have ranged from about half a point to over one point a year.

Stripping out the noise.

MAC 0509 Core Inflation

Core inflation leaves out the most volatile items, chiefly food and energy, to show the underlying trend rather than month-to-month noise. A spike in fuel prices moves headline inflation and leaves core alone. Core is not the inflation households feel: it is a guide to policy, not a cost-of-living measure.

The other indices.

MAC 0510 Other Price Indices

Other indices price other things: producer prices for inputs, an employment cost index for wages, and the GDP deflator for everything counted in output. The deflator is not a fixed basket, so its contents change as output changes. The central bank watches a fourth, the personal consumption expenditures index.

Choosing between them.

MAC 0511 Which Index Fits?

Match the index to the question. For a household's cost of living, use the consumer price index, which prices only what households buy. For the prices of everything the country produced, use the GDP deflator, which covers investment and government purchases but excludes imports. For whether a movement will persist, use core. For what is happening upstream of retail, use producer prices. A pensioner wants the consumer index; a central banker facing a fuel spike wants core. The indices disagree, sometimes by a full point, and none is wrong.

Five entries on comparing amounts across years, and on who a surprise favours.

Comparing across years.

MAC 0512 Nominal and Real Values

A nominal value is measured in the money of its own time; a real value is adjusted for price changes, so amounts from different years can be compared. A wage that doubles while prices double has not risen at all in real terms. Nearly every comparison across years that matters is a real one.

Doing the conversion.

MAC 0513 Converting a Nominal Wage

To compare amounts from different years, divide each nominal amount by that year's price index, then compare. If the index is stated around one hundred, divide it by a hundred first. The result is in the base year's money, so both figures are in the same units. A wage of twenty thousand when the index was one hundred, and thirty thousand when it was one hundred and eighty, converts to twenty thousand and about sixteen thousand seven hundred: the nominal wage rose by half while the real wage fell by about a sixth.

The same idea applied to interest.

MAC 0514 The Real Interest Rate

The real interest rate is the nominal rate minus the inflation rate: what a lender actually earns in purchasing power. Four percent interest with five percent inflation is a real return of minus one percent. Tax is charged on the nominal gain, so a saver can owe tax on a return that lost purchasing power.

Who comes off better.

MAC 0515 Computing the Real Interest Rate

Subtract the inflation rate from the nominal rate. The answer can be negative when inflation runs above deposit rates. Then ask who it favours. A borrower with a fixed nominal rate gains when inflation turns out higher than expected, because the payments are fixed and the money is worth less; the lender loses by that amount. A fixed loan at six percent with inflation expected at two has an expected real rate of four; at seven, the realized rate is minus one. What matters is whether inflation was anticipated, not whether it was high.

The wider pattern.

MAC 0516 Who Gains and Who Loses

Unexpected inflation moves purchasing power around. Holders of cash lose, fixed-rate borrowers gain, lenders lose, and anyone on a payment fixed in money terms loses: a pension fixed in dollars buys less every year. Wages usually catch up, but with a lag, and the catching up has to be argued for.

Three entries on the cost that falls on everyone, and the two extremes.

A cost that falls on everyone.

MAC 0517 Blurred Price Signals

Prices carry information about scarcity, and inflation is noise on the line. A higher price may mean one good is scarce or that every price is rising, and buyers and sellers cannot tell which, so they respond more slowly. This is why inflation has a cost even when incomes keep pace.

Prices falling instead.

MAC 0518 Deflation

Deflation is a falling price level. It sounds welcome and is not, because falling prices give buyers a reason to wait, and waiting cuts demand further. It also raises the real value of debts, so borrowers repay in dearer money. The United States saw deflation through the Great Depression.

The opposite extreme.

MAC 0519 Hyperinflation

Hyperinflation is inflation running out of control, and it has one usual cause: a government paying its bills by creating money. Money can lose value by the day, so people spend it on receipt. The usual sequence follows: price controls, then shortages, then black markets, and finally a foreign currency.

Three entries on where inflation comes from, and the test that tells them apart.

The first of two ways.

MAC 0520 Demand-Pull Inflation

Demand-pull inflation happens when demand grows faster than the economy's capacity to supply it, so producers raise prices. The old phrase is too much money chasing too few goods. It is demand that moves, so output and the price level rise together, which unit eight draws as aggregate demand shifting right.

The other way.

MAC 0521 Cost-Push Inflation

Cost-push inflation happens when the cost of producing rises sharply, from wages or raw materials, and producers pass the increase into prices. The oil price rises of the nineteen seventies are the standard example. Here supply moves, so the price level rises while output falls: the stagflation of unit eight.

Telling them apart.

MAC 0522 Which Kind of Inflation?

The two look alike in the price level and differ in everything else, so use output to tell them apart. Ask what moved first. If spending rose, from households, firms, government or abroad, it is demand-pull, and output rises with prices. If the cost of producing rose, from wages, materials or a disruption to supply, it is cost-push, and output falls while prices rise. A tax cut spent while factories are near capacity raises both. A war closing a shipping route raises prices and lowers output. Expectations complicate both, because people who expect inflation help bring it about.

Two entries on living with inflation, and why experts and the public disagree.

Protecting people from it.

MAC 0523 Indexing

Indexing means a payment adjusts automatically with the price level, so its real value holds. Tax brackets and social security payments are indexed, and an indexed bond pays a real return on top of whatever inflation turns out to be. Indexing is always partial, so it protects some and leaves others exposed.

Why the experts worry less.

MAC 0524 Why Economists Worry Less Than the Public

Here the unit's governing idea is at work. The public rates inflation far more serious than economists do, and the reason is worth understanding. Suppose overnight every price, wage and balance rose by the same percentage. Nothing real would have changed: everyone could buy what they could the day before. Inflation fully anticipated and perfectly even is close to harmless. Real inflation is neither. It arrives unevenly, so some prices move first, and partly unexpected, so money contracts mean something neither party intended. Everything costly comes from those departures. Three costs follow: redistribution between savers and fixed-rate borrowers; blurred signals, where a shopkeeper cannot tell a scarce input from a general rise; and planning in a currency of uncertain value. Three cautions, the last mattering most. Scale decides everything: two to four percent is a nuisance indexing absorbs; hyperinflation destroys trade. A moderate rate may do some good, letting real wages fall without a visible pay cut, since unit five showed nominal wages resist falling — genuinely disputed, offered as a position not a finding. And this calm is about the measured costs of moderate, anticipated inflation, not a claim the public is wrong to notice prices: people feel inflation through food and fuel, the items core removes.

Look at what you can now do. You can build a price index by pricing one fixed basket in two periods, and compute a rate by dividing the change by the earlier index. You can choose the index that fits the question, knowing they disagree. You can convert a nominal amount to a real one by deflating before comparing. You can say who gains from unexpected inflation, and why the surprise rather than the level moves purchasing power. And you can tell demand-pull from cost-push by looking at output. Unit seven turns to measuring trade with the world.