Inflation

Another factor in understanding the economy is inflation. InflationA general increase in the level of prices. is a general rise in the level of prices. Since World War II, it has been a near constant feature of most economies around the world.

Inflation has three basic causes:

1. Cost-pushInflation driven by a shortage of supply, such as oil.: If there’s a shortage of goods or inputs for goods, prices will rise if demand remains constant. You’ve already seen this in your lifetimes with oil and gasoline. When supply is interrupted, say, by a storm that shuts down refineries on the Gulf Coast, supply falls and prices rise.

2. Demand-pullInflation driven by demand that is rising faster than supply can respond.: If demand exceeds supply, prices will rise. So, turning to gasoline once again, people drive more in the summer as the weather improves and folks go on vacation. So, typically gasoline prices will rise after Memorial Day and fall after Labor Day, when school resumes and the weather begins to get worse. High government spending in the late 1960s, when the economy was already doing well, may have contributed to inflation in the 1970s.

   In both of these instances, markets will take care of the problem. Remember the law of supply: As prices rise, suppliers want to sell more of a good. The Arab Oil Embargo of the 1970s greatly restricted the supply of oil to the western world. Prices doubled and tripled in less than a decade. But higher prices made other sources of oil more economical to recover (such as the oil underneath the North Sea between Britain and Norway), and prices eventually came down. And don’t forget the law of demand: As prices rise, consumers want less of a good. In the latest run-up in gas prices, consumers stopped buying gas-guzzling vehicles and began to demand more high-mileage alternatives. More people take the bus or carpool. So the market tends to sort this kind of inflation out.

3. Printing too much money: Governments can cause inflation if they print too much money. This happened in Germany in the 1920s, when inflation got so high that restaurants stopped printing menus because prices were rising throughout the day. In more recent times, Argentina and Zimbabwe have struggled through bouts of prolonged inflation, as their governments simply printed too much money. Printing too much money can let the government spend more, which puts more cash in circulation, which makes everyone feel richer, temporarily. But if we all suddenly had more cash, we’d likely spend some of it, in the process bidding up prices.

Inflation isn’t usually good for an economy. It makes people feel somewhat helpless when they see prices rising all the time; it punishes savers, investors and lenders. Your savings account loses value as inflation increases; your investments also may be worth less. Lenders such as banks and other financial institutions see their loans lose value because they’re being paid back with cheaper dollars or euros or yuan. Conversely, borrowers are helped by inflation because their loan payments tend to stay the same even as their incomes rise with inflation. (That’s why banks began to offer adjustable rate mortgages—ARMS—for house loans. The rate can be adjusted up or down depending on inflation.) Inflation is especially hard on the poor and people on fixed incomes, because rising prices eat away at their purchasing power. Wealthier people may be able to shift their mix of investments to account for inflation (such as inflation-linked bonds). The poor don’t tend to have investments (or they wouldn’t be poor). Finally, inflation complicates business planning. So all in all, it’s not a good thing.

Another thing to remember about inflation is that it can make things seem more expensive than they are. Remember the idea of purchasing power parity—what does something cost relative to the incomes of a particular time and place? So when we talk about the price of something, there’s the money price, which is the nominal price, and the real price, which is the price accounting for inflation. We should always ask, what does a good or service cost today in constant dollars? The relative price is the price in terms of other goods and services. We also often consider the price adjusted for inflation, in order to tell if it’s more expensive now or earlier. For example, $3 a gallon gasoline may seem very expensive, but when you account for inflation, gasoline was more expensive both in 1918 and in the early 1980s. Similarly, while Avatar is listed as the top grossing film of all time, if you account for inflation (and hence the difference in relative ticket prices), the clear winner is Gone With the Wind.

In the United States, we measure inflation by the Consumer Price Index (CPI)The Consumer Price Index, a government measurement of price levels as experienced by a typical consumer., and by the Producer Price Index (PPI). As their names imply, the CPI is a measurement of inflation for consumer goods, and the PPI measures the price businesses receive for their products. Both are measured by the federal Bureau of Labor Statistics. Researchers from the BLS survey prices around the country, using a “market-basket” approach—a hypothetical list of things consumers might normally buy. The CPI includes a national average and several regional averages, to account for differences in costs of things in different parts of the country. It’s not bad measure, but because it is a laundry list of items, it’s not perfect. For example, if the price of clothing is rising, and you’re not buying any new clothes at the moment, the stated inflation rate is different from what you might be experiencing. The bureau also provides a “core” rate of inflation, subtracting out changes in the cost of food and energy. Those prices tend to be more volatile, experiencing wider swings in price over shorter periods of time. On the other hand, as everybody has to buy food and energy, the “core” rate may not be all that important.

Inflation doesn’t normally occur during recessions, because people are spending less money, so there’s less upward pressure on prices.The British economist A.W.H. Phillips suggested that there was a trade-off between inflation and unemployment, which became known as the Phillips Curve. Then some folks went out and tested inflation versus unemployment, to see if there was in fact a correlation. There was none. However, considering only these two statistics leaves out everything else that might be influencing either inflation or unemployment at the moment. Experience at least tells us that most of the time, if unemployment is high, we get less inflation, and if more people have jobs, prices may get pushed up. However, on occasion, a nation can experience inflation and a weak economy, which is called stagflationHigh inflation and high unemployment occurring at the same time.. This is the worst of all possible worlds: You’ve lost your job, and prices are rising. This only seems to happen if the inflation is driven by cost-factors. So, in the U.S. in the mid- to late 1970s, a soft economy meant high unemployment and the Arab oil embargo caused inflation by driving up the price of oil. (Rising or falling energy prices affect nearly everything else, since our society is so energy dependent.) Economists even came up with a “misery index,” combining numbers for inflation and unemployment.

It’s a particularly vexing problem for policy makers, because the usual fixes tend to make one or the other problem even worse. So, doing something to spur demand and raise employment levels may make the inflation worse; curbing demand to battle inflation will make the employment problem worse. In the long run, the market will sort out the inflation problem, because high prices will attract investment and eventually either more supply or alternatives to the high-priced goods. In the case of the U.S. in the 1970s, the answer was to raise interest rates to curb demand and crush inflation. That produced a very deep recession as well. As always, there were tradeoffs. The long-term solution to both problems is gains in productivity, but most people don’t want to wait that long for an answer. More on that in a moment.

The opposite of inflation is deflationA general decrease in the level of prices., which is when prices fall. This can be a good thing when it means prices are falling because firms’ costs are falling. The price of many electronic goods, from calculators to computers to smart phones, has fallen over the last several decades, as the start-up costs have been covered and firms have become more efficient at producing them. On the other hand, if prices are falling because of falling consumer demand, that means firms are selling goods at a loss. If firms can’t cover their costs, they go out of business, workers lose their jobs, and the whole economy takes a downward plunge. Few things scare economists and policy makers more than that kind of deflation.