Principle 8: Monetary and Fiscal policies influence people’s choices
Objectives
Define inflation as a sustained increase in the general price level.
Name three measures of inflation.
Explain the distributive effects of inflation and deflation.
Given sufficient data, calculate a real rate of interest.
Use FRED to analyze recent inflation data.
Inflation is a sustained increase in the general price level as measured by the rate of change of the Consumer Price Index (CPI) or the GDP Implicit Price Deflator (IPD) or the Personal Consumer Expenditure Price Index (PCE) . Deflation is a sustained decrease in the general price level. An annual inflation rate of 100% would mean that prices had doubled during the previous year. In the summary to Lesson 10a, we described the Consumer Price Index (CPI) and the Implicit Price Deflator (IPD) and the way that these two indices are used to measure the rate of inflation.
Why do we care about inflation or deflation?
Inflation is harmful to the economy in many ways. It confuses demanders and suppliers because they don’t know if an increase in their product is a change in the relative price of the product or not. In addition, unanticipated inflation arbitrarily redistributes purchasing power. Those who can increase their income as a result of inflation by an amount greater than inflation will benefit. If sellers can raise their prices beyond the increase in the general price level they will gain purchasing power.
Borrowers gain from unanticipated inflation since the interest rate they pay on the loan is often less than the rate of inflation. During times of unanticipated inflation, borrowers are paying back “less powerful” dollars than they borrowed, and the real interest rate is less than the stated interest rate. The real interest rate is the market rate minus the rate of inflation.
Example:
Peter and Sophia are good friends. Peter borrows $100 from Sophia. Sophia was going to use the money to buy some new computer software which would make her life much easier and more fun but she gives up that opportunity by lending the money to Peter. Sophia wants to be able to buy the software and she wants to be compensated for her deferred software consumption and the risk of not being repaid by Peter, her very close friend.
She charges him 5% interest for a year. A year later, Peter faithfully repays the loan with interest, giving Sophia $105. The problem is that inflation has been 9%. The $100 software now costs $109 ($100 * 1.09). Sophia can’t buy the software with the $105 that Peter handed her. The rate of interest of 5% was meant to compensate her for having to wait a year and she was supposed to be able to buy the software and have an additional $5 to do with as she pleased. But she didn’t ask enough to cover the unanticipated inflation, so, at the end of the year, she can’t even buy the software. If the rate of inflation is greater than the rate of interest charged to borrowers, the real rate of interest is negative.
Real rate of interest = market rate of interest minus the rate of inflation.
In Sophia’s case,
Real rate of interest = 5% - 9% = - 4%
What should Sophia have done if she had correctly anticipated the inflation rate? She would have wanted to charge 9% to cover the inflation and something, say 3%, for delayed consumption and the risk of not being repaid. If she had correctly anticipated inflation, she would have charged 12%: 3% would be the real rate of interest.
So unanticipated inflation hurts borrowers and helps lenders. Borrowers repay loans with weaker dollars, dollars that can buy less than the dollars that were loaned.
Other groups are also affected by inflation. Retirees on fixed incomes can see their incomes dwindle in terms of purchasing power. If their income is $30,000 per year and the rate of inflation is 10%, they lose the equivalent of $3,000 in purchasing power. If the inflation continues, they will eventually have little or no income. While this may sound far-fetched, it happens to people every day. Inflation can be disastrous for people on fixed incomes. Similarly, inflation can have dramatic effects on savers whose interest rates are lower than the rate of inflation.
Business owners become confused by inflation because it distorts the signals sent by prices. Is a change in the price of a product simply a reflection of inflation, or is it a genuine increase in the relative prices of products? Workers whose salaries don’t increase as much as inflation lose purchasing power. Businesses with fixed contracts and owners of rentals with long term leases are also hurt by inflation.
Others are either unaffected or actually helped by inflation. As mentioned above, borrowers are helped if the interest they pay on their loans is less than the rate of inflation. In addition, some businesses are able to raise their prices faster than the rate of inflation, some unions with Cost of Living Adjustments can “overcompensate” for inflation.
To summarize, inflation is a sustained increase in the overall price level as measured by the CPI or the IPD. It distorts market signals and arbitrarily redistributes purchasing power and can wipe out folks who are living on fixed incomes or savers whose savings diminish as inflation erodes purchasing power.
What causes inflation?
A common and basically correct saying is that inflation is “too much money chasing too few goods.” In later lessons you will learn how the Federal Reserve increases the money supply but, at this point, it is sufficient to say that a goal of monetary policy is to ensure that the amount of money in the economy should increase by about the same percentage as the rate of economic growth (the increase in production of goods and services in the economy). Too much money causes inflation and too little money causes deflation. Inflation occurs when money increases too rapidly and deflation occurs when it increases too slowly. Think of an auction. Buyers enter the room and begin bidding on the objects for sale. After a while, a generous gentleman enters the room and gives each bidder a very large sum of money. What will happen to the average price bid on various products? Because people have more money, they are likely to increase their bids which means that the selling price of the products will increase. The same thing is true in the economy; if people have more money to spend, they will bid up the prices of goods and services. So, to avoid inflation, the Federal Reserve attempts to increase the money supply by about the same as the rate of economic growth.
Hyperinflation
Technically hyperinflation is a period of 50% or greater inflation. It is rapid and “out of control” inflation. During periods of hyperinflation, paper money is practically worthless. Perhaps the best example of hyperinflation was Germany under the Weimar Republic during the post World War I era. There were many problems with the German economy, one of the most serious being rampant inflation. The government was printing money as fast as people could spend it. Things got so bad that workers demanded to be paid twice a day so they could spend their money at noon because it would be worth so much less later in the day when they finished work. People papered their walls with money because that was "cheaper" than buying wallpaper. They burned mark notes for heat since it was cheaper than buying firewood.
More recently, in Zimbabwe in 2006, the price of a two-ply sheet of toilet paper was four hundred seventeen Zimbabwean dollars. A roll costs $145,750. A newspaper sold for 3 million Zimbabwean dollars and a chicken sold for 7.5 million Zimbabwean dollars per pound. In 2020 inflation reached 79.6 billion percent month-on-month. The largest Zimbabwean banknote printed was $100 trillion. These numbers are incomprehensible but what is clear is that this hyperinflation combined with government policies to attempt to stabilize the currency wiped out the savings of many hard-working Zimbabweans, some of whom were saving money to send their children to school. While we often treat inflation as an academic issue, it is earth shattering for many people.
Bottom Line
Inflation is a sustained increase in the general price level measured by changes in the CPI, the PCE or the IPD.
Unanticipated inflation hurts lenders and helps borrowers, hurts people on fixed incomes, hurts savers if the real interest rate is negative, distorts price signals, and generally arbitrarily redistributes purchasing power.
Inflation is caused by an increase in the money supply that is greater than the increase in real GDP.
Hyperinflation is inflation at or over 50%. It robs people of their income and savings and renders currencies useless.
Which of the following is NOT a measure of inflation?
CPI
PCE
INP
IPD
Which of the following is likely to be helped by unanticipated inflation?
Lenders
Borrowers
People on fixed incomes
Savers
Which of the following is most likely to cause inflation?
A decrease in the supply of cocoa beans
A strike by meat packers
An excessive increase in the money supply
An increase in the price of oil
You receive a 4% raise. The rate of inflation is 5%. Your real raise rate is?
1%
9%
-1%
--9%
Go to FRED and search for the Consumer Price Index. Scroll down to “Consumer Price Index: All Items: Total for United States”.
Look for a red bar towards the top that says “Edit Graph” Click on it. Change the units to “Percent change from a year ago” and the frequency to “Annual”.
Hold down the slider bar and pull it to the right until the graph displays 2006 to the present. What do you notice about 2009 Why might some people be upset about this? (Hint: the distributive effects of deflation are the opposite of inflation.)
What can you say about the years 2020 to the present?
If you are a Republican, what would you say about this period? What would a Democrat say?
Write a paragraph describing hyperinflation and its effects.
For a more detailed explanation of recent inflation, go to: https://www.bls.gov/opub/mlr/2023/beyond-bls/what-caused-inflation-to-spike-after-2020.htm