Whip inflation now.President Gerald Ford
(Reelection bid, 1976)

Inflation is Public Enemy #1.  President Jimmy Carter, 1976
(Lost reelection bid, 1980)

Inflation is the cruelest tax..President Ronald Reagan, 1982
(Reelected, 1984)

           

            After years of careful planning for retirement, a new home, or a child’s education, a saver can have his plans completely shattered by inflation.  Inflation - increases in most nominal prices - is a vital macroeconomic issue. Rapid inflation obscures the meaning of nominal prices, making even simple exchanges confusing and uncertain. Although some inflation has been of concern for decades, Americans have fortunately only rarely experienced the severe galloping inflation that has plagued other countries.

 

            The earliest recorded anti-inflation policies were price controls imposed by Egyptian pharaohs 4,000 years ago. In the United States, a battle against inflation begun during the 1960s escalated into the early 1980s, but inflation rates rose from 3.1 percent in 1967 to 13.6 percent in 1980. Finally, monetary growth was slashed during 1981--1982 to "cure" double-digit inflation. The employment rate as well as personal incomes were greatly affected, as this shock therapy to growth of Aggregate Demand plunged the economy into its deepest slump (1981--1983) since the Great Depression.  By 1986, the economy had largely recovered, while inflation fell below 2 percent. Nevertheless, through the mid-1990s, mild inflation persisted, with average prices rising 2 to 4 percent annually.

 

            The drop in U.S. national income in response to anti-inflationary policies parallels international adjustments. Russia's battle against inflation during 1990--1993, for example, imposed hardships on most Russians, threatening the presidency of Boris Yeltsin. Are efforts to control inflation worth the concomitant losses of employment and income? Such questions about costs and benefits are unanswerable without knowledge of what inflation is and how it is measured.

 

·        The Concept of Inflation

 

            Most people view any price hikes as inflationary, but macroeconomics is concerned primarily with changes in the average level of absolute prices---changes that reflect inflation or deflation.

            Inflation occurs when the average level of prices rises; the average price level falls during deflation.

Price increases for a single good may not be inflationary. For example, a rise in the price of cable service is not inflationary if offset by price cuts for movies or computer hardware. Only increases in the average price level constitute inflation.[1]

 

Inflation's Costs and Benefits

            Surprisingly, some people "win" from inflation, while others lose. Losses from inflation are of two major types. First, inflation may reduce the efficiency of production and distribution. In this case, there will be declines in standards of living. These are the real-income costs of inflation. Second, inflation fractures the implicit and explicit agreements that bind people together. These are the social costs of inflation.

 

Real-Income Costs of Inflation

            Inflation increases transaction costs and reduces real income (a) by making the information about market conditions summarized in monetary prices less certain, and (b) by unnecessarily shifting resources into the repricing of goods. Real income is also reduced because inflation distorts economic decisions.

 

Inflated Transaction Costs

 

Information about prices collected through expenditures of time and effort by producers, resource suppliers, and consumers becomes obsolete more quickly during inflation. Have you ever visited a store intending to buy a certain item, only to discover that you can no longer afford it because its price has risen? Workers are caught in a similar squeeze when they learn that price hikes have made it impossible for them to cover all the purchases they planned when they agreed to a wage offered by an employer. Transaction costs are increased, because perceptions about prices and purchasing power turn out to be mistaken far more frequently during inflationary periods than when average prices are stable.

            Another way inflation increases transaction costs is that resources that could have been used productively elsewhere are used to reprice goods. Some repricing occurs at all times because relative prices change even when price levels are stable. During an inflationary period, however, it is not unusual to find that most items in your grocery cart have been marked up since they were first put on the shelf. Restaurant menus and airline ticket schedules must be reprinted, and vending machines must be adjusted to accept new denominations of coins. Where government regulates prices (e.g., utility rates or bus fares), considerable time and effort may be absorbed in redesigning rate schedules. Such increases in information cost are called the menu costs of inflation.

 

Distortion Costs

            Another major cost of inflation emerges from feelings of uncertainty among savers and investors. Saving and investing reflects faith in the future. Uncertainty caused by inflation stifles investment and saving, which then hampers growth of Aggregate Supply. Funds that would normally flow into new capital may be diverted into real estate or inventories, so that growth and technological advances sputter well below the levels needed for a healthy economy. Firms also mark up price margins to compensate for increased risks. If so, over the long run, inflation causes Aggregate Supply to wither.

 

            Relative prices are distorted if inflation artificially causes prices to rise at different rates; inefficient decisions about production and consumption result. For example, many people incurred huge mortgages in the early 1980s that required monthly payments they could afford only if double-digit inflation continued. An epidemic of foreclosures swept the country during 1984--1991 when inflation slowed down. Many buyers might have waited were it not for their fear that "if we don't buy now, we won't ever be able to afford a home." Inefficiencies in decision making caused by inflation are termed distortion costs.

 

Social Costs of Inflation

            Inflation stimulates strife between buyers (who want low prices maintained) and sellers (who want prices raised to reflect rising production costs). Conflicts among consumers, producers, and regulatory agencies are accentuated during inflationary episodes. Ignoring menu and distortion costs for a moment, inflation is roughly what mathematicians call a zero sum game. For every loser during inflation (someone who must pay more for a given good), there is a winner (someone who receives a greater price for the things sold).

 

            You gain during inflation if the prices of things you sell go up faster than the prices of things you buy. Some people lose because their incomes do not keep pace with the average prices of the goods they buy. Why all the furor over inflation if the gains and losses are roughly in balance? Income redistributions from inflation are a major source of inflation's social costs. Even though losses to some are offset by gains to others, the process seems capricious and erodes the trust we have in each other.

 

            A basic problem is that inflation is often blamed for unfavorable events that would have arisen because of shifts in uninflated demands and supplies. Most of us feel that increases in our paychecks are much-deserved rewards for hard work. Have you ever considered that your raise is an increase in the price of your services and is seen as inflation by purchasers of the goods you produce? If your neighbor's pay rises faster than your own, supply and demand may be at work, not inflation.

 

            Even if our nominal income keeps pace with inflation, it erodes the value of money we have saved. A past irritant was that progressivity in our federal income tax system allowed inflation to bump us into higher tax brackets, a process called bracket creep. Federal income tax rates were indexed to inflation in 1985, reducing bracket creep, but it remains a problem where state or local governments use progressive taxes.

 

            On the other hand, the prices of physical assets such as land and housing often rise even more rapidly than the rate of inflation. Homeowners gain during inflation; prospective home buyers lose. Borrowers are an important group of gainers from inflation. Homeowners with huge mortgages find repaying loans increasingly easy if inflation pushes up nominal income. (Would you like to borrow $1,000,000 today if inflation was going to be 1,000,000 percent next year---before the loan was due?) Of course, borrowers' gains are almost exactly offset by losses in the real wealth of lenders.

 

            Government, business firms, farmers, and young families tend to be net debtors and often gain from unexpected inflation. The federal debt now exceeds $4 trillion. Holders of U.S. Treasury bonds are the losers in this exchange of wealth. Established households and mature people anticipating retirement are usually savers and lose from inflation. (The ultimate lenders are people with bank deposits, not bankers.) A related cost of inflation is that this redistributional effect of rewarding borrowing and penalizing saving provides substantial incentives to use credit, but going even deeper in debt than we already are is probably a bad idea for most of us.

 

            Still another consideration is that some people live on fixed incomes---their pensions or wage contracts are not adjusted for changes in the cost of living. The growing numbers of contracts containing escalator clauses illustrates how people adjust to inflation over time. Even so, there are people whose incomes are at least partially fixed; those living on life insurance annuities or who long ago contracted for long-term fixed-dollar payments to take care of their old age are examples. Inflation harms many senior citizens to the extent that portions of their incomes are fixed.

 

            Redistributions caused by inflation are commonly seen as arbitrary and capricious, but many social ills blamed on it actually result from other forces. You may have seen news programs about how low-income people suffer most from inflation, a charge refuted by most studies of this problem. The difficulties faced by the poor result from poverty, not inflation per se. Joseph Minarik analyzed census data and concluded that the sustained but moderate inflation of the 1970s harmed people at the top proportionally far more than people at the lower end of the income spectrum.[2]

 

            The income redistribution aspects of inflation generally do not affect the real level of national production, which Adam Smith (in 1776) rightly termed the wealth of nations. Rather, the redistributive properties of inflation are part of the larger problem of achieving and maintaining an equitable distribution of our real national income.

 

Benefits of Inflation

            A little inflationary pressure may ease needed changes in relative prices. This is especially true if price reductions are resisted more vigorously than price increases. For example, in the 1970s the demand for college professors fell due to declines in enrollment, but the supply of professors grew. Market pressures to reduce profs' real wages were accommodated fairly easily by allowing their salaries' purchasing power to shrink through inflation. During this period, the rate of inflation grew faster than nominal walary increases and thus, real salaries fell. This process would have been far more traumatic if colleges had been forced to negotiate lower money wages for faculty, which might have been necessary had the price level been stable.

 

            Inflation's effects on capital accumulation and economic growth may also be positive at times. If managers believe that equipment costs will rise in the near future, firms may invest more in capital equipment, boosting Aggregate Supply in the short run. Such planning can backfire, however; investment decisions made prematurely because of inflationary expectations can wipe out some investors.

 

            A third possible benefit is that inflation may ease expanding government spending relative to private spending. Politicians may prefer to use inflation to finance more government spending instead of relying on an unpopular tax system---spending can grow without paying for it directly via taxes. For example, inflationary pressures were allowed to build during World War II. Tax hikes sufficient to finance the war without inflation might have posed severe disincentives for production. Of course, many people would argue that under most circumstances, inflationary growth of government is a cost, not a benefit, of inflation. This issue will be treated in more detail in future chapters.

 

The Discomfort Index

            Arthur Okun, chairman of President Lyndon Johnson's Council of Economic Advisors, developed an index intended to summarize the general state of the economy.

The economic discomfort index equals the inflation rate plus the overall unemployment rate.

In 1976, Jimmy Carter renamed this the misery index and used it to brand President Ford's economic policies as failures. Ronald Reagan then resurrected the misery index to condemn economic performance during President Carter's administration. The index was also featured in the 1984 political campaign.

            The index for 4-year presidential terms (averaged to smooth short-run fluctuations) since 1950 is presented in Table 2. This index showed remarkable stability during the 1950s and 1960s but took a big jump during the 1970s and early 1980s. By 1990, however, the discomfort index had returned to levels accepted as normal before 1970.

Table 2  Average Discomfort Indices and Presidential Administrations, 1949-1994
Term	President	Avg % Inflation	Avg % Unemployment	Discomfort      Index
1949-52	Truman	2.8	4.4	7.2
1953-56	Eisenhower	1.4	4.2	5.6
1957-60	Eisenhower	1.7	5.5	7.2
1961-64	Kennedy-Johnson	1.2	5.8	7.0
1965-68	Johnson	3.2	3.9	7.1
1969-72	Nixon	4.6	5.0	9.6
1973-76	Nixon-Ford	8.2	6.7	14.9
1977-80	Carter	10.6	6.5	17.1
1981-84	Reagan	5.2	8.6	13.8
1985-88	Reagan	3.4	6.4	9.8
1989-92	Bush	4.3	6.3	10.6
1993-94	Clinton	3.1	5.9	9.0
Source: Economic Report of the President, 1994.

 

            Macroeconomic policies focus on the goals of full employment, price-level stability, and economic growth. Implementing appropriate policies requires relatively accurate measures of unemployment and inflation.

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