CHAPTER 18
How do we measure inflation?©Photodisc/Getty Images
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1. LO1Explain how the consumer price index (CPI) is constructed and use it to calculate the inflation rate.
2. LO2Show how the CPI is used to adjust dollar amounts to eliminate the effects of inflation.
3. LO3Discuss the two most important biases in the CPI.
4. LO4Distinguish between inflation and relative price changes in order to find the true costs of inflation.
5. LO5Summarize the connections among inflation, nominal interest rates, and real interest rates.
Would you be able to retire comfortably in 40 years if by then you managed to save $100 million?
If you did not immediately answer “Of course!” you may have very expensive taste; alternatively, you may hesitate because you do not know what $100 million will buy for you in 40 years. What if in 40 years one loaf of bread cost $5 million?
This $100 million question illustrates a simple but very important point, which is that the value of money depends entirely on the prices of the goods and services one wants to buy. A $100 million nest egg is a substantial fortune at the prices prevailing in the United States today, but it is only a pittance if a loaf of bread costs $5 million. Likewise, high and sustained inflation—a rapid and ongoing increase in the prices of most goods and services—can radically reduce the buying power of a given amount of money. History provides some extreme examples: many people who retired in 1923 in Germany or in 2008 in Zimbabwe found that their hard-earned lifetime savings could not buy for them even a single loaf of bread.
Over long periods of time, even much lower inflation rates—such as those in the U.S. over the past century—dramatically change the buying power of money, as Example 18.3 will illustrate. More generally, inflation can make a comparison of economic conditions at different points in time quite difficult. Your grandparents remember being able to buy both a comic book and a chocolate sundae for a quarter. Today, the same two items might cost $4 or $5. You might conclude from this fact that kids were much better off in “the good old days,” but were they really? Without more information, we can’t tell, for though the prices of comic books and sundaes have gone up, so have allowances. The real question is whether young people’s spending money has increased as much as or more than the prices of the things they want to buy. If so, then they are no worse off today than their grandparents were when they were young and candy bars cost a nickel.
Inflation also creates uncertainty when we try to look into the future, to ask questions such as: “How much should I plan to save for retirement?” The answer to this question depends on how much inflation is likely to occur before one retires (and thus how much heating oil, food, and clothing will cost). Inflation can pose similar problems for policymakers. For example, to plan long-term government spending programs they must estimate how much the government’s purchases will cost several years in the future.
An important benefit of studying macroeconomics is learning how to avoid the confusion inflation interjects into comparisons of economic conditions over time or projections for the future. In this chapter, a continuation of our study of the construction and interpretation of economic data, we will see how both prices and inflation are measured and how dollar amounts, such as the price of a sundae, can be “adjusted” to eliminate the effects of inflation. Quantities that are measured in dollars (or other currency units) and then adjusted for inflation are called real quantities (recall, for example, the concept of real GDP in Chapter 17, Measuring Economic Activity: GDP and Unemployment). By working with real quantities, economists can compare economic conditions across different years.
More important than the complications inflation creates for economic measurement are the costs that it imposes on the economy. In this chapter, we will see why high inflation can significantly impair an economy’s performance, to the extent that economic policymakers claim a low and stable rate of inflation as one of their chief objectives. We will conclude the chapter by showing how inflation is linked to another key economic variable, the rate of interest on financial assets.
THE CONSUMER PRICE INDEX AND INFLATION
The basic tool economists use to measure the price level in the U.S. economy is the consumer price index, or CPI for short. The CPI is a measure of the “cost of living” during a particular period. Specifically, the consumer price index (CPI) for any period measures the cost in that period of a standard set, or basket, of goods and services relative to the cost of the same basket of goods and services in a fixed year, called the base year.
To illustrate how the CPI is constructed, suppose the government has designated 2010 as the base year. Assume for the sake of simplicity that in 2010 a typical American family’s monthly household budget consisted of spending on just three items: rent on a two-bedroom apartment, hamburgers, and movie tickets. In reality, of course, families purchase hundreds of different items each month, but the basic principles of constructing the CPI are the same no matter how many items are included. Suppose too that the family’s average monthly expenditures in 2010, the base year, were as shown in Table 18.1.
Now let’s fast-forward to the year 2015. Over that period, the prices of various goods and services are likely to have changed; some will have risen and some fallen. Let’s suppose that by the year 2015 the rent that our family pays for their two-bedroom apartment has risen to $945. Hamburgers now cost $2.50 each, and the price of movie tickets has risen to $8.00 each. So, in general, prices have been rising.
By how much did the family’s cost of living increase between 2010 and 2015? Table 18.2 shows that if the typical family wanted to consume the same basket of goods and services in the year 2015 as they did in the year 2010, they would have to spend $1,175 per month, or $235 more than the $940 per month they spent in 2010. In other words, to live the same way in the year 2015 as they did in the year 2010, the family would have to spend 25 percent more ($235/$940) each month. So, in this example, the cost of living for the typical family rose 25 percent between 2010 and 2015.
The government—actually, the Bureau of Labor Statistics (BLS), the same agency that is responsible for determining the unemployment rate—calculates the official consumer price index (CPI) using essentially the same method. The first step in deriving the CPI is to pick a base year and determine the basket of goods and services that were consumed by the typical family during that year. In practice, the government learns how consumers allocate their spending through a detailed survey, called the Consumer Expenditure Survey, in which randomly selected families record every purchase they make and the price they paid over a given month. (Quite a task!) Let’s call the basket of goods and services that results the base-year basket. Then, each month BLS employees visit thousands of stores and conduct numerous interviews to determine the current prices of the goods and services in the base-year basket.1
The CPI in any given year is computed using this formula:
Returning to the example of the typical family that consumes three goods, we can calculate the CPI in the year 2015 as
In other words, in this example, the cost of living in the year 2015 is 25 percent higher than it was in 2010, the base year. Notice that the base-year CPI is always equal to 1.00 since in that year the numerator and the denominator of the CPI formula are the same. The CPI for a given period (such as a month or year) measures the cost of living in that period relative to what it was in the base year.
The BLS multiplies the CPI by 100 to get rid of the decimal point. If we were to do that here, the year 2015 CPI would be expressed as 125 rather than 1.25, and the base-year CPI would be expressed as 100 rather than 1.00. However, many calculations are simplified if the CPI is stated in decimal form, so we will not adopt the convention of multiplying it by 100.
EXAMPLE 18.1Calculating the CPI
How do we measure the typical family’s cost of living?
Suppose that in addition to the three goods and services the typical family consumed in 2010, they also bought four sweaters at $30 each. In the year 2015, the same sweaters cost $50 each. The prices of the other goods and services in 2010 and 2015 were the same as in Table 18.2. With this additional item, what was the change in the family’s cost of living between 2010 and 2015?
In the example in the text, the cost of the base-year (2010) basket was $940. Adding four sweaters at $30 each raises the cost of the base-year basket to $1,060. What does this same basket (including the four sweaters) cost in 2015? The cost of the apartment, the hamburgers, and the movie tickets is $1,175, as before. Adding the cost of the four sweaters at $50 each raises the total cost of the basket to $1,375. The CPI equals the cost of the basket in 2015 divided by the cost of the basket in 2010 (the base year), or $1,375/$1,060 = 1.30. We conclude that the family’s cost of living rose 30 percent between 2010 and 2015.
CONCEPT CHECK 18.1
Returning to the three-good example in Tables 18.1 and 18.2, find the year 2015 CPI if the rent on the apartment falls from $750 in 2010 to $600 in 2015. The prices for hamburgers and movie tickets in the two years remain the same as in the two tables.
The CPI does not measure the price of a specific good or service. Indeed, it has no units of measurement at all since the dollars in the numerator of the fraction cancel with the dollars in the denominator. Rather, the CPI is an index. The value of an index in a particular year has meaning only in comparison with the value of that index in another year. Thus, a price index measures the average price of a class of goods or services relative to the price of those same goods or services in a base year. The CPI is an especially well-known price index, one of many economists use to assess economic trends. For example, because manufacturers tend to pass on increases in the prices of raw materials to their customers, economists use indexes of raw materials’ prices to forecast changes in the prices of manufactured goods. Other indexes are used to study the rate of price change in energy, food, health care, and other major sectors.
CONCEPT CHECK 18.2
The consumer price index captures the cost of living for the “typical” or average family. Suppose you were to construct a personal price index to measure changes in your own cost of living over time. In general, how would you go about constructing such an index? Why might changes in your personal price index differ from changes in the CPI?
INFLATION
The CPI provides a measure of the average level of prices relative to prices in the base year. Inflation, in contrast, is a measure of how fast the average price level is changing over time. The rate of inflation is defined as the annual percentage rate of change in the price level, as measured, for example, by the CPI. Suppose, for example, that the CPI has a value of 1.25 in the year 2016 and a value of 1.27 in the year 2017. The rate of inflation between 2016 and 2017 is the percentage increase in the price level, or the increase in the price level (0.02) divided by the initial price level (1.25), which is equal to 1.6 percent.
EXAMPLE 18.2Calculating Inflation Rates: 1972–1976
How do we calculate the inflation rate using the CPI?
CPI values for the years 1972 through 1976 are shown in the following table. Find the rates of inflation between 1972 and 1973, 1973 and 1974, 1974 and 1975, and 1975 and 1976.
The inflation rate between 1972 and 1973 is the percentage increase in the price level between those years, or (0.444 − 0.418)/0.418 = 0.026/0.418 = 0.062 = 6.2 percent. Do the calculations on your own to confirm that inflation during each of the next three years was 11.0, 9.1, and 5.8 percent, respectively. During the 1970s, inflation rates were much higher than the 1.5 to 3 percent inflation rates that have prevailed in most years during the past quarter century.
CONCEPT CHECK 18.3
Following are CPI values for the years 1929 through 1933. Find the rates of inflation between 1929 and 1930, 1930 and 1931, 1931 and 1932, and 1932 and 1933.
How did inflation rates in the 1930s differ from those of the 1970s?
CONCEPT CHECK 18.4
CPI values for the years 2012 to 2016 are shown here. Calculate the inflation rate for each year.
The results of the calculations for Concept Check 18.3 include some examples of negative inflation rates. A situation in which the prices of most goods and services are falling over time so that inflation is negative is called deflation. The early 1930s was the last time the United States experienced significant deflation. Japan experienced relatively mild deflation during the past two decades. As Concept Check 18.4 demonstrates, most recently in the U.S. inflation rates have been low (below 2 percent) but not negative.
ADJUSTING FOR INFLATION
The CPI is an extremely useful tool. Not only does it allow us to measure changes in the cost of living; it also can be used to adjust economic data to eliminate the effects of inflation. In this section, we will see how the CPI can be used to convert quantities measured at current dollar values into real terms, a process called deflating. We also will see that the CPI can be used to convert real quantities into current-dollar terms, a procedure called indexing. Both procedures are useful not only to economists but to anyone who needs to adjust payments, accounting measures, or other economic quantities for the effects of inflation.
DEFLATING A NOMINAL QUANTITY
An important use of the CPI is to adjust nominal quantities—quantities measured at their current dollar values—for the effects of inflation. To illustrate, suppose we know that the typical family in a certain metropolitan area had a total income of $40,000 in 2010 and $44,000 in 2015. Was this family economically better off in the year 2015 than in 2010?
Without any more information than this, we might be tempted to say yes. After all, their income rose by 10 percent over the five-year period. But prices also might have been rising, as fast as or faster than the family’s income. Suppose the prices of the goods and services the family consumes rose 25 percent over the same period. Since the family’s income rose only 10 percent, we would have to conclude that the family is worse off, in terms of the goods and services they can afford to buy, despite the increase in their nominal, or current-dollar, income.
We can make a more precise comparison of the family’s purchasing power in 2010 and 2015 by calculating their incomes in those years in real terms. In general, a real quantity is one that is measured in physical terms—for example, in terms of quantities of goods and services. To convert a nominal quantity into a real quantity, we must divide the nominal quantity by a price index for the period, as shown in Table 18.3. The calculations in the table show that in real or purchasing power terms, the family’s income actually decreased by $4,800, or 12 percent of their initial real income of $40,000, between 2010 and 2015.
The problem for this family is that though their income has been rising in nominal (dollar) terms, it has not kept up with inflation. Dividing a nominal quantity by a price index to express the quantity in real terms is called deflating the nominal quantity. (Be careful not to confuse the idea of deflating a nominal quantity with deflation, or negative inflation. The two concepts are different.)
Dividing a nominal quantity by the current value of a price index to measure it in real or purchasing power terms is a very useful tool. It can be used to eliminate the effects of inflation from comparisons of any nominal quantity—workers’ wages, health care expenditures, the components of the federal budget—over time. Why does this method work? In general, if you know both how many dollars you have spent on a given item and the item’s price, you can figure out how many of the item you bought (by dividing your expenditures by the price). For example, if you spent $100 on hamburgers last month and hamburgers cost $2.50 each, you can determine that you purchased 40 hamburgers. Similarly, if you divide a family’s dollar income or expenditures by a price index, which is a measure of the average price of the goods and services they buy, you will obtain a measure of the real quantity of goods and services they purchased. Such real quantities are sometimes referred to as inflation-adjusted quantities.
EXAMPLE 18.3Babe Ruth versus Clayton Kershaw
Who earned more, Babe Ruth or Clayton Kershaw?
In 1930, the great baseball player Babe Ruth earned a salary of $80,000. When it was pointed out to him that he had earned more than President Hoover, Ruth replied, with some justification, “I had a better year than he did.” In 2017, the highest-paid baseball player was Clayton Kershaw, a star pitcher for the Los Angeles Dodgers. His total earnings were $33.8 million: He earned $33 million in salary and an estimated $800,000 in endorsements. Adjusting for inflation, whose salary was higher, Ruth’s or Kershaw’s?
To answer this question, we need to know that the CPI (using the average of 1982–1984 as the base year) was 0.167 in 1930 and as of July 2017, it was 2.45 (for simplicity, we will treat this figure as if it were the annual 2017 figure). Dividing Babe Ruth’s salary by 0.167, we obtain approximately $479,000, which is Ruth’s salary “in 1982–1984 dollars.” In other words, to enjoy the same purchasing power during the 1982–1984 period as in 1930, the Babe would have needed a salary of $479,000. Dividing Clayton Kershaw’s 2017 salary by the July 2017 CPI, 2.45, yields a salary of $13.5 million in 1982–1984 dollars. We can now compare the salaries of the two players. Although adjusting for inflation brings the two figures closer together (since part of Kershaw’s higher salary compensates for the increase in prices between 1930 and 2017), in real terms Kershaw’s salary was still more than 28 times Ruth’s salary. Incidentally, Kershaw’s salary was also about 82 times the U.S. president’s salary.
Clearly, in comparing wages or earnings at two different points in time, we must adjust for changes in the price level. Doing so yields the real wage—the wage measured in terms of real purchasing power. The real wage for any given period is calculated by dividing the nominal (dollar) wage by the CPI for that period.
CONCEPT CHECK 18.5
In 2001, Barry Bonds of the San Francisco Giants hit 73 home runs, breaking the previous single-season home run record and becoming the current record holder. Bonds earned $10.3 million in 2001. In that year the CPI was 1.77. How did Bonds’ real earnings compare to Ruth’s and Kershaw’s real salaries?
EXAMPLE 18.4Real Wages of U.S. Production Workers
How do you compare workers’ real wages?
Production workers are nonsupervisory workers, such as those who work on factory assembly lines. According to the Bureau of Labor Statistics, the average U.S. production worker earned $3.40 per hour in 1970 and $21.56 in 2016. Compare the real wages for this group of workers in these years.
To find the real wage in 1970 and 2016, we need to know the CPI in both years and then divide the wage in each year by the CPI for that year. For 1970, the nominal wage was $3.40 and the CPI was 0.388 (using the 1982–1984 average as the base period), so the real wage in 1970 was $8.76. Similarly, in 2016 the nominal wage was $21.56 and the CPI was 2.40, so the real wage in 2016 was $8.98. Thus, we find that in real terms, production workers’ wages stayed almost the same between 1970 and 2016, despite the fact that the nominal wage in 2016 was more than six times the nominal wage in 1970.
Figure 18.1 shows nominal wages and real wages for U.S. production workers for the period 1970–2016. Notice the dramatic difference between the two trends. Looking only at nominal wages, one might conclude that production-line workers were much better paid in 2016 than in 1970. But once wages are adjusted for inflation, we see that, in terms of buying power, production-line workers’ wages have stagnated since the early 1970s. This example illustrates the crucial importance of adjusting for inflation when comparing dollar values over time.
FIGURE 18.1 Nominal and Real Wages for Production Workers, 1970–2016.Though nominal wages of production workers have risen dramatically since 1970, real wages have stagnated.Source: FRED, Federal Reserve Economic Data, from the Federal Reserve Bank of St. Louis, http://fred.stlouisfed.org.
CONCEPT CHECK 18.6
In 1950, the minimum wage prescribed by federal law was $0.75 per hour. In 2016, it was $7.25 per hour. The CPI was 0.24 in 1950 and 2.40 in 2016. How does the real minimum wage in 2016 compare to that of 1950?
INDEXING TO MAINTAIN BUYING POWER
The consumer price index also can be used to convert real quantities to nominal quantities. Suppose, for example, that in the year 2015, the government paid certain Social Security recipients $1,000 per month in benefits. Let’s assume that Congress would like the buying power of these benefits to remain constant over time so that the recipients’ standard of living is unaffected by inflation. To achieve that goal, at what level should Congress set the monthly Social Security benefit in the year 2020?
The nominal, or dollar, benefit Congress should pay in the year 2020 to maintain the purchasing power of retired people depends on how much inflation has taken place between 2015 and 2020. Suppose that the CPI has risen 20 percent between 2015 and 2020. That is, on average the prices of the goods and services consumers buy have risen 20 percent over that period. For Social Security recipients to “keep up” with inflation, their benefit in the year 2020 must be $1,000 + .20($1,000) = $1,200 per month, or 20 percent more than it was in 2015. In general, to keep purchasing power constant, the dollar benefit must be increased each year by the percentage increase in the CPI.
The practice of increasing a nominal quantity according to changes in a price index to prevent inflation from eroding purchasing power is called indexing. In the case of Social Security, federal law provides for the automatic indexing of benefits. Each year, without any action by Congress, benefits increase by an amount equal to the percentage increase in the CPI. Some labor contracts are indexed as well so that wages are adjusted fully or partially for changes in inflation (See Example 18.5).
EXAMPLE 18.5An Indexed Labor Contract
How much do workers get paid when they have an indexed contract?
A labor contract provides for a first-year wage of $12.00 per hour and specifies that the real wage will rise by 2 percent in the second year of the contract and by another 2 percent in the third year. The CPI is 1.00 in the first year, 1.05 in the second year, and 1.10 in the third year. Find the dollar wage that must be paid in the second and third years of the contract.
Because the CPI is 1.00 in the first year, both the nominal wage and the real wage are $12.00. Let W2 stand for the nominal wage in the second year. Deflating by the CPI in the second year, we can express the real wage in the second year as W2/1.05. The contract says that the second-year real wage must be 2 percent higher than the real wage in the first year, so W2/1.05 = $12.00 × 1.02 = $12.24. Multiplying through by 1.05 to solve for W2, we get W2 = $12.85, the nominal wage required by the contract in the second year. In the third year, the nominal wage W3 must satisfy the equation W3/1.10 = $12.24 × 1.02 = $12.48. (Why?) Solving this equation for W3 yields $13.73 as the nominal wage that must be paid in the third year.
CONCEPT CHECK 18.7
The minimum wage is not indexed to inflation, but suppose it had been starting in 1950. What would the nominal minimum wage have been in 2016? See Concept Check 18.6 for the data necessary to answer this question.
The Economic Naturalist 18.1
Every few years, there is a well-publicized battle in Congress over whether the minimum wage should be raised. Why do these heated legislative debates recur so regularly?
Because the minimum wage is not indexed to inflation, its purchasing power falls as prices rise. Congress must therefore raise the nominal minimum wage periodically to keep the real value of the minimum wage from eroding. Ironically, despite the public’s impression that Congress has raised the nominal minimum wage steeply over the years, the real minimum wage has fallen almost 30 percent since 1970.
Why doesn’t Congress index the minimum wage to the CPI and eliminate the need to reconsider it so often? Evidently, some members of Congress prefer to hold a highly publicized debate on the issue every few years—perhaps because it mobilizes both advocates and opponents of the minimum wage to make campaign donations to those members who represent their views.
RECAP
METHODS TO ADJUST FOR INFLATION
Deflating. To correct a nominal quantity, such as a family’s dollar income, for changes in the price level, divide it by a price index such as the CPI. This process expresses the nominal quantity in terms of real purchasing power. If nominal quantities from two different years are deflated by a price index with the same base year, the purchasing power of the two deflated quantities can be compared.
Indexing. To ensure that a nominal payment, such as a Social Security benefit, represents a constant level of real purchasing power, increase the nominal quantity each year by a percentage equal to the rate of inflation for that year.
DOES THE CPI MEASURE “TRUE” INFLATION?
You may have concluded that measuring inflation is straightforward, but as with GDP and the unemployment rate, the issue is not free from controversy. Indeed the question of whether U.S. inflation is properly measured has been the subject of serious debate. Because the CPI is one of the most important U.S. economic statistics, the issue is far from academic. Policymakers pay close attention to the latest inflation numbers when deciding what actions to take. Furthermore, because of the widespread use of indexing, changes in the CPI directly impact the government’s budget. For example, if the CPI rises by 3 percent during a given year, by law Social Security benefits—which are a significant part of the federal budget—increase automatically by 3 percent. Many other government payments and private contracts, such as union labor contracts, are indexed to the CPI as well.
One of the difficulties in measuring inflation is that in practice, government statisticians cannot always adjust adequately for changes in the quality of goods and services. Suppose a new laptop computer has 20 percent more memory, computational speed, and data storage capacity than last year’s model. Suppose too for the sake of illustration that its price is 20 percent higher. Has there been inflation in computer prices? Economists would say no; although consumers are paying 20 percent more for a computer, they are getting a 20 percent better machine. The situation is really no different from paying 20 percent more for a pizza that is 20 percent bigger. However, because quality change is difficult to measure precisely and because they have many thousands of goods and services to consider, government statisticians often miss or understate changes in quality. In general, whenever statisticians fail to adjust adequately for improvements in the quality of goods or services, they will tend to overstate inflation. This type of overstatement is called quality adjustment bias.
One important consequence of quality adjustment bias, and of an overstated rate of inflation in general, is an underestimation of the true improvement in living standards over time. If the typical family’s nominal income increases by 3 percent per year, and inflation is reported to be 3 percent per year, economists would conclude that American families are experiencing no increase in their real income. But if the “true” inflation rate, adjusting for quality improvements, is really 2 percent per year, then the family’s real income is actually rising by 1 percent per year (the 3 percent increase in nominal income minus 2 percent inflation).
The Bureau of Labor Statistics (the agency responsible for calculating the CPI) makes significant efforts to adjust for quality and avoid overstating inflation. In spite of these efforts, in recent years some economists have argued that the problem of quality adjustment bias has in fact been getting worse. For example, some argue that as the U.S. economy shifts from producing computer hardware to producing software and digital content, accurately measuring quality change becomes increasingly harder.
An extreme example of quality adjustment bias can occur whenever a totally new good becomes available. For instance, the introduction of the first effective AIDS drugs significantly increased the quality of medical care received by AIDS patients. In practice, however, quality improvements that arise from totally new products are likely to be poorly captured by the CPI, if at all. The problem is that because the new good was not produced in the base year, there is no base-year price with which to compare the current price of the good. Government statisticians use various approaches to correct for this problem, such as comparing the cost of the new drug to the cost of the next-best therapies. But such methods are necessarily imprecise and open to criticism.
Another problem in measuring inflation arises from the fact that the CPI is calculated for a fixed basket of goods and services. This procedure does not allow for the possibility that consumers can switch from products whose prices are rising to those whose prices are stable or falling. Ignoring the fact that consumers can switch from more expensive to less expensive goods leads statisticians to overestimate the true increase in the cost of living and, again, underestimate the true improvement in living standards over time.
Suppose, for instance, that people like coffee and tea equally well and in the base year consumed equal amounts of each. But then a frost hits a major coffee-producing nation, causing the price of coffee to double. The increase in coffee prices encourages consumers to forgo coffee and drink tea instead—a switch that doesn’t make them worse off since they like coffee and tea equally well. However, the CPI, which measures the cost of buying the base-year basket of goods and services, will rise significantly when the price of coffee doubles. This rise in the CPI, which ignores the fact that people can substitute tea for coffee without being made worse off, exaggerates the true increase in the cost of living. This type of overstatement of inflation is called substitution bias.
EXAMPLE 18.6Substitution Bias
Why does substitution bias matter?
Suppose the CPI basket for 2010, the base year, is as follows:
Assume that consumers are equally happy to drink coffee or tea with their scones. In 2010, coffee and tea cost the same, and the average person drinks equal amounts of coffee and tea.
In the year 2015, coffee has doubled in price to $2 per cup. Tea remains at $1 per cup, and scones are $1.50 each. What has happened to the cost of living as measured by the CPI? How does this result compare to the true cost of living?
To calculate the value of the CPI for the year 2015, we must first find the cost of consuming the 2010 basket of goods in that year. At year 2015 prices, 50 cups each of coffee and tea and 100 scones cost (50 × $2) + (50 × $1) + (100 × $1.50) = $300. Since consuming the same basket of goods cost $200 in 2010, the base year, the CPI in 2015 is $300/$200, or 1.50. This calculation leads us to conclude that the cost of living has increased 50 percent between 2010 and 2015.
However, we have overlooked the possibility that consumers can substitute a cheaper good (tea) for the more expensive one (coffee). Indeed, since consumers like coffee and tea equally well, when the price of coffee doubles, they will shift entirely to tea. Their new consumption basket—100 cups of tea and 100 scones—is just as enjoyable to them as their original basket. If we allow for the substitution of less expensive goods, how much has the cost of living really increased? The cost of 100 cups of tea and 100 scones in the year 2015 is only $250, not $300. From the consumer’s point of view, the true cost of living has risen by only $50, or 25 percent. The 50 percent increase in the CPI therefore overstates the increase in the cost of living as the result of substitution bias.
While quality adjustment bias and substitution bias undoubtedly distort the measurement of inflation, estimating precisely how much of an overstatement they create is difficult. (If economists knew exactly how big these biases were, they could simply correct the data.) Nonetheless, the Bureau of Labor Statistics has in the past two decades made significant efforts to improve the quality of its data.
THE COSTS OF INFLATION: NOT WHAT YOU THINK
In the late 1970s, when inflation was considerably higher than it is now, the public told poll takers that they viewed it as “public enemy number one”—that is, as the nation’s most serious problem.
Although U.S. inflation rates have not been very high in recent years, today many Americans remain concerned about inflation or the threat of inflation. Why do people worry so much about inflation? Detailed opinion surveys often find that many people are confused about the meaning of inflation and its economic effects. When people complain about inflation, they are often concerned primarily about relative price changes.
Before describing the true economic costs of inflation, which are real and serious, let’s examine this confusion people experience about inflation and its costs.
We need first to distinguish between the price level and the relative price of a good or service. The price level is a measure of the overall level of prices at a particular point in time as measured by a price index such as the CPI. Recall that the inflation rate is the percentage change in the price level from year to year. In contrast, a relative price is the price of a specific good or service in comparison to the prices of other goods and services. For example, if the price of oil were to rise by 10 percent while the prices of other goods and services were rising on average by 3 percent, the relative price of oil would increase. But if oil prices rise by 3 percent while other prices rise by 10 percent, the relative price of oil would decrease. That is, oil would become cheaper relative to other goods and services, even though it has not become cheaper in absolute terms.
Public opinion surveys suggest that many people are confused about the distinction between inflation, which is an increase in the overall price level, and an increase in a specific relative price. Suppose that supply disruptions in the Middle East were to double the price of gas at the pump, leaving other prices unaffected. Appalled by the increase in gasoline prices, people might demand that the government do something about “this inflation.” But while the increase in gas prices hurts consumers, is it an example of inflation? Gasoline is only one item in a consumer’s budget, one of the thousands of goods and services that people buy every day. Thus, the increase in the price of gasoline might affect the overall price level, and hence the inflation rate, only slightly. In this example, inflation is not the real problem. What upsets consumers is the change in the relative price of gasoline, particularly compared to the price of labor (wages). By increasing the cost of using a car, the increase in the relative price of gasoline reduces the income people have left over to spend on other things.
Again, changes in relative prices do not necessarily imply a significant amount of inflation. For example, increases in the prices of some goods could well be counterbalanced by decreases in the prices of other goods, in which case the price level and the inflation rate would be largely unaffected. Conversely, inflation can be high without affecting relative prices. Imagine, for instance, that all prices in the economy, including wages and salaries, go up exactly 10 percent each year. The inflation rate is 10 percent, but relative prices are not changing. Indeed, because wages (the price of labor) are increasing by 10 percent per year, people’s ability to buy goods and services is unaffected by the inflation.
These examples show that changes in the price level (inflation) and changes in the relative prices of specific goods are two quite different issues. The public’s tendency to confuse the two is important because the remedies for the two problems are different. To counteract changes in relative prices, the government would need to implement policies that affect the supply and demand for specific goods. In the case of an increase in oil prices, for example, the government could try to restore supplies by mediating the peace process in the Middle East, or it could try to encourage the development of alternative sources of energy. To counteract inflation, however, the government must resort (as we will see) to changes in macroeconomic policies such as monetary or fiscal policies. If, in confusion, the public forces the government to adopt anti-inflationary policies when the real problem is a relative price change, the economy could actually be hurt by the effort. This is an important example of why economic literacy is important—to both policymakers and the general public.
EXAMPLE 18.7The Price Level, Relative Prices, and Inflation
Has the price of oil risen faster or slower than the price level?
Suppose the value of the CPI is 1.20 in the year 2015, 1.32 in 2016, and 1.40 in 2017. Assume also that the price of oil increases 8 percent between 2015 and 2016 and another 8 percent between 2016 and 2017. What is happening to the price level, the inflation rate, and the relative price of oil?
The price level can be measured by the CPI. Since the CPI is higher in 2016 than in 2015 and higher still in 2017 than in 2016, the price level is rising throughout the period. Since the CPI increases by 10 percent between 2015 and 2016, the inflation rate between those years is 10 percent. However, the CPI increases only about 6 percent between 2016 and 2017 (1.40/1.32 ≈ 1.06), so the inflation rate decreases to about 6 percent between those years. The decline in the inflation rate implies that although the price level is still rising, it is doing so at a slower pace than the year before.
The price of oil rises 8 percent between 2015 and 2016. But because the general inflation over that period is 10 percent, the relative price of oil—that is, its price relative to all other goods and services—falls by about 2 percent (8% − 10% = −2%). Between 2016 and 2017, the price of oil rises by another 8 percent, while the general inflation rate is about 6 percent. Hence, the relative price of oil rises between 2016 and 2017 by about 2 percent (8% − 6%).
THE TRUE COSTS OF INFLATION
Having dispelled the common confusion between inflation and relative price changes, we are now free to address the true economic costs of inflation. There are a variety of such costs, each of which tends to reduce the efficiency of the economy. Five of the most important are discussed here.
“Noise” in the Price System
In Chapter 3, Supply and Demand, we described the remarkable economic coordination that is necessary to provide the right amount and the right kinds of food to New Yorkers every day. This feat is not orchestrated by some Food Distribution Ministry staffed by bureaucrats. It is done much better by the workings of free markets, operating without central guidance, than a ministry ever could.
How do free markets transmit the enormous amounts of information necessary to accomplish complex tasks like the provisioning of New York City? The answer is through the price system. When the owners of French restaurants in Manhattan cannot find sufficient quantities of chanterelles, a particularly rare and desirable mushroom, they bid up its market price. Specialty food suppliers notice the higher price for chanterelles and realize that they can make a profit by supplying more chanterelles to the market. At the same time, price-conscious diners will shift to cheaper, more available mushrooms. The market for chanterelles will reach equilibrium only when there are no more unexploited opportunities for profit and both suppliers and demanders are satisfied at the market price (the Equilibrium Principle). Multiply this example a million times, and you will gain a sense of how the price system achieves a truly remarkable degree of economic coordination.
When inflation is high, however, the subtle signals that are transmitted through the price system become more difficult to interpret, much in the way that static, or “noise,” makes a radio message harder to interpret. In an economy with little or no inflation, the supplier of specialty foodstuffs will immediately recognize the increase in chanterelle prices as a signal to bring more to market. If inflation is high, however, the supplier must ask whether a price increase represents a true increase in the demand for chanterelles or is just a result of the general inflation, which causes all food prices to rise. If the price rise reflects only inflation, the price of chanterelles relative to other goods and services has not really changed. The supplier therefore should not change the quantity of mushrooms he brings to market.
In an inflationary environment, to discern whether the increase in chanterelle prices is a true signal of increased demand, the supplier needs to know not only the price of chanterelles, but also what is happening to the prices of other goods and services. Because this information takes time and effort to collect, the supplier’s response to the change in chanterelle prices is likely to be slower and more tentative.
In summary, price changes are the market’s way of communicating information to suppliers and demanders. An increase in the price of a good or service, for example, tells demanders to economize on their use of the good or service and suppliers to bring more of it to market. But in the presence of inflation, prices are affected not only by changes in the supply and demand for a product but by changes in the general price level. Inflation creates static, or “noise,” in the price system, obscuring the information transmitted by prices and reducing the efficiency of the market system. This reduction in efficiency imposes real economic costs.
Distortions of the Tax System
Just as some government expenditures, such as Social Security benefits, are indexed to inflation, many taxes are also indexed. In the United States, people with higher incomes pay a higher percentage of their income in taxes. Without indexing, an inflation that raises people’s nominal incomes would force them to pay an increasing percentage of their income in taxes, even though their real incomes may not have increased. To avoid this phenomenon, which is known as bracket creep, Congress has indexed income tax brackets to the CPI. The effect of this indexation is that a family whose nominal income is rising at the same rate as inflation does not have to pay a higher percentage of income in taxes.
Although indexing has solved the problem of bracket creep, many provisions of the tax code have not been indexed, either because of lack of political support or because of the complexity of the task. As a result, inflation can produce unintended changes in the taxes people pay, which in turn may cause them to change their behavior in economically undesirable ways.
To illustrate, an important provision in the business tax code for which inflation poses problems is the capital depreciation allowance, which works as follows. Suppose a firm buys a machine for $1,000, expecting it to last for 10 years. Under U.S. tax law, the firm can take one-tenth of the purchase price, or $100, as a deduction from its taxable profits in each of the 10 years. By deducting a fraction of the purchase price from its taxable profits, the firm reduces its taxes. The exact amount of the yearly tax reduction is the tax rate on corporate profits times $100.
The idea behind this provision of the tax code is that the wearing out of the machine is a cost of doing business that should be deducted from the firm’s profit. Also, in giving firms a tax break for investing in new machinery, Congress intended to encourage firms to modernize their plants. Yet capital depreciation allowances are not indexed to inflation. Suppose that, at a time when the inflation rate is high, a firm is considering purchasing a $1,000 machine. The managers know that the purchase will allow them to deduct $100 per year from taxable profits for the next 10 years. But that $100 is a fixed amount that is not indexed to inflation. Looking forward, managers will recognize that 5, 6, or 10 years into the future, the real value of the $100 tax deduction will be much lower than at present because of inflation. They will have less incentive to buy the machine and may decide not to make the investment at all. Indeed, many studies have found that a high rate of inflation can significantly reduce the rate at which firms invest in new factories and equipment.
Because the U.S. tax code contains hundreds of provisions and tax rates that are not indexed, inflation can seriously distort the incentives provided by the tax system for people to work, save, and invest. The resulting effects on economic efficiency and economic growth represent a real cost of inflation.
“Shoe-Leather” Costs
As all shoppers know, cash is convenient. Unlike checks, which are not accepted everywhere, and credit cards, for which a minimum purchase is sometimes required, cash can be used in almost any routine transaction. Businesses, too, find cash convenient to hold. Having plenty of cash on hand facilitates transactions with customers and reduces the need for frequent deposits and withdrawals from the bank.
Inflation raises the cost of holding cash to consumers and businesses. Consider a miser with $10,000 in $20 bills under his mattress. What happens to the buying power of his hoard over time? If inflation is zero so that, on average, the prices of goods and services are not changing, the buying power of the $10,000 does not change over time. At the end of a year, the miser’s purchasing power is the same as it was at the beginning of the year. But suppose the inflation rate is 10 percent. In that case, the purchasing power of the miser’s hoard will fall by 10 percent each year. After a year, he will have only $9,000 in purchasing power. In general, the higher the rate of inflation, the less people will want to hold cash because of the loss of purchasing power that they will suffer.
Technically, currency is a debt owed by the government to the currency holder. So when currency loses value, the losses to holders of cash are offset by gains to the government, which now owes less in real terms to currency holders. Thus, from the point of view of society as a whole, the loss of purchasing power is not in itself a cost of inflation because it does not involve wasted resources. (Indeed, no real goods or services were used up when the miser’s currency hoard lost part of its value.)
However, when faced with inflation, people are not likely to accept a loss in purchasing power but, instead, will take actions to try to “economize” on their cash holdings. For example, instead of drawing out enough cash for a month the next time they visit the bank, they will draw out only enough to last a week. The inconvenience of visiting the bank more often to minimize one’s cash holdings is a real cost of inflation. Similarly, businesses will reduce their cash holdings by sending employees to the bank more frequently, or by installing computerized systems to monitor cash usage. To deal with the increase in bank transactions required by consumers and businesses trying to use less cash, banks will need to hire more employees and expand their operations.
The costs of more frequent trips to the bank, new cash management systems, and expanded employment in banks are real costs. They use up resources, including time and effort, that could be used for other purposes. Traditionally, the costs of economizing on cash have been called shoe-leather costs—the idea being that shoe leather is worn out during extra trips to the bank. Shoe-leather costs probably are not a significant problem in the United States today, where inflation is only 2 to 3 percent per year. But in economies with high rates of inflation, they can become quite significant.
Unexpected Redistributions of Wealth
When inflation is unexpected, it may arbitrarily redistribute wealth from one group to another. Consider a group of union workers who signed a contract setting their wages for the next three years. If those wages are not indexed to inflation, then the workers will be vulnerable to upsurges in the price level. Suppose, for example, that inflation is much higher than expected over the three years of the contract. In that case, the buying power of the workers’ wages—their real wages—will be less than anticipated when they signed the contract.
From society’s point of view, is the buying power that workers lose to inflation really “lost”? The answer is no; the loss in their buying power is exactly matched by an unanticipated gain in the employer’s buying power because the real cost of paying the workers is less than anticipated. In other words, the effect of the inflation is not to destroy purchasing power but to redistribute it, in this case from the workers to the employer. If inflation had been lower than expected, the workers would have enjoyed greater purchasing power than they anticipated and the employer would have been the loser.
Another example of the redistribution caused by inflation takes place between borrowers (debtors) and lenders (creditors). Suppose one of the authors of this book wants to buy a house on a lake and borrows $150,000 from the bank to pay for it. Shortly after signing the mortgage agreement, he learns that inflation is likely to be much higher than expected. How should he react to the news? Perhaps as a public-spirited macroeconomist, the author should be saddened to hear that inflation is rising, but as a consumer he should be pleased. In real terms, the dollars with which he will repay his loan in the future will be worth much less than expected. The loan officer should be distraught because the dollars the bank will receive from the author will be worth less, in purchasing power terms, than expected at contract signing. Once again, no real wealth is “lost” to the inflation; rather, the borrower’s gain is just offset by the lender’s loss. In general, unexpectedly high inflation rates help borrowers at the expense of lenders because borrowers are able to repay their loans in less-valuable dollars. Unexpectedly low inflation rates, in contrast, help lenders and hurt borrowers by forcing borrowers to repay in dollars that are worth more than expected when the loan was made.
Although redistributions caused by inflation do not directly destroy wealth, but only transfer it from one group to another, they are still bad for the economy. Our economic system is based on incentives. For it to work well, people must know that if they work hard, save some of their income, and make wise financial investments, they will be rewarded in the long run with greater real wealth and a better standard of living. Some observers have compared a high-inflation economy to a casino, in which wealth is distributed largely by luck—that is, by random fluctuations in the inflation rate. In the long run, a “casino economy” is likely to perform poorly, as its unpredictability discourages people from working and saving. A high-inflation economy encourages people to use up resources in trying to anticipate inflation and protect themselves against it.
Interference with Long-Term Planning
The fifth and final cost of inflation we will examine is its tendency to interfere with the long-term planning of households and firms. Many economic decisions take place within a long time horizon. Planning for retirement, for example, may begin when workers are in their twenties or thirties. And firms develop long-term investment and business strategies that look decades into the future.
Clearly, high and erratic inflation can make long-term planning difficult. Recall, for example, the question we asked in the beginning of this chapter: Would you be able to retire comfortably in 40 years if by then you managed to save $100 million? Let’s try to answer this question. Suppose that you want to enjoy a certain standard of living when you retire. How much of your income do you need to save to make your dreams a reality? That depends on what the goods and services you plan to buy will cost 40 years from now (would $100 million be enough to buy them during your retirement years?). With high and erratic inflation, even guessing what your chosen lifestyle will cost by the time you retire is extremely difficult. You may end up saving too little and having to compromise on your retirement plans; or you may save too much, sacrificing more than you need to during your working years. Either way, inflation will have proved costly.
In summary, inflation damages the economy in a variety of ways. Some of its effects are difficult to quantify and affect different segments of the population in different ways. But most economists agree that a low and stable inflation rate is instrumental in maintaining a healthy economy.
HYPERINFLATION
Although there is some disagreement about whether an inflation rate of, say, 5 percent per year imposes important costs on an economy, few economists would question the fact that an inflation rate of 500 percent or 1,000 percent per year disrupts economic performance. A situation in which the inflation rate is extremely high is called hyperinflation. Although there is no official threshold above which inflation becomes hyperinflation, inflation rates in the range of 500 to 1,000 percent per year would surely qualify.
In the past few decades, episodes of hyperinflation have occurred in Israel (400 percent inflation in 1985), Nicaragua (33,000 percent inflation in 1988), several South American countries, including Bolivia, Argentina, Brazil, and most recently Venezuela (forecast to have more than 1,000 percent inflation in 2017), and several countries attempting to make the transition from communism to capitalism, including Russia. Zimbabwe has recently experienced a severe episode of hyperinflation, and in early 2009, the Zimbabwean government issued a Z$100 trillion bill—that’s 100,000,000,000,000 Zimbabwean dollars! Perhaps the most well-known episode occurred in Germany in 1923 when inflation was 102,000,000 percent. In the German hyperinflation, prices rose so rapidly that for a time, workers were paid twice each day so their families could buy food before the afternoon price increases, and many people’s life savings became worthless. But the most extreme hyperinflation ever recorded was in Hungary in 1945, at the end of the Second World War, when inflation peaked at 3.8 × 1027 percent. The United States has never experienced hyperinflation, although the short-lived Confederate States of America suffered severe inflation during the Civil War. Between 1861 and 1865, prices in the Confederacy rose to 92 times their prewar levels.
Hyperinflation greatly magnifies the costs of inflation. For example, shoe-leather costs—a relatively minor consideration in times of low inflation—become quite important during hyperinflation. In this type of environment, people may visit the bank two or three times per day to hold money for as short a time as possible. With prices changing daily or even hourly, markets work quite poorly, slowing economic growth. Massive redistributions of wealth take place, impoverishing many and enriching only a few. Not surprisingly, episodes of hyperinflation rarely last more than a few years; they are so disruptive that they quickly lead to public outcry for relief.
A consequence of hyperinflation.©Feije Riemersma/Alamy Stock Photo
RECAP
THE TRUE COSTS OF INFLATION
The public sometimes confuses changes in relative prices (such as the price of oil) with inflation, which is a change in the overall level of prices. This confusion can cause problems because the remedies for undesired changes in relative prices and for inflation are different.
There are a number of true costs of inflation, which together tend to reduce economic growth and efficiency. Hyperinflation—a situation in which the inflation rate is extremely high—greatly magnifies these costs. They include:
· “Noise” in the price system, which occurs when general inflation makes it difficult for market participants to interpret the information conveyed by prices.
· Distortions of the tax system (for example, when provisions of the tax code are not indexed).
· “Shoe-leather” costs, or the costs of economizing on cash (for example, by making more frequent trips to the bank or installing a computerized cash management system).
· Unexpected redistributions of wealth, as when higher-than-expected inflation hurts wage earners to the benefit of employers or hurts creditors to the benefit of debtors.
· Interference with long-term planning, arising because people find it difficult to forecast prices over long periods.
INFLATION AND INTEREST RATES
So far, we have focused on the measurement and economic costs of inflation. Another important aspect of inflation is its close relationship to other key macroeconomic variables. For example, economists have long realized that during periods of high inflation, interest rates tend to be high as well. We will close this chapter with a look at the relationship between inflation and interest rates, which will provide a useful background in the chapters to come.
INFLATION AND THE REAL INTEREST RATE
Earlier in our discussion of the ways in which inflation redistributes wealth, we saw that inflation tends to hurt creditors and help debtors by reducing the value of the dollars with which debts are repaid. The effect of inflation on debtors and creditors can be explained more precisely using an economic concept called the real interest rate. An example will illustrate.
Suppose that there are two neighboring countries, Alpha and Beta. In Alpha, whose currency is called the alphan, the inflation rate is zero and is expected to remain at zero. In Beta, where the currency is the betan, the inflation rate is 10 percent and is expected to remain at that level. Bank deposits pay 2 percent annual interest in Alpha and 10 percent annual interest in Beta. In which countries are bank depositors getting a better deal?
You may answer “Beta” because interest rates on deposits are higher in that country. But if you think about the effects of inflation, you will recognize that Alpha, not Beta, offers the better deal to depositors. To see why, think about the change over a year in the real purchasing power of deposits in the two countries. In Alpha, someone who deposits 100 alphans in the bank on January 1 will have 102 alphans on December 31. Because there is no inflation in Alpha, on average, prices are the same at the end of the year as they were at the beginning. Thus, the 102 alphans the depositor can withdraw represent a 2 percent increase in buying power.
In Beta, the depositor who deposits 100 betans on January 1 will have 110 betans by the end of the year—10 percent more than she started with. But the prices of goods and services in Beta, we have assumed, also will rise by 10 percent. Thus, the Beta depositor can afford to buy precisely the same amount of goods and services at the end of the year as she could at the beginning; she gets no increase in buying power. So the Alpha depositor has the better deal, after all.
Economists refer to the annual percentage increase in the real purchasing power of a financial asset as the real interest rate, or the real rate of return, on that asset. In our example, the real purchasing power of deposits rises by 2 percent per year in Alpha and by 0 percent per year in Beta. So the real interest rate on deposits is 2 percent in Alpha and 0 percent in Beta. The real interest rate should be distinguished from the more familiar market interest rate, also called the nominal interest rate. The nominal interest rate is the annual percentage increase in the nominal, or dollar, value of an asset.
As the example of Alpha and Beta illustrates, we can calculate the real interest rate for any financial asset, from a checking account to a government bond, by subtracting the rate of inflation from the market or nominal interest rate on that asset. So in Alpha, the real interest rate on deposits equals the nominal interest rate (2 percent) minus the inflation rate (0 percent), or 2 percent. Likewise in Beta, the real interest rate equals the nominal interest rate (10 percent) minus the inflation rate (10 percent), or 0 percent.
We can write this definition of the real interest rate in mathematical terms:
r = i − π,
where
|
r |
= |
the real interest rate, |
|
i |
= |
the nominal, or market, interest rate, |
|
π |
= |
the current inflation rate. |
Notice that at the time of purchasing an asset, the inflation rate that will prevail over the life of the asset is not yet known. Economists therefore distinguish between the expected real interest rate, measured by the nominal interest rate minus the inflation rate that is expected at the time of purchase, and the actual real interest rate, measured by the nominal interest rate minus the inflation rate that actually prevailed. The expected real interest rate reflects what people who bought an asset anticipated their real rate of return to be, while the actual real interest rate reflects what their real rate of return ended up being. In order to keep things simple, our preceding discussion assumes that the two are equal, by assuming that the current inflation rate will not change. We discuss unanticipated inflation-rate changes below.
EXAMPLE 18.8Real Interest Rates Since the 1970s
Why is the real interest rate important?
Following are interest rates on 3-month government bonds for selected years since the 1970s. In which of these years did the financial investors who bought government bonds get the best deal? The worst deal?
Financial investors and lenders do best when the real (not the nominal) interest rate is high because the real interest rate measures the increase in their purchasing power. We can calculate the real interest rate for each year by subtracting the inflation rate from the nominal interest rate. The results are shown in the third column of the accompanying table. For purchasers of government bonds, the best of these years was 1985, when they enjoyed a real return of 3.9 percent. The worst year was 1975, when their real return was actually negative 3.3 percent. In other words, despite receiving 5.8 percent nominal interest, financial investors ended up losing buying power in 1975, as the inflation rate exceeded the interest rate earned by their investments.
Figure 18.2 shows the real interest rate in the United States since 1970 as measured by the nominal interest rate paid on the federal government’s debt minus the inflation rate. Note that the real interest rate was negative in the 1970s, reached historically high levels in the mid-1980s, and has been negative again in many of the past 15 years.
FIGURE 18.2 The Real Interest Rate in the United States, 1970–2016.The real interest rate is the nominal interest rate—here the interest rate on funds borrowed by the federal government for a term of three months—minus the rate of inflation. In the United States, the real interest rate was negative in the 1970s, reached historically high levels in the mid-1980s, and has often been negative in the past 15 years.Source: Federal Reserve Economic Data, http://fred.stlouisfed.org, and authors’ calculations.
CONCEPT CHECK 18.8
You have some funds to invest but are unimpressed with the low interest rates your bank offers. You consult a broker, who suggests a bond issued by the government of a small island nation. The broker points out that these bonds pay 25 percent interest —much more than your bank—and that the island’s government has never failed to repay its debts. What should be your next question?
The concept of the real interest rate helps to explain more precisely why an unexpected surge in inflation is bad for lenders and good for borrowers. For any given nominal interest rate that the lender charges the borrower, the higher the inflation rate, the lower the real interest rate the lender actually receives. So, unexpectedly high inflation leaves the lender worse off. Borrowers, on the other hand, are better off when inflation is unexpectedly high because their real interest rate is lower than anticipated.
Although unexpectedly high inflation hurts lenders and helps borrowers, a high rate of inflation that is expected may not redistribute wealth at all because expected inflation can be built into the nominal interest rate. Suppose, for example, that the lender requires a real interest rate of 2 percent on new loans. If the inflation rate is confidently expected to be zero, the lender can get a 2 percent real interest rate by charging a nominal interest rate of 2 percent. But if the inflation rate is expected to be 10 percent, the lender can still ensure a real interest rate of 2 percent by charging a nominal interest rate of 12 percent. Thus, high inflation, if it is expected, need not hurt lenders—as long as the lenders can adjust the nominal interest they charge to reflect the expected inflation rate.
In response to people’s concerns about unexpected inflation, in 1997 the United States Treasury introduced inflation-protected bonds, which pay a fixed real interest rate. People who buy these bonds receive a nominal interest rate each year equal to a fixed real rate plus the actual rate of inflation during that year. Owners of inflation-protected bonds suffer no loss in real wealth even if inflation is unexpectedly high.
CONCEPT CHECK 18.9
What is the real rate of return to holding cash? (Hint: Does cash pay interest?) Does this real rate of return depend on whether the rate of inflation is correctly anticipated? How does your answer relate to the idea of shoe-leather costs?
THE FISHER EFFECT
Earlier we made the observation that interest rates tend to be high when inflation is high and low when inflation is low. This relationship can be seen in Figure 18.3, which shows both the U.S. inflation rate and a nominal interest rate (the rate at which the government borrows for short periods) from 1970 to the present. Notice that nominal interest rates have tended to be high in periods of high inflation, such as the late 1970s, and have been declining since then, along with inflation.
FIGURE 18.3 Inflation and Interest Rates in the United States, 1970–2016.Nominal interest rates tend to be high when inflation is high and low when inflation is low, a phenomenon called the Fisher effect.Source: Federal Reserve Economic Data, http://fred.stlouisfed.org.
Why do interest rates tend to be high when inflation is high? Our discussion of real interest rates provides the answer. Suppose inflation has recently been high, so borrowers and lenders anticipate that it will be high in the near future. We would expect lenders to raise their nominal interest rate so that their real rate of return will be unaffected. For their part, borrowers are willing to pay higher nominal interest rates when inflation is high because they understand that the higher nominal interest rate only serves to compensate the lender for the fact that the loan will be repaid in dollars of reduced real value—in real terms, their cost of borrowing is unaffected by an equal increase in the nominal interest rate and the inflation rate. Conversely, when inflation is low, lenders do not need to charge so high a nominal interest rate to ensure a given real return. Thus, nominal interest rates will be high when inflation is high and low when inflation is low.
This tendency for nominal interest rates to follow inflation rates is called the Fisher effect, after the early twentieth-century American economist Irving Fisher, who first pointed out the relationship.
SUMMARY
· The basic tool for measuring inflation is the consumer price index (CPI). The CPI measures the cost of purchasing a fixed basket of goods and services in any period relative to the cost of the same basket of goods and services in a base year. The inflation rate is the annual percentage rate of change in the price level as measured by a price index such as the CPI. (LO1)
· A nominal quantity is a quantity that is measured in terms of its current dollar value. Dividing a nominal quantity such as a family’s income or a worker’s wage in dollars by a price index such as the CPI expresses that quantity in terms of real purchasing power. This procedure is called deflating the nominal quantity. If nominal quantities from two different years are deflated by a common price index, the purchasing power of the two quantities can be compared. To ensure that a nominal payment such as a Social Security benefit represents a constant level of real purchasing power, the nominal payment should be increased each year by a percentage equal to the inflation rate. This method of adjusting nominal payments to maintain their purchasing power is called indexing. (LO2)
· The official U.S. inflation rate, based on the CPI, may overstate the true inflation rate for two reasons: First, it may not adequately reflect improvements in the quality of goods and services. Second, the method of calculating the CPI ignores the fact that consumers can substitute cheaper goods and services for more expensive ones. (LO3)
· The public sometimes confuses increases in the relative prices for specific goods or services with inflation, which is an increase in the general price level. Because the remedies for a change in relative prices are different from the remedies for inflation, this confusion can cause problems. (LO4)
· Inflation imposes a number of true costs on the economy, including “noise” in the price system; distortions of the tax system; “shoe-leather” costs, which are the real resources that are wasted as people try to economize on cash holdings; unexpected redistributions of wealth; and interference with long-term planning. Because of these costs, most economists agree that sustained economic growth is more likely if inflation is low and stable. Hyperinflation, a situation in which the inflation rate is extremely high, greatly magnifies the costs of inflation and is highly disruptive to the economy. (LO4)
· The real interest rate is the annual percentage increase in the purchasing power of a financial asset. It is equal to the nominal, or market, interest rate minus the inflation rate. When inflation is unexpectedly high, the real interest rate is lower than anticipated, which hurts lenders but benefits borrowers. When inflation is unexpectedly low, lenders benefit and borrowers are hurt. To obtain a given real rate of return, lenders must charge a high nominal interest rate when inflation is high and a low nominal interest rate when inflation is low. The tendency for nominal interest rates to be high when inflation is high and low when inflation is low is called the Fisher effect. (LO5)
KEY TERMS
consumer price index (CPI)
core rate of inflation
deflating (a nominal quantity)
deflation
Fisher effect
hyperinflation
indexing
inflation-protected bonds
market interest rate
nominal interest rate
nominal quantity
price index
price level
rate of inflation
real interest rate
real quantity
real wage
relative price
REVIEW QUESTIONS
1. Explain why changes in the cost of living for any particular individual or family may differ from changes in the official cost-of-living index, the CPI. (LO1)
2. What is the difference between the price level and the rate of inflation in an economy? (LO1)
3. Why is it important to adjust for inflation when comparing nominal quantities (for example, workers’ average wages) at different points in time? What is the basic method for adjusting for inflation? (LO2)
4. Describe how indexation might be used to guarantee that the purchasing power of the wage agreed to in a multiyear labor contract will not be eroded by inflation. (LO2)
5. Give two reasons the official inflation rate may understate the “true” rate of inflation. Illustrate by examples. (LO3)
6. “It’s true that unexpected inflation redistributes wealth, from creditors to debtors, for example. But what one side of the bargain loses, the other side gains. So from the perspective of the society as a whole, there is no real cost.” Do you agree? Discuss. (LO4)
7. How does inflation affect the real return on holding cash? (LO5)
8. True or false: If both the potential lender and the potential borrower correctly anticipate the rate of inflation, inflation will not redistribute wealth from the creditor to the debtor. Explain. (LO5)
PROBLEMS
1. Government survey takers determine that typical family expenditures each month in the year designated as the base year are as follows:
o 20 pizzas at $10 each
o Rent of apartment, $600 per month
o Gasoline and car maintenance, $100
o Phone service (basic service plus 10 long-distance calls), $50
In the year following the base year, the survey takers determine that pizzas have risen to $11 each, apartment rent is $640, gasoline and maintenance have risen to $120, and phone service has dropped in price to $40. (LO1)
e. Find the CPI in the subsequent year and the rate of inflation between the base year and the subsequent year.
f. The family’s nominal income rose by 5 percent between the base year and the subsequent year. Are they worse off or better off in terms of what their income is able to buy?
2. Here are values of the CPI (multiplied by 100) for each year from 1990 to 2000. For each year beginning with 1991, calculate the rate of inflation from the previous year. What happened to inflation rates over the 1990s? (LO1)
3. Refer to the CPI data given in Problem 2. A report found that the real entry-level wage for college graduates declined by 8 percent between 1990 and 1997. The nominal entry-level wage in 1997 was $13.65 per hour. (LO2)
a. What was the real entry-level wage in 1997?
b. What was the real entry-level wage in 1990?
c. What was the nominal entry-level wage in 1990?
4. Consider the following table. It shows a hypothetical income tax schedule, expressed in nominal terms, for the year 2014.
The legislature wants to ensure that families with a given real income are not pushed up into higher tax brackets by inflation. The CPI (times 100) is 175 in 2014 and 185 in 2016. How should the income tax schedule above be adjusted for the year 2016 to meet the legislature’s goal? (LO2)
5. According to the U.S. Census Bureau (www.census.gov), nominal income for the typical family of four in the United States (median income) was $23,618 in 1985, $34,076 in 1995, $46,326 in 2005, and $49,276 in 2010. In purchasing power terms, how did family income compare in each of those four years? You will need to know that the CPI (multiplied by 100, 1982–1984 = 100) was 107.6 in 1985, 152.4 in 1995, 195.3 in 2005, and 218.1 in 2010. (LO2)
6. The typical consumer’s food basket in the base year 2015 is as follows:
o 30 chickens at $3.00 each
o 10 hams at $6.00 each
o 10 steaks at $8.00 each
A chicken feed shortage causes the price of chickens to rise to $5.00 each in the year 2016. Hams rise to $7.00 each, and the price of steaks is unchanged. (LO1, LO3)
d. Calculate the change in the “cost-of-eating” index between 2015 and 2016.
e. Suppose that consumers are completely indifferent between two chickens and one ham. For this example, how large is the substitution bias in the official “cost-of-eating” index?
7. The following table lists the actual per-gallon prices for unleaded regular gasoline for June of each year between 1978 and 1986, together with the values of the CPIs for those years. For each year from 1979 to 1986, find the CPI inflation rate and the change in the real price of gasoline, both from the previous year. Would it be fair to say that most of the changes in gas prices during this period were due to general inflation, or were factors specific to the oil market playing a role as well? (LO1, LO4)
8. On January 1, 2012, Albert invested $1,000 at 6 percent interest per year for three years. The CPI on January 1, 2012, stood at 100. On January 1, 2013, the CPI (times 100) was 105; on January 1, 2014, it was 110; and on January 1, 2015, the day Albert’s investment matured, the CPI was 118. Find the real rate of interest earned by Albert in each of the three years and his total real return over the three-year period. Assume that interest earnings are reinvested each year and themselves earn interest. (LO5)
9. Frank is lending $1,000 to Sarah for two years. Frank and Sarah agree that Frank should earn a 2 percent real return per year.
a. The CPI (times 100) is 100 at the time that Frank makes the loan. It is expected to be 110 in one year and 121 in two years. What nominal rate of interest should Frank charge Sarah?
b. Suppose Frank and Sarah are unsure about what the CPI will be in two years. Show how Frank and Sarah could index Sarah’s annual repayments to ensure that Frank gets an annual 2 percent real rate of return.
10. * The Bureau of Labor Statistics has found that the base-year expenditures of the typical consumer break down as follows:
Suppose that since the base year, the prices of food and beverages have increased by 10 percent, the price of housing has increased by 5 percent, and the price of medical care has increased by 10 percent. Other prices are unchanged. Find the CPI for the current year. (LO5)
ANSWERS TO CONCEPT CHECKS
18.1The cost of the family’s basket in 2010 remains at $940, as in Table 18.1. If the rent on their apartment falls to $600 in 2015, the cost of reproducing the 2010 basket of goods and services in 2015 is $830 ($600 for rent + $150 for hamburgers + $80 for movie tickets). The CPI for 2015 is accordingly $830/$940, or 0.883. So in this example, the cost of living fell nearly 12 percent between 2010 and 2015. (LO1)
18.2To construct your own personal price index, you would need to determine the basket of goods and services that you personally purchased in the base year. Your personal price index in each period would then be defined as the cost of your personal basket in that period relative to its cost in the base year. To the extent that your mix of purchases differs from that of the typical American consumer, your cost-of-living index will differ from the official CPI. For example, if in the base year, you spent a higher share of your budget than the typical American on goods and services that have risen relatively rapidly in price, your personal inflation rate will be higher than the CPI inflation rate. (LO1)
18.3The percentage changes in the CPI in each year from the previous year are as follows:
Negative inflation is called deflation. The experience of the 1930s, when prices were falling, contrasts sharply with the 1970s, during which prices rose rapidly. (LO1)
18.4The percent changes in inflation rates in each year from the previous year are as follows:
In the past few years, inflation has been non-negative but low, in the range 0–2 percent range. (Due to rounding, the inflation rates calculated above are slightly different from those published by the BLS.) (LO1)
18.5Barry Bonds’ real earnings, in 1982–1984 dollars, were $10.3 million/1.77, or $5.8 million. That is more than 12 times Babe Ruth’s salary in 1930, but less than half of Clayton Kershaw’s salary in 2017.
18.6The real minimum wage in 1950 is $0.75/0.24, or $3.12 in 1982–1984 dollars. The real minimum wage in 2016 is $7.25/2.40, or $3.02 in 1982–1984 dollars. So the real minimum wage in 2016 was slightly lower than what it was in 1950. (LO2)
18.7The increase in the cost of living between 1950 and 2016 is reflected in the ratio of the 2016 CPI to the 1950 CPI, or 2.40/0.24 = 10. That is, the cost of living in 2016 was 10 times what it was in 1950. If the minimum wage were indexed to preserve its purchasing power, it would have been 10 times higher in 2016 than in 1950, or 10 × $0.75 = $7.50. (LO2)
18.8You should be concerned about the real return on your investment, not your nominal return. To calculate your likely real return, you need to know not only the nominal interest paid on the bonds of the island nation, but also the prevailing inflation rate in that country. So your next question should be, “What is the rate of inflation in this country likely to be over the period that I am holding these bonds?” (LO5)
18.9The real rate of return to cash, as with any asset, is the nominal interest rate less the inflation rate. But cash pays no interest; that is, the nominal interest rate on cash is zero. Therefore, the real rate of return on cash is just minus the inflation rate. In other words, cash loses buying power at a rate equal to the rate of inflation. This rate of return depends on the actual rate of inflation and does not depend on whether the rate of inflation is correctly anticipated.
If inflation is high so that the real rate of return on cash is very negative, people will take actions to try to reduce their holdings of cash, such as going to the bank more often. The costs associated with trying to reduce holdings of cash are what economists call shoe-leather costs. (LO5)
1More details on how the Bureau of Labor Statistics constructs the CPI are available at www.bls.gov/cpi/questions- and-answers.htm.