Inflation is a general increase in the price level. The price of most things is increasing when we have inflation. The forces of supply and demand still determine prices in individual markets. Yet, inflation creates a tendency for prices to rise throughout the economy.

Although the causes of inflation can be debated, most economists agree a primary culprit is expectations of further price increases.

For example, if most things you buy are increasing in price (e.g., groceries, clothing, rent) and you expect the inflation to continue, there is a natural tendency for you to ask your boss for a raise in salary to cover your increased living costs. If you (and your co-workers) are given a raise, the business's labor costs increase. Higher labor costs contribute to the expectation that the inflation will continue. Once inflation becomes entrenched in an economy, it tends to be self-perpetuating. Businesses seek higher prices for their products to cover increasing costs. In turn, workers seek higher wages & salaries to cover their increased cost of living. A key to reducing inflation is to break the cycle of expectations that the price level will continue to rise.


WHY IS INFLATION BAD?

Suppose the price of EVERYTHING in the economy doubled every year. For example, suppose prices double on January 1st and remain at that level throughout the year. The week after January 1st, your paycheck is twice as big as it was the week before. Are you better off? If you rush to the mall to spend your increased pay, you will find that things cost twice as much. Your purchasing power has stayed the same.

(If you have $1 in your pocket and a Coke costs 50 cents, then you can buy two of them. If the money you have doubles to $2 and the price of Cokes doubles to $1, still you can only buy two of them. Your purchasing power has not changed.)

If the price of EVERYTHING went up at the same rate, inflation would not be so bad. It would create some inefficiencies, however.

The biggest problem with inflation is that prices do not rise uniformly. Some people's income is indexed to inflation so it rises automatically. Most people's income is not indexed, however. Consequently certain people benefit from inflation while others lose. Inflation redistributes income.

REASONS WHY INFLATION IS BAD


HOW WE MEASURE INFLATION

Inflation is measured most commonly by price indices. A price index is designed to measure how the price of a basket of goods changes over time.

These include:

Consumer Price Index (CPI)

Producer Price Index (PPI)

GDP Deflator

Monthly CPI and PPI data for the past 12 months - from the Bureau of Labor Statistics (BLS)


LINKS

Frequently Asked Questions (FAQs) about the Consumer Price Index (CPI) - from the Bureau of Labor Statistics (BLS)

Frequently Asked Questions (FAQs) about the Producer Price Index (PPI) - from the Bureau of Labor Statistics (BLS)

How Does the Producer Price Index Differ from the Consumer Price Index? -



More Information about the CPI - from the Bureau of Labor Statistics (BLS)


LIMITATIONS OF USING THE CPI TO MEASURE INFLATION

1. Price indices have difficulty including new technology. Consumers benefit from new technology, but the fixed basket of goods used in the CPI will not include the newest products and technology.

2. Prices of different products rise at different rates. Consumers tend to shift their consumption away from the more expensive products and substitute cheaper products. Because the CPI uses a fixed basket of goods, it will assume people are still buying the same amount of the relatively expensive products. In reality, however, they are buying less of the expensive products. So their overall expenses are not as large as the CPI suggests.

3. Price indices also have difficulty measuring changes in quality. Consumers benefit more from higher quality products. When you use a fixed basket of goods, however, the implicit assumption is the quality does not change.

Because of these shortcomings, most economists feel the CPI overestimates the inflation rate.


INFLATION DATA

Monthly CPI and PPI data for the past 12 months - from the Bureau of Labor Statistics (BLS)


TYPES OF INFLATION

1. Demand-Pull Inflation - an increase in the price level caused by excess demand. It is often referred to as "too much money chasing too few goods."

2. Cost-Push Inflation - an increase in the price level caused by higher costs of production. For example, when unemployment is low, businesses may need to pay higher wages to attract new workers. Higher labor costs can lead to higher prices. This is one of the chief concerns of Alan Greenspan, the chairman of the Board of Governors of the Federal Reserve System.


STRATEGIES FOR CONTROLLING INFLATION

1. Break the cycle of expectations

2. Reduce aggregate demand.


IMPORTANT TERMS AND CONCEPTS

inflation -

(market) basket of goods -

price indexes (indices) -

consumer price index

producer price index

GDP deflator

demand-pull inflation -

cost-push inflation -


WHY WE SHOULD CARE ABOUT INFLATION

Inflation creates an environment of uncertainty. This may make businesses reluctant to proceed with some investment projects (e.g., new factories). Reduced investment might inhibit economic growth causing our future standard of living to be less than what it could have been with the investment.

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Controlling inflation is one of our macroeconomic objectives.

Macroeconomic policy goals include:





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