Unit 4: Price Stability & Inflation

Price Stability: Inflation, Deflation, and The Price Index

The second of any society’s four major goals for it’s macro economy is to “Achieve stable money and prices”.  Of the four major goals, this is probably the goal that is least obvious or self-evident.  After all, it’s easy to see that a society might want growth in output, or stable and predictable growth or full employment of labor.  After all, growth, stability, and full employment are rather self-evident goals.  Given a moment to think about it, most everybody would these are worthy and desirable goals.  But “stable money? “Stable prices”? How and why are these worthy goals?

In this unit we are .going to focus on this goal of “Achieving stable money and prices”.  I hope you’ll come to the conclusion, that although it may not be as obvious, stable money and prices is indeed a worthy goal for society.

In the this unit we are going to look closer at price indexes, the measure we introduced to help convert nominal GDP into the more meaningful real GDP. There are actually multiple versions of the price index, not just one. Thus, I use the term price indexes .  We will read about how price indexes are calculated and how we can calculate the inflation or deflation rate from the price index.  We will also take a closer look at the phenomenon of inflation (or deflation) and try to understand it better.

Learning Objectives for this Unit:

  • Calculate and explain measures of  …  the price level.
  • Describe how a price index is created.
  • Calculate rates of inflation/deflation from a price index.
  • Describe and explain the effects of inflation/deflation on different people in the economy.
  • Describe who gains and who loses when inflation (or deflation) occurs.
  • Describe some of the effects of unrestrained inflation on society.

Measuring the “Price Level” – Tricky Business

In the last unit we looked at the first of any society’s four major goals for it’s macro economy:  growth in real GDP.  In the course of looking at how to measure the aggregate output (production) of goods and services, we realized that we needed to adjust the “nominal GDP”, the amount of spending we can observe, for changes in a thing we called a “price level” so that we could arrive at a measure we called “real GDP”.  Now we need to look closer at this measure we called a price index.

In reality, an economy has multiple price indexes.  In the U.S. for example, there are multiple versions of the Consumer Price Index, the Producer Price Index, the GDP Deflator Index, and numerous others.  Some magazines even research and publish their own indexes, such as a Fast Food Price Index. The reason there are so many slightly different price indexes is because a price index is a very imperfect measure.  What we want to measure is the degree to which all prices in an economy are going up or going down together. This would tell us how much the level of overall prices, what we call the aggregate price level, has changed.

Of course measuring the change in all prices is an impossibility. We cannot directly measure changes in the aggregate price level.  At any one time some prices are going up and some going down – that’s the working of a microeconomics, supply and demand in action.  What we’re concerned with though, is whether in the midst of some prices going up and some down, there’s an underlying trend of all prices to go up.  For example, suppose there are only 4 products in the economy.  Microeconomic supply-and-demand suggests that if we observed say 2 products go up in price by 3% each, the other 2 products should go down in price by an offsetting amount.  That’s the micro price mechanism in action. Some products became cheaper and some more expensive.

But suppose, one product went down 1%, and the other three products went up in price by 7%, 9% and 10% respectively. Just looking at these price changes we might suspect that there’s something else going on.  It appears that there’s an underlying tendency for all the prices to go up.  Somehow the up-and-down of price changes created by supply-and-demand in each micro market is getting confused with a general tendency for all prices to go up.  This general tendency of all prices to go up we call inflation.  Or, if there’s a general tendency for all prices to go down, we call it deflation.  It’s impossible to directly and accurately measure inflation or deflation in prices.  So, instead we have to create a measure called a price index.  Then we call changes in the price index either inflation or deflation.

Conceptually, we can think of the aggregate price level as being the “average price” of goods. Of course, it is practically impossible to actually calculate the true “average” of all prices.  If nothing else, there are simply too many different products and prices to be able to calculate it.  So economists have created a proxy measure called a price index.  What happens with a price index is that an economist defines a small artificial list of products that are supposed to representative of the economy.  It’s called a market basket.  The market basket is a pre-defined list of fixed quantities of particular items.  The economist then goes out into the economy and finds out what the prices of these goods are.  She calculates what it would cost to actually purchase that market basket at the prices in effect in the economy then.  The economist then compares what the market basket costs at that point in time to what it would cost to purchase the same identical goods and quantities at another point in time.  She arbitrarily picks one point in time as a “base year” and assigns a value of 100 to the cost of the market basket in the base year.  When the total cost of the market goes up, she calculates how much it went up relative to the base year.  Suppose the market basket costs 10% more the year after the base year.  Then the price index would now read 110 because 110 is 10% higher than 100.

You could create a price index of your own very easily.  Suppose you created a shopping list of certain items and quantities.  You go out and price all the items and calculate what it costs to buy your list. This is your “base year”. You assign a value of 100 to this total cost in the “base year”.  Next you go shopping each week (or month, or year) and price what it would cost to buy the full, exact same shopping list.  As the total cost of the shopping list changes, you adjust the price index the same relative change.  You would have your price index for the goods you buy.  If the total cost of the shopping list hardly changes, in other words, the price index stays very close to 100, then you are experiencing “price level stability”. You are NOT experiencing inflation or deflation, even though the price of some individual products may have gone up and others gone down.  But, if the overall cost of the shopping list keeps going up, then you are experiencing inflation.  And inflation is not a good thing.

In this course, I do not ask you to calculate a price index itself or to calculate changes to a price index from the raw prices in the market basket.  You will have to calculate an inflation rate from price index data.  What is important to is understand the concept of a price index and how it depends on the market basket of goods chosen.

There are different price indexes because there are different “market baskets” defined.  Any price index, no matter what market basket is based upon, is only an approximation of what the true, actual inflation or deflation has been in economy.  We don’t have a means to accurately, directly measure inflation or deflation.  Changes in a price index are the best we can do. Economists try to refine their methodology and to refine the selection of goods in the market basket, but it is still imperfect.  So any given price index may tend to overstate or understate the true, actual rate of inflation .  For example, in the late 1990’s a change was made to how the Consumer Price Index was calculated.  As a result, inflation as calculated from the CPI has been lower since the change than it was before.  See here if you want to know more about this particular change and how it affects today’s data as reported in the news.

What’s Money Good For Anyway?

A market-based economy runs into big trouble if inflation or deflation happens.  Inflation and deflation are not good phenomena.  The reason is because inflation, the general rise in all/most prices, is only a symptom of other real problems.  Inflation often indicates an economy is “overheating” and that collectively all of us are trying to buy more goods/services than all of us together are capable of producing, and thus we bid up the prices of everything. Deflation usually indicates that collectively we are not willing to buy all the goods or services we are capable of producing, thus prices of everything drop due to a  lack of aggregate demand.

In general inflation or deflation indicates a sick monetary and financial system.  For a market-based economy to work well and efficiently, we all need to have money we can count on.  Literally.  Think about it.  We actually use money as a way to measure and count the value of goods.  Even though we learned in microeconomics that goods get their true value because of the utility consuming them provides, in reality we use money as the way to measure and compare the value we put on different goods.  We assume that the money we are using is an objective, unchanging standard of value.  We assume a “dollar is a dollar is a dollar”.  We assume that when the price of something goes up it has become scarcer and more valuable.  We use money as a yardstick or meter stick to measure the value of  goods.  And, like a good ruler, we assume that the ruler stays the same size all the time.  We assume the measure is constant itself.

But, money doesn’t always keep it’s value.  Money, at times, is a very poor measure because it sometimes loses (or gains) value over time.  Imagine trying to measure the height of child year-by-year as the child grows when the yardstick or meter stick you use to measure their height keeps shrinking each year.  You might conclude the child grew a full 12 inches, when in fact they only grew 3 inches and the yardstick shrank by nine inches.   Trying to understand prices in a market when inflation exists is like measuring height with a shrinking ruler. It doesn’t work.

When an economy experiences inflation (or deflation), what is really happening is that the money the society uses is changing in value.  Inflation means that dollars (or whatever the society uses for money) are becoming less valuable as time goes by.  Deflation means dollars (money) are actually gaining in value.  Ideally, a society wants neither inflation nor deflation.  Whether a society experiences either inflation or deflation is largely determined by what the society chooses to use as money and how it regulates it’s financial and banking sector – a topic for a later unit in this course.

Inflation/Deflation Creates Unequal Winners and Losers

In real-life, very few societies are able to have zero inflation or deflation.  There’s almost always some degree.  In modern economies (the developed nations since the mid-20th century), deflation rarely happens.  Instead, what is more common is mild to moderate amounts of inflation.  As a result, most people expect inflation to happen to some degree and try to adjust their behavior accordingly.  For example, most banks in the U.S. expect some inflation of around 2% per year.  So, when they loan money to someone, they increase the interest rate to reflect their expected inflation.  The banks know that they will get paid back dollars that aren’t as valuable as the dollars they loaned out.  So they increase the interest rate so that the bank gets paid back with even more dollars.

One of the worst aspects of inflation/deflation is that it doesn’t affect everybody the same.  For example, when inflation exists, borrowers borrow valuable dollars one year and pay back with less-valuable dollars in future years.  Borrowers gain from inflation.  Lenders lose from inflation.  In deflation, the reverse happens.  The borrower loses and the lender gains.

When inflation happens, people living on fixed dollar-amount incomes suffer. There incomes stay fixed while the prices of what they buy goes up.  But when there is inflation, people who own real assets (houses, land, machinery, etc) gain.  The value of what they own in dollar terms goes up.

Deflation is Worse than Mild Inflation

Not only does inflation (or deflation) affect different people differently, but the macroeconomic consequences of inflation as compared to deflation are not symmetric.  You might think a 2% inflation rate is just as unstable as a 2% deflation, but it doesn’t work that way.  The evidence is pretty strong that capitalist market economies (especially with large financial sectors) do reasonably well at 2% or so inflation.  Even inflation as high as 5% is manageable.  On the other hand, a deflation rate of 1% (prices drop 1% per year) or even 0.5% can wreak havoc and produce a long and severe depression.  This is because of debt.  When deflation happens, prices drop.  But wages and incomes also drop.  The only thing that doesn’t drop are payments on previously borrowed debts.  The payment stays fixed in nominal terms and as income drops, the payment takes a larger and larger share of income forcing even bigger cutbacks in spending. But cutbacks in spending mean somebody else’s income drops, forcing them to make cutbacks also.  This process is called debt deflation and it was a major part of the Great Depression and is also a significant part of why the U.S. and Europe have struggled for years to recover from the Great Recession/Financial Crisis of 2007-09.

Everybody Loses With High Rates of Inflation or Deflation

At times a nation’s inflation rate gets very high.  As inflation increases, it tends to accelerate.  In other words, suppose all prices go up 20% this year. The following year they will likely go up even faster, perhaps 40-60%.  And then they will go up even faster, even 100% or even 1000% per year.  When this happens, it typically means the economy collapses. We call this hyper-inflation. Despite popular belief, a hyper-inflation does not happen simply because a nation borrows money or prints money.  Creating a larger supply of money is an important part of creating a hyperinflation, but it is not enough.  To have a hyperinflation, a nation must experience what we call a large “supply shock” – it’s capacity to produce real goods must be suddenly reduced.

Germany in 1923 experienced a massive hyperinflation.  The proximate cause was a French occupation and seizure of German coal mines and steel mills in the Ruhr valley in response to German default on paying World War I reparations to France.  The German government continued to support Germans’ purchasing power by creating new money even though the supply and production of goods had drastically declined.  Hyperinflation resulted. In one famous example of the price increases, two potatoes cost one Reichsmark (the German currency at the time) in early 1923.  A few months later a buyer needed a wheelbarrow full of paper Reichsmarks to purchase even one potato.  An economy cannot function well in such an environment, although the German economy recovered nicely once a diplomatic solution to the reparations and French occupation was achieved. But damage had been done.  In Germany, in 1923 the inflation largely wiped out the cash savings of the entire middle class.  Contrary to popular belief, the inflation of 1923 was not a direct cause of Germans electing the National Socialist (Nazi) Party and Adolph Hitler to power.  Hitler came to power 9 years after the inflation.  What happened is the painful memories of the hyperinflation made the subsequent German governments and central bankers overly afraid of any amount of inflation or money creation. When the Great Depression hit Germany in 1930, the fear of inflation caused the central bank to not respond. A deflation resulted and unemployment skyrocketed.  The widespread unemployment set the stage for the Nazi electoral victory.

Other nations have suffered severe hyperinflations.  Russia, Argentina, Bolivia, and Brazil have all suffered severe hyperinflations in the 1990’s-2000 period.  The Spanish Empire of the 15th-16th century largely collapsed as a result of inflation.  The sad reality is that, while inflation and deflation may seem like abstract economic concepts, they can be all too real.  History shows that when nations experience extremely high inflation, either war or revolution often follows.

Summary: The Goal —  Stable Money and A Stable “Price Level”

Money is essential for markets to function efficiently.  And for money to function, it must retain its value.  Unfortunately, we don’t have any way to directly measure the value of money.  So the next best option is to observe the effects of money losing it’s value: changes in the overall aggregate price level.

But again, we can’t even measure changes in the aggregate price level directly.  The closest we can come is to create a market basket of goods and track changes in those prices.  We call such a measure a price index.   When the price index goes up, we call it inflation.  When the price index goes down, we call it deflation.

Thus, our second macroeconomic goal is Stable Money and Stable Price Level.  The way we measure our progress toward this goal is by monitoring changes in price indexes, a very imperfect way of measuring.

What’s Next?

In the next unit we will look at the next major macro policy goal: Full Employment. We’ll look at how we measure progress towards full employment and reducing unemployment. Turns out measuring unemployment isn’t as simple as it might seem first.

Inflation is the one form of taxation that can be imposed without legislation.
Milton FriedmanInflation does not lubricate trade but by rescuing traders from their errors of optimism or stupidity.
John Kenneth Galbraith

Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.
Ronald Reagan

Some idea of inflation comes from seeing a youngster get his first job at a salary you dreamed of as the culmination of your career.
Bill Vaughan