Inflation refers to a general increase in prices in an economy.
Relative price changes are not a part of inflation, such as when the price of ice rises but the price of mangoes falls. In an inflationary economy, most, if not all, markets are pressured to increase prices. Price increases are modelled as one-time events, whereas inflation is ongoing.
Tracking Inflation
Since an economy consists of many, many goods and services, goods and services must be binned to obtain a single price level, of which the percent change is obtained.
Basket of Goods
A basket of goods and services consists of items purchased by individuals and businesses. In reality, some items in the basket matter more than others, so they must be weighed to obtain the price level, as opposed to taking the mean.
Calculating Inflation from a Basket
Some items in the basket may increase while others decrease in price. Thus, the items that are more important have a greater impact on the change.
Index Numbers
Rather than using the actual price of goods, index numbers are used to compare relative prices. An arbitrary base year is chosen where that year’s price index number is 100.
In the below example, P3 is chosen as the base year.
| Basket Price | Index Number | Period Inflation Rate | |
|---|---|---|---|
| P1 | $200 | 200/2.14 = 93.5 | |
| P2 | $204 | 204/2.14 = 95.3 | (95.3 - 93.5) / 93.5 * 100 = 1.93% |
| P3 | $214 | 214/2.14 = 100.0 | (100 - 95.3) / 95.3 * 100 = 4.93% |
| P4 | $219 | 219/2.14 = 102.3 | (102.3 - 100) / 100 * 100 = 2.30% |
Consumer Price Index
The Consumer Price Index (CPI) measures the prices of a fixed basket of goods representing what an average family of four would purchase in the US.
The CPI is an imperfect measure of the cost of living:
- Substitution bias assumes that a consumer cannot change what they buy if one item rises in relative price. In reality, a consumer can switch to tea if coffee is too expensive
- New goods bias means that a fixed basket cannot take into account whether a good increases in price due to increased quality, rather than inflationary pressure
- Adjusting the basket may allow the CPI to better reflect the actual COL at the cost of complicating the index
Core Inflation Index
Core inflation indices are calculated by removing volatile variables from the CPI. Food and energy prices may vary due to natural disasters and respond quickly, whereas other parts of the economy remain unaffected. The CPI pertains to households, while policy changes are based on the core inflation index.
Other Indices
- The Producer Price Index measures supplies and inputs for goods and services
- The International Price Index measures imported and exported merchandise prices
- Employment cost indices measure wage inflation
- The GDP deflator includes all GDP components, with re-calculated baskets compared to the base year
US and International Inflation
In the US, deflation sometimes occurs when unemployment is high, often during recessions, due to reduced demand. Inflation can conversely occur when the economy is strong.
Command economies, such as Soviet Russia, experienced very low inflation, since prices were centrally determined, not increasing unless determined by the government.
Redistributing Purchasing Power
Holding cash during inflationary periods yields negative returns. Additionally, capital gains are taxed based on the nominal rate of return. An account with an interest rate below the inflation rate would result in a negative real return, yet would be taxed, furthering the loss in purchasing power.
Wage increases follow inflation, often lagging behind. Workers who make minimum wage lose buying power if it is not frequently adjusted for inflation.
Fixed income, such as pensions, may not adjust for inflation. Defined contribution plans such as 401(k)s may be invested in ways that better respond to inflation.
Loans with interest rates lower than inflation can result in a zero or negative real rate.
Price Signals
When inflation is high, it may not be obvious if prices are high due to overall inflation, increased demand, or reduced supply. This makes it difficult to achieve equilibrium in the short term, which can result in situations of where there is a surplus or shortage.
Long-Term Planning
High inflation affects choices made by firms. There is less incentive to innovate and improve, and instead focus on minimizing costs. Varied inflation rates incentivize firms to use shorter-term strategies so that they may respond quickly to inflation.
Indexing
Indexing refers to the adjustment or prices, wages, and interest rates for inflation.
Private Markets
Cost-of-living adjustments (COLAs) are contractual clauses to increase wages by inflation, plus an additional percentage.
Adjustable-rate mortgages (ARMs) are mortgages that have interest rates that change with inflation, often offering lower rates compared to fixed-rate mortgages. ARMs are less risky for lenders since their real payments will remain the same, lowering the risk premium.
Contracts may include provisions for inflation where parties agree upon a real rather than nominal price.
Governments
Income tax brackets are indexed to rise with inflation in the US.
The upper bound of income taxed for Social Security is adjusted to the CPI.
Indexed bonds offer rates of return on top of inflation, as opposed to fixed-rate bonds.