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What is Inflation? Why Do We Care?


The following is a continuation of last week’s posts (Basics of Money and Fiat Money) from economics professor, Art Carden. This week’s post explores the issue of monetary inflation and examines why it matters to an economy and its currency holders.

What is Inflation? Why Do We Care?

Once, during a middle-of-the-night conversation in college, we started talking about which Force powers we would use if we had command over the Force. As an economics major interested at the time in money and banking, I said that I would want "Force price stability." In short, I would use the Force to maintain a stable price level.

Price stability is one of the three major goals of macroeconomic policy (the other two are growing output and full employment). Its importance is evident from financial and economic news: if you turn on the radio or a financial news network like CNBC, you might hear about how some economists are worried about inflation in response to a strong jobs report or why the specter of deflation might haunt the United States or Europe.

In the last few decades, price levels have tended to rise rather than fall, and governments have strong incentives to pursue inflationary policies. Therefore, economists have mostly focused on inflation. Indeed, textbooks usually talk about the importance of not allowing inflation to get out of hand. Central bankers judge their performance in part by their ability to keep inflation low, and as the economist Justin Wolfers points out in this tweet (accompanied by a handy chart), "The Fed’s preferred inflation measure…has now been at or below its 2% target for 68 months."

6 Things You Should Know About Inflation

1. It Causes a Redistribution of Resources

Why do people worry about inflation? First, inflation redistributes resources from creditors to debtors (though this is a transfer from one group to another, not necessarily a cost to society). Interest rates incorporate people’s expectations about inflation, so if my mortgage is 3.25% and the inflation rate is 1.25%, then my bank is earning a real rate of 2% and an additional 1.25% to make up for the falling purchasing power of the dollars with which I am repaying the loan. If the inflation rate suddenly jumps to 2% and the nominal interest rate is fixed, the bank’s real return falls to 1.25%. This is good news for me (but bad news for the bank) because I am making the same monthly payment every year with dollars that are worth less than we expected them to be.

2. It’s an Indicator of Economic Health

Second, low inflation can also be an indicator of an institutional environment that is conducive to growth while high inflation can be an indicator of an institutional environment that is not. Governments like having command over real resources, and they can obtain command over real resources by taxing, by borrowing, or by simply printing money and forcing people to take it. Calvin Coolidge said that "inflation is repudiation" because a government that pays its debts by printing money returns to its creditors dollars that are worth less than the dollars the government originally borrowed and at a lower real interest rate than was originally agreed to.

Inflation has been called "the cruelest tax" because it is harder to see than other taxes and harder to trace to the government... When the government finances its activities, the cost shows up on your grocery bill rather than your tax bill.

Inflation has been called "the cruelest tax" because it is harder to see than other taxes and harder to trace to the government. When the government raises your taxes, it shows up in every paycheck and you feel it every April 15th. When the government finances its activities, the cost shows up on your grocery bill rather than your tax bill. This makes it easier to blame not the people causing the inflation (the government monetary authorities running the printing press), but the merchants and businesspeople who are responding to higher expressed demand for their products by raising prices. This can lead to positively destructive policies like price controls and persecution of businesspeople, as has recently happened in Venezuela. The temptation to print money to cover deficits can be tempting, even overwhelming in some places, so a low rate of inflation is a marker of fiscal and monetary discipline.

3. Menu Costs

These issues aside, inflation has other real costs. When inflation is low, you don’t have to change prices very often. Economists call the real costs of changing prices "menu costs." Consider a restaurant. If inflation is low, then a restaurant won’t have to reprint its menu very often. In a higher-inflation environment, restaurants have to reprint their menus more frequently, and printing menus consumes real resources (ink, paper, etc.) that could have been used for other things had they not been used to reprint menus. Across the economy, changing prices frequently consumes resources that could be used for other things.

4. Shoeleather Costs

When inflation is low, it isn’t very costly to hold your wealth as money or as non-interest bearing (or very low-interest) bank deposits. I keep some change in the car for parking meters and the like; at an inflation rate of 1.4% the change in my car isn’t depreciating rapidly enough to cause me much concern. I can hold cash and (non-interest-bearing) gift cards in my wallet without fearing that they will depreciate too rapidly. If the inflation rate were much higher and if prices were rising rapidly, I wouldn’t carry cash and gift cards. I would want to hold more assets with higher interest rates. This would mean more trips to the bank and to the ATM. Economists call the costs of managing your cash balances "shoeleather costs" because someone running back and forth between his house and the bank would wear out more shoes.

5. It Causes Tax Distortions

Inflation also interacts with the tax system to distort the decisions people make. Taxes are usually paid based on nominal values, not real values, and a high inflation rate can lead to a very large tax bite. Inflation means that "bracket creep"—where inflation pushes people into higher tax brackets even though their real incomes haven’t changed—is an important problem. It can also mean a net consumption of the capital stock. The capital gains tax, for example, taxes nominal increases rather than real increases in the value of assets.

Suppose you buy stocks for $100,000 and sell them a year later for $110,000. Suppose the inflation rate was 10%. In that case, you have earned a real return of 0%: adjusted for inflation, the stocks you sell in a year have the same value as they did when you bought them. In the eyes of the taxing authority, however, this is not the case. If the capital gains tax is 20%, then you owe the government $2,000 even though your real return was actually zero. Financial planners and others have come up with a lot of ways to deal with inflation, but the time and energy they have spent doing so represent one of the costs of inflation. If prices were stable, that time and energy would have been available for other things.

6. It Creates Confusion

Perhaps most importantly, inflation distorts people’s decisions because it adds noise and confusion to the decisions people are making. It is easier to plan and invest for the very long term if prices are stable; volatile inflation can therefore make people more short-sighted than they would otherwise be. Unanticipated changes in inflation distort the information content of prices, as well. Suppose a corn farmer sees that prices are rising. Should he plant more corn? In other words, are the rising prices due to a real increase in demand for corn, or are they simply due to the fact that there is now more money chasing fewer goods? If the rising prices are solely due to inflation, the farmer might produce too much corn. As we have discussed, a government distorting interest rates by printing too much money can also create a business cycle.

Summary

Three marks of a healthy economy are high output, full employment, and stable prices (or just "low inflation"). When inflation gets too high, it might be a marker of an unsound institutional environment. Inflation can also be costly as it requires people to consume real resources changing prices, managing the amount of money they keep on hand, and dealing with the uncertainties created by an inflationary environment. For these reasons and others, it is important to keep inflation under control.

Here is a brief video from the Foundation for Economic Education in which Steve Horwitz explains the costs of inflation.



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Comments
27 Comments.
Comment #1 by paoli2 posted on
paoli2
What I hate most about inflation is that it costs the "sale" prices of the items I need to buy be more expensive.  So I would never pay retail for anything during high inflation.  There is always someplace to find what I need discontinued, on clearance, or just on regular sales.  Even supermarkets have steaks on sale if you just wait until the following  day to buy.  It's a matter of disciplining onesself to be willing to "wait" to buy that item you want.  If you really "need" it, you get burned and may have to bite the bullet and pay the inflated price.

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Comment #2 by QED posted on
QED
This entire piece is very well taken.  Perhaps,  were Professor Carden running things, America would have an encouraging probability of survival and even return to greatness.  He isn't . . . . and we don't!

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Comment #3 by Anonymous posted on
Anonymous
Rising inflation is a scourge on renters. Landlords just keep raising the rents on the tenants whose salaries may not be keeping up.  Meanwhile, I'd rather receive 2% yield on a certificate of deposit with 1.5% inflation than 6% yield with an annual inflation rate of 10%.

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Comment #4 by Anonymous posted on
Anonymous
I'll simplify it as the purchasing power of the dollar diminishes and you need more bucks to pay for the same item in future.

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Comment #6 by QED posted on
QED
Agreed.  Very succinctly stated.

But don't forget that with America's "progressive" tax system, the tax rate on those "more bucks" you mention will constantly be increasing.  The "more bucks", as you imply, will not buy more goods.  But those same bucks will nevertheless be taxed at a higher rate.  Inflation, so favored by the Fed, is merely a way quietly, and in an almost clandestine manner, to impose higher taxes.  

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Comment #7 by Anonymous posted on
Anonymous
Plus the Feds can pay down the accumulated debt with cheaper dollars.  Not that the federal deficit is ever going to be wiped clean.

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Comment #10 by Anonymous posted on
Anonymous
#7, if the cheaper dollar is your aim, your savings will become less valuable and the interest received will go to your taxes instead in your pocket in other words, inflation is worst thing to happen to a saver. You do not want to see inflation, if you are a saver, otherwise you will receive interest money that will go on taxes and inflation and nothing will be left for you.

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Comment #18 by Anonymous posted on
Anonymous
I agree more with the comments following the article.

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Comment #8 by Anonymous posted on
Anonymous
Inflation is what helped the debtors in the 80's. My parents and grandparents each paid off their home and car with their large raises. Others bought things quickly before the price went up the following week expanding the economy. During deflation people wait for the price to go down even further slowing the economy even more. But those that went into debt during times of high inflation did not do well at all. 

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Comment #11 by Anonymous posted on
Anonymous
This time there will be no salary raises, you will sink together with the inflation and become poorer.

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Comment #13 by Anonymous posted on
Anonymous
I know a group of employees who last month received a $6 increase in a 3 year contract. If your services or talents are worthwhile during this time the money can be there. 

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Comment #14 by Anonymous posted on
Anonymous
The only group I know around my area that gets better raises than that are the school teachers.  And their services and talents aren't that great.  It has more to do with the teachers unions and school boards spending tax payers money and not their own.

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Comment #16 by Anonymous posted on
Anonymous
These were not school teachers. School teachers in our area have not received raises over 1-2% for many years. Please let me know what school district received $6 raises for a 3 year contract or actually MORE as you stated. 

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Comment #17 by Anonymous posted on
Anonymous
Northeast Pennsylvania.

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Comment #12 by Anonymous posted on
Anonymous
#8, there is no roaring economy to support pay increases, that will not work in today's environment.

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Comment #19 by Anonymous posted on
Anonymous
How about "stagflation"?

It was  just announced recently the U.S. economy contracted by almost 3%.  Gross domestic productivity fell by 2.9 percent, the worst performance in five years.

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Comment #20 by Anonymous posted on
Anonymous
For the ordinary consumer, high inflation has been a constant, since middle of last decade, when Alan Greenspan's low rate policies initiated the housing bubble. At that time the BLS CPI was stripped of consumer components so the fed could justify its ongoing strategy. Since then the CPI has been relatively unchanged from an average of 2%. A better indication of inflation is the rate that minimum wages are rising. The federal minimum wage is proposed to increase from $7.25 / hour in 2009 (start of the feds low rate stance) to $10.10 / hour in 2016 (the second full presidential election year since the bailout ). A year to year inflation of 4.8%.
The effects of inflation has revealed itself more in the lower class economy, since low wage workers don't have the large asset debts, that can be offset by low interest rate loans, as does the middle class. A record number of low wage earners have turned to public assistance, to offset the effect of inflation on their household. By increasing the minimum wage, the current administration, is attempting to move the  burden of inflation from the public sector, onto the corporate side, so that taxes are not raised before the 2016 elections. 
In economically prosperous regions of the country, minimum wages are rising proportionally to the local rate of living expenses. Seattle, where minimum wage was increased to $15 / hour, is a rate increase of 17% year to year, from 2014-2017. A flashback to 1970s style inflation. 

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Comment #21 by Anonymous posted on
Anonymous
The minimum wage was never meant to be a life long wage. It's an entry level wage for non-skilled workers. The idea that increasing the minimum wage solves any economic problem is silly. All it does is skew the stats for a short period of time until wages and prices stabilize in the affected industries.   

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Comment #22 by Anonymous posted on
Anonymous
Then, if it all comes to stabilization, no harm/foul in letting the increase go through!

1
Comment #23 by Anonymous posted on
Anonymous
Not if you're laid off or (more likely) replaced with a machine that will always show up on time and get the job done. When will people learn that market forces are far more effective than government intervention. When forty-year olds are marching for an increase in their minimum wage job I think it's time for a national conversation on the economic value assigned to particular skill sets, not individuals. Remember, there are 16 -year olds working side-by-side with 40-year olds at many of these jobs. The reason is the 40-year old has a 16-year old's skill set or, in some cases, no ambition for self-improvement.

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Comment #24 by Anonymous posted on
Anonymous
Why not mandate lower wage to have less machines and full employment?

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Comment #25 by Anonymous posted on
Anonymous
Because mandating wages has never worked, will never work and is, therefore, a dumb think to do. Only government hacks think otherwise.

1
Comment #26 by Anonymous posted on
Anonymous
Got it!  If one can't "negotiate" a private wage, they don't get the job and society is better off with that person or persons being on the public dough.  Most think otherwise and want society or brothers/sisters to have some safeguards than the whim of the employer.  Understand where "you" are coming from.

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Comment #27 by Anonymous posted on
Anonymous
Most do not think otherwise. Most want to paid according to their individual contribution. Most students want the grade they earned, not an average of the "group" effort. Most homeowners don't allow squatters. Minimum wage is just that...a minimum wage for a minimum contribution.

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Comment #28 by DonGeddis posted on
DonGeddis
This article is a poor overview of the effects of inflation in general.  First, it doesn't clearly distinguish the very different cases of zero inflation (gold standard) from low, stable inflation, from high, stable inflation, from highly volatile inflation.  Much of the so-called damage is actually from unexpected changes in inflation, not from inflation itself.

It also doesn't list the benefits of (low, stable) inflation (vs. zero inflation).  Nor does it discuss the parallel case of the damage from deflation (or even: "below expected" inflation).

The overview of the damage from high, volatile inflation is reasonable, but it's highly misleading to suggest that this article discusses the important cases of "inflation" in the large.

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Comment #29 by DonGeddis posted on
DonGeddis
To give a concrete example, the first item "you should know about inflation" says: "inflation redistributes resources from creditors to debtors".  Not only is this statement false, it isn't even supported in the text itself!  The very example in that paragraph, has a bank which anticipates and accounts for the existing low, stable, 1.25% inflation rate.  The very example is about an unanticipated change in the inflation rate (to 2%), not about inflation itself.

The correct statement would be, "an unanticipated rise in inflation redistributes resources from creditors to debtors".  But this is a very, very different statement from the one actually made.

Unfortunately, this kind of sloppiness pervades the article.

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