- Study Guide (Course-wide Content)
A. Definition and Impact of Inflation
- Recall that inflation occurs when the general level of prices is rising. The rate of inflation is the percentage change in a price index from one period to the next. The major price indexes are the consumer price index (CPI) and the GDP deflator.
- Like diseases, inflations come in different strains. We generally see low inflation in the United States (a few percentage points annually). Sometimes, galloping inflation produces price rises of 50 or 100 or 200 percent each year. Hyperinflation takes over when the printing presses spew out currency and prices start rising many times each month. Historically, hyperinflations have almost always been associated with war and revolution.
- Inflation affects the economy by redistributing income and wealth and by impairing efficiency. Unanticipated inflation usually favors debtors, profit seekers, and risk-taking speculators. It hurts creditors, fixed-income classes, and timid investors. Inflation leads to distortions in relative prices, tax rates, and real interest rates. People take more trips to the bank, taxes may creep up, and measured income may become distorted.
- At any time, an economy has a given expected inflation rate. This is the rate that people have come to anticipate and that is built into labor contracts and other agreements. The expected rate of inflation is a short-run equilibrium and persists until the economy is shocked.
- In reality, the economy receives incessant price shocks. The major kinds of shocks that propel inflation away from its expected rate are demand-pull and supply-shock. Demand-pull inflation results from too much spending chasing too few goods, causing the aggregate demand curve to shift up and to the right. Wages and prices are then bid up in markets. Supply-shock inflation is a new phenomenon of modern industrial economies and occurs when the costs of production rise even in periods of high unemployment and idle capacity.
- The Phillips curve shows the relationship between inflation and unemployment. In the short run, lowering one rate means raising the other. But the short-run Phillips curve tends to shift over time as expected inflation and other factors change. If policymakers attempt to hold unemployment below the NAIRU for long periods, inflation will tend to spiral upward.
- Modern inflation theory relies on the concept of the nonaccelerating inflation rate of unemployment, or NAIRU, which is the lowest sustainable unemployment rate that the nation can enjoy without risking an upward spiral of inflation. It represents the level of unemployment of resources at which labor and product markets are in inflationary balance. Under the NAIRU theory, there is no permanent tradeoff between unemployment and inflation, and the long-run Phillips curve is vertical.
- A central concern for policymakers is the cost of reducing inflation. Current estimates indicate that a substantial recession is necessary to slow expected inflation.
- Economists have put forth many proposals for lowering the NAIRU; notable proposals include improving labor market information, improving education and training programs, and refashioning government programs so that workers have greater incentives to work.