Inflation: Is it really all bad? Mrs. Jeane McNamara GVHS: SP 2002

What is Inflation? Sustained increase in price level

Is inflation all bad? Depends!--The key is that increases in real wages must be > increase in the price level

What is impacted by inflation? Purchasing power: given a fixed sum of $, what goods/services will it buy? Real wages: what is the purchasing power of your wages

Does inflation erode wages? DEPENDS! Remember, REAL wages must be > rate of inflation COLA--”Cost of Living Adjustment”--If the COLA is tied to at or above inflation, the wage earner is ok

Inflation does NOT... SYSTEMATICALLY erode purchasing power (price changes could be tied to a specific sector of the economy) DOES NOT lead to unfair prices SHOULDN’T be blamed when the price of one good goes up relative to the price of another good

Who is hurt by inflation? Lenders at fixed rates (lower than the rate of inflation) Savers at fixed rates (lower than the rate of inflation) Borrowers at variable rates (adjustable rates are tied to inflationary indecies) Income earners at fixed wages (e.g. contract/union workers)

Who is hurt by inflation?(con’t) Those individuals living on fixed incomes (NOTE: SS does allow for a COLA, but it isn’t always tied to the rate of inflation) Consumers, unless wages keep pace

Who is helped by inflation? Borrowers at fixed rates (lower than the rate of inflation) Lenders at adjustable rates

Conclusions about inflation Inflation tends to arbitrarily redistribute income

Interest rates and inflation The Real Rate of Interest = i-rate adjusted for inflation = TRUE borrowing power The Nominal Rate of Interest = ‘expected’ interest rate + inflation = % i-rate borrower pays lender not adjusted for inflation

Interest rates and taxes Our tax system was designed for an inflation-free economy--taxes tax nominal interest rates Conclusion: in periods of high inflation, taxes penalize interest income because our tax system doesn’t distinguish between real and nominal interest rates

Interest rates and taxes (con’t) THEREFORE: Savings and Investment are DISCOURAGED by our own tax system

Types of Inflation Creeping--Upward pressure on the price level at a steady pace Bracket Creep--inflation pushing wage earners into higher tax brackets Galloping--spikey increases (ex: post WWI Germany, Latin countries)

Types of Inflation (con’t) Dis-inflation: a sustained period of little or no inflation Deflation: sustained decreases in the price level

How is the inflation rate measured? Representatives from the Commerce Department purchase the “market basket” of goods and services to come up with a “Consumer Price Index” (CPI) Economists like the “core inflation” measure--the CPI with food and energy extracted

Problems with the CPI Often overstated as the market basket doesn’t change in step with consumer preference and/or regional demand

What’s the difference between “cost-push” and “demand-pull” inflation? Demand-pull inflation is driven by increased demand in the economy for goods and services Cost-push inflation is driven by increased costs of production