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Principles of Economics 3e

22.4 The Confusion Over Inflation

Principles of Economics 3e22.4 The Confusion Over Inflation

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Table of contents
  1. Preface
  2. 1 Welcome to Economics!
    1. Introduction
    2. 1.1 What Is Economics, and Why Is It Important?
    3. 1.2 Microeconomics and Macroeconomics
    4. 1.3 How Economists Use Theories and Models to Understand Economic Issues
    5. 1.4 How To Organize Economies: An Overview of Economic Systems
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  3. 2 Choice in a World of Scarcity
    1. Introduction to Choice in a World of Scarcity
    2. 2.1 How Individuals Make Choices Based on Their Budget Constraint
    3. 2.2 The Production Possibilities Frontier and Social Choices
    4. 2.3 Confronting Objections to the Economic Approach
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  4. 3 Demand and Supply
    1. Introduction to Demand and Supply
    2. 3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services
    3. 3.2 Shifts in Demand and Supply for Goods and Services
    4. 3.3 Changes in Equilibrium Price and Quantity: The Four-Step Process
    5. 3.4 Price Ceilings and Price Floors
    6. 3.5 Demand, Supply, and Efficiency
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  5. 4 Labor and Financial Markets
    1. Introduction to Labor and Financial Markets
    2. 4.1 Demand and Supply at Work in Labor Markets
    3. 4.2 Demand and Supply in Financial Markets
    4. 4.3 The Market System as an Efficient Mechanism for Information
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  6. 5 Elasticity
    1. Introduction to Elasticity
    2. 5.1 Price Elasticity of Demand and Price Elasticity of Supply
    3. 5.2 Polar Cases of Elasticity and Constant Elasticity
    4. 5.3 Elasticity and Pricing
    5. 5.4 Elasticity in Areas Other Than Price
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  7. 6 Consumer Choices
    1. Introduction to Consumer Choices
    2. 6.1 Consumption Choices
    3. 6.2 How Changes in Income and Prices Affect Consumption Choices
    4. 6.3 Behavioral Economics: An Alternative Framework for Consumer Choice
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  8. 7 Production, Costs, and Industry Structure
    1. Introduction to Production, Costs, and Industry Structure
    2. 7.1 Explicit and Implicit Costs, and Accounting and Economic Profit
    3. 7.2 Production in the Short Run
    4. 7.3 Costs in the Short Run
    5. 7.4 Production in the Long Run
    6. 7.5 Costs in the Long Run
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  9. 8 Perfect Competition
    1. Introduction to Perfect Competition
    2. 8.1 Perfect Competition and Why It Matters
    3. 8.2 How Perfectly Competitive Firms Make Output Decisions
    4. 8.3 Entry and Exit Decisions in the Long Run
    5. 8.4 Efficiency in Perfectly Competitive Markets
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  10. 9 Monopoly
    1. Introduction to a Monopoly
    2. 9.1 How Monopolies Form: Barriers to Entry
    3. 9.2 How a Profit-Maximizing Monopoly Chooses Output and Price
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  11. 10 Monopolistic Competition and Oligopoly
    1. Introduction to Monopolistic Competition and Oligopoly
    2. 10.1 Monopolistic Competition
    3. 10.2 Oligopoly
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  12. 11 Monopoly and Antitrust Policy
    1. Introduction to Monopoly and Antitrust Policy
    2. 11.1 Corporate Mergers
    3. 11.2 Regulating Anticompetitive Behavior
    4. 11.3 Regulating Natural Monopolies
    5. 11.4 The Great Deregulation Experiment
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  13. 12 Environmental Protection and Negative Externalities
    1. Introduction to Environmental Protection and Negative Externalities
    2. 12.1 The Economics of Pollution
    3. 12.2 Command-and-Control Regulation
    4. 12.3 Market-Oriented Environmental Tools
    5. 12.4 The Benefits and Costs of U.S. Environmental Laws
    6. 12.5 International Environmental Issues
    7. 12.6 The Tradeoff between Economic Output and Environmental Protection
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  14. 13 Positive Externalities and Public Goods
    1. Introduction to Positive Externalities and Public Goods
    2. 13.1 Investments in Innovation
    3. 13.2 How Governments Can Encourage Innovation
    4. 13.3 Public Goods
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  15. 14 Labor Markets and Income
    1. Introduction to Labor Markets and Income
    2. 14.1 The Theory of Labor Markets
    3. 14.2 Wages and Employment in an Imperfectly Competitive Labor Market
    4. 14.3 Market Power on the Supply Side of Labor Markets: Unions
    5. 14.4 Bilateral Monopoly
    6. 14.5 Employment Discrimination
    7. 14.6 Immigration
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
  16. 15 Poverty and Economic Inequality
    1. Introduction to Poverty and Economic Inequality
    2. 15.1 Drawing the Poverty Line
    3. 15.2 The Poverty Trap
    4. 15.3 The Safety Net
    5. 15.4 Income Inequality: Measurement and Causes
    6. 15.5 Government Policies to Reduce Income Inequality
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  17. 16 Information, Risk, and Insurance
    1. Introduction to Information, Risk, and Insurance
    2. 16.1 The Problem of Imperfect Information and Asymmetric Information
    3. 16.2 Insurance and Imperfect Information
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  18. 17 Financial Markets
    1. Introduction to Financial Markets
    2. 17.1 How Businesses Raise Financial Capital
    3. 17.2 How Households Supply Financial Capital
    4. 17.3 How to Accumulate Personal Wealth
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  19. 18 Public Economy
    1. Introduction to Public Economy
    2. 18.1 Voter Participation and Costs of Elections
    3. 18.2 Special Interest Politics
    4. 18.3 Flaws in the Democratic System of Government
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  20. 19 The Macroeconomic Perspective
    1. Introduction to the Macroeconomic Perspective
    2. 19.1 Measuring the Size of the Economy: Gross Domestic Product
    3. 19.2 Adjusting Nominal Values to Real Values
    4. 19.3 Tracking Real GDP over Time
    5. 19.4 Comparing GDP among Countries
    6. 19.5 How Well GDP Measures the Well-Being of Society
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  21. 20 Economic Growth
    1. Introduction to Economic Growth
    2. 20.1 The Relatively Recent Arrival of Economic Growth
    3. 20.2 Labor Productivity and Economic Growth
    4. 20.3 Components of Economic Growth
    5. 20.4 Economic Convergence
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  22. 21 Unemployment
    1. Introduction to Unemployment
    2. 21.1 How Economists Define and Compute Unemployment Rate
    3. 21.2 Patterns of Unemployment
    4. 21.3 What Causes Changes in Unemployment over the Short Run
    5. 21.4 What Causes Changes in Unemployment over the Long Run
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  23. 22 Inflation
    1. Introduction to Inflation
    2. 22.1 Tracking Inflation
    3. 22.2 How to Measure Changes in the Cost of Living
    4. 22.3 How the U.S. and Other Countries Experience Inflation
    5. 22.4 The Confusion Over Inflation
    6. 22.5 Indexing and Its Limitations
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  24. 23 The International Trade and Capital Flows
    1. Introduction to the International Trade and Capital Flows
    2. 23.1 Measuring Trade Balances
    3. 23.2 Trade Balances in Historical and International Context
    4. 23.3 Trade Balances and Flows of Financial Capital
    5. 23.4 The National Saving and Investment Identity
    6. 23.5 The Pros and Cons of Trade Deficits and Surpluses
    7. 23.6 The Difference between Level of Trade and the Trade Balance
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  25. 24 The Aggregate Demand/Aggregate Supply Model
    1. Introduction to the Aggregate Supply–Aggregate Demand Model
    2. 24.1 Macroeconomic Perspectives on Demand and Supply
    3. 24.2 Building a Model of Aggregate Demand and Aggregate Supply
    4. 24.3 Shifts in Aggregate Supply
    5. 24.4 Shifts in Aggregate Demand
    6. 24.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
    7. 24.6 Keynes’ Law and Say’s Law in the AD/AS Model
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  26. 25 The Keynesian Perspective
    1. Introduction to the Keynesian Perspective
    2. 25.1 Aggregate Demand in Keynesian Analysis
    3. 25.2 The Building Blocks of Keynesian Analysis
    4. 25.3 The Phillips Curve
    5. 25.4 The Keynesian Perspective on Market Forces
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  27. 26 The Neoclassical Perspective
    1. Introduction to the Neoclassical Perspective
    2. 26.1 The Building Blocks of Neoclassical Analysis
    3. 26.2 The Policy Implications of the Neoclassical Perspective
    4. 26.3 Balancing Keynesian and Neoclassical Models
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  28. 27 Money and Banking
    1. Introduction to Money and Banking
    2. 27.1 Defining Money by Its Functions
    3. 27.2 Measuring Money: Currency, M1, and M2
    4. 27.3 The Role of Banks
    5. 27.4 How Banks Create Money
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  29. 28 Monetary Policy and Bank Regulation
    1. Introduction to Monetary Policy and Bank Regulation
    2. 28.1 The Federal Reserve Banking System and Central Banks
    3. 28.2 Bank Regulation
    4. 28.3 How a Central Bank Executes Monetary Policy
    5. 28.4 Monetary Policy and Economic Outcomes
    6. 28.5 Pitfalls for Monetary Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  30. 29 Exchange Rates and International Capital Flows
    1. Introduction to Exchange Rates and International Capital Flows
    2. 29.1 How the Foreign Exchange Market Works
    3. 29.2 Demand and Supply Shifts in Foreign Exchange Markets
    4. 29.3 Macroeconomic Effects of Exchange Rates
    5. 29.4 Exchange Rate Policies
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  31. 30 Government Budgets and Fiscal Policy
    1. Introduction to Government Budgets and Fiscal Policy
    2. 30.1 Government Spending
    3. 30.2 Taxation
    4. 30.3 Federal Deficits and the National Debt
    5. 30.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation
    6. 30.5 Automatic Stabilizers
    7. 30.6 Practical Problems with Discretionary Fiscal Policy
    8. 30.7 The Question of a Balanced Budget
    9. Key Terms
    10. Key Concepts and Summary
    11. Self-Check Questions
    12. Review Questions
    13. Critical Thinking Questions
    14. Problems
  32. 31 The Impacts of Government Borrowing
    1. Introduction to the Impacts of Government Borrowing
    2. 31.1 How Government Borrowing Affects Investment and the Trade Balance
    3. 31.2 Fiscal Policy and the Trade Balance
    4. 31.3 How Government Borrowing Affects Private Saving
    5. 31.4 Fiscal Policy, Investment, and Economic Growth
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  33. 32 Macroeconomic Policy Around the World
    1. Introduction to Macroeconomic Policy around the World
    2. 32.1 The Diversity of Countries and Economies across the World
    3. 32.2 Improving Countries’ Standards of Living
    4. 32.3 Causes of Unemployment around the World
    5. 32.4 Causes of Inflation in Various Countries and Regions
    6. 32.5 Balance of Trade Concerns
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  34. 33 International Trade
    1. Introduction to International Trade
    2. 33.1 Absolute and Comparative Advantage
    3. 33.2 What Happens When a Country Has an Absolute Advantage in All Goods
    4. 33.3 Intra-industry Trade between Similar Economies
    5. 33.4 The Benefits of Reducing Barriers to International Trade
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  35. 34 Globalization and Protectionism
    1. Introduction to Globalization and Protectionism
    2. 34.1 Protectionism: An Indirect Subsidy from Consumers to Producers
    3. 34.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions
    4. 34.3 Arguments in Support of Restricting Imports
    5. 34.4 How Governments Enact Trade Policy: Globally, Regionally, and Nationally
    6. 34.5 The Tradeoffs of Trade Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  36. A | The Use of Mathematics in Principles of Economics
  37. B | Indifference Curves
  38. C | Present Discounted Value
  39. D | The Expenditure-Output Model
  40. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
    17. Chapter 17
    18. Chapter 18
    19. Chapter 19
    20. Chapter 20
    21. Chapter 21
    22. Chapter 22
    23. Chapter 23
    24. Chapter 24
    25. Chapter 25
    26. Chapter 26
    27. Chapter 27
    28. Chapter 28
    29. Chapter 29
    30. Chapter 30
    31. Chapter 31
    32. Chapter 32
    33. Chapter 33
    34. Chapter 34
  41. References
  42. Index

Learning Objectives

By the end of this section, you will be able to:

  • Explain how inflation can cause redistributions of purchasing power
  • Identify ways inflation can blur the perception of supply and demand
  • Explain the economic benefits and challenges of inflation

Economists usually oppose high inflation, but they oppose it in a milder way than many non-economists. Robert Shiller, one of 2013’s Nobel Prize winners in economics, carried out several surveys during the 1990s about attitudes toward inflation. One of his questions asked, “Do you agree that preventing high inflation is an important national priority, as important as preventing drug use or preventing deterioration in the quality of our schools?” Answers were on a scale of 1–5, where 1 meant “Fully agree” and 5 meant “Completely disagree.” For the U.S. population as a whole, 52% answered “Fully agree” that preventing high inflation was a highly important national priority and just 4% said “Completely disagree.” However, among professional economists, only 18% answered “Fully agree,” while the same percentage of 18% answered “Completely disagree.”

The Land of Funny Money

What are the economic problems caused by inflation, and why do economists often regard them with less concern than the general public? Consider a very short story: “The Land of Funny Money.”

One morning, everyone in the Land of Funny Money awakened to find that everything denominated in money had increased by 20%. The change was completely unexpected. Every price in every store was 20% higher. Paychecks were 20% higher. Interest rates were 20 % higher. The amount of money, everywhere from wallets to savings accounts, was 20% larger. This overnight inflation of prices made newspaper headlines everywhere in the Land of Funny Money. However, the headlines quickly disappeared, as people realized that in terms of what they could actually buy with their incomes, this inflation had no economic impact. Everyone’s pay could still buy exactly the same set of goods as it did before. Everyone’s savings were still sufficient to buy exactly the same car, vacation, or retirement that they could have bought before. Equal levels of inflation in all wages and prices ended up not mattering much at all.

When the people in Robert Shiller’s surveys explained their concern about inflation, one typical reason was that they feared that as prices rose, they would not be able to afford to buy as much. In other words, people were worried because they did not live in a place like the Land of Funny Money, where all prices and wages rose simultaneously. Instead, people live here on Planet Earth, where prices might rise while wages do not rise at all, or where wages rise more slowly than prices.

Economists note that over most periods, the inflation level in prices is roughly similar to the inflation level in wages, and so they reason that, on average, over time, people’s economic status is not greatly changed by inflation. If all prices, wages, and interest rates adjusted automatically and immediately with inflation, as in the Land of Funny Money, then no one’s purchasing power, profits, or real loan payments would change. However, if other economic variables do not move exactly in sync with inflation, or if they adjust for inflation only after a time lag, then inflation can cause three types of problems: unintended redistributions of purchasing power, blurred price signals, and difficulties in long-term planning.

Unintended Redistributions of Purchasing Power

Inflation can cause redistributions of purchasing power that hurt some and help others. People who are hurt by inflation include those who are holding considerable cash, whether it is in a safe deposit box or in a cardboard box under the bed. When inflation happens, the buying power of cash diminishes. However, cash is only an example of a more general problem: anyone who has financial assets invested in a way that the nominal return does not keep up with inflation will tend to be affected by inflation. For example, if a person has money in a bank account that pays 4% interest, but inflation rises to 5%, then the real rate of return for the money invested in that bank account is negative 1%.

The problem of a good-looking nominal interest rate transforming into an ugly-looking real interest rate can be worsened by taxes. The U.S. income tax is charged on the nominal interest received in dollar terms, without an adjustment for inflation. Thus, the government taxes a person who invests $10,000 and receives a 5% nominal rate of interest on the $500 received—no matter whether the inflation rate is 0%, 5%, or 10%. If inflation is 0%, then the real interest rate is 5% and all $500 is a gain in buying power. However, if inflation is 5%, then the real interest rate is zero and the person had no real gain—but owes income tax on the nominal gain anyway. If inflation is 10%, then the real interest rate is negative 5% and the person is actually falling behind in buying power, but would still owe taxes on the $500 in nominal gains.

Inflation can cause unintended redistributions for wage earners, too. Wages do typically creep up with inflation over time, eventually. The last row of Table 22.1 at the start of this chapter showed that the average hourly wage in manufacturing in the U.S. economy increased from $3.23 in 1970 to $30.11 in 2021, which is an increase by a factor of close to ten. Over that time period, the Consumer Price Index increased by about a factor of eight. However, increases in wages may lag behind inflation for a year or two, since wage adjustments are often somewhat sticky and occur only once or twice a year. Moreover, the extent to which wages keep up with inflation creates insecurity for workers and may involve painful, prolonged conflicts between employers and employees. If the government adjusts minimum wage for inflation only infrequently, minimum wage workers are losing purchasing power from their nominal wages, as Figure 22.6 shows.

This graph illustrates minimum wage and inflation. The y-axis measures the minimum wage in dollars, from 0 to 16, in increments of 2 dollars. The x-axis measures years, from 1965 to 2020. The minimum wage starts in 1965 at around 9 dollars, but then steadily declines over time, until it is around 6 dollars in 2020.
Figure 22.6 U.S. Minimum Wage and Inflation After adjusting for inflation, the federal minimum wage dropped about 30 percent from 1965–2020, even though the nominal figure climbed from $1.40 to $7.25 per hour. Increases in the minimum wage in between 2008 and 2010 kept the decline from being worse—as it would have been if the wage had remained the same as it did from 1997 through 2007. Since 2010, the real minimum wage has continued to decline. (Sources: http://www.dol.gov/whd/minwage/chart.htm and http://data.bls.gov/cgi-bin/surveymost?cu)

One sizable group of people has often received a large share of their income in a form that does not increase over time: retirees who receive a private company pension. Most pensions have traditionally been set as a fixed nominal dollar amount per year at retirement. For this reason, economists call pensions “defined benefits” plans. Even if inflation is low, the combination of inflation and a fixed income can create a substantial problem over time. A person who retires on a fixed income at age 65 will find that losing just 1% to 2% of buying power per year to inflation compounds to a considerable loss of buying power after a decade or two.

Fortunately, pensions and other defined benefits retirement plans are increasingly rare, replaced instead by “defined contribution” plans, such as 401(k)s and 403(b)s. In these plans, the employer contributes a fixed amount to the worker’s retirement account on a regular basis (usually every pay check). The employee often contributes as well. The worker invests these funds in a wide range of investment vehicles. These plans are tax deferred, and they are portable so that if the individual takes a job with a different employer, their 401(k) comes with them. To the extent that the investments made generate real rates of return, retirees are not burdened by the inflation costs of traditional pensioners.

However, ordinary people can sometimes benefit from the unintended redistributions of inflation. Consider someone who borrows $10,000 to buy a car at a fixed interest rate of 9%. If inflation is 3% at the time the loan is made, then the borrower must repay the loan at a real interest rate of 6%. However, if inflation rises to 9%, then the real interest rate on the loan is zero. In this case, the borrower’s benefit from inflation is the lender’s loss. A borrower paying a fixed interest rate, who benefits from inflation, is just the flip side of an investor receiving a fixed interest rate, who suffers from inflation. The lesson is that when interest rates are fixed, rises in the rate of inflation tend to penalize suppliers of financial capital, who receive repayment in dollars that are worth less because of inflation, while demanders of financial capital end up better off, because they can repay their loans in dollars that are worth less than originally expected.

The unintended redistributions of buying power that inflation causes may have a broader effect on society. America’s widespread acceptance of market forces rests on a perception that people’s actions have a reasonable connection to market outcomes. When inflation causes a retiree who built up a pension or invested at a fixed interest rate to suffer, however, while someone who borrowed at a fixed interest rate benefits from inflation, it is hard to believe that this outcome was deserved in any way. Similarly, when homeowners benefit from inflation because the price of their homes rises, while renters suffer because they are paying higher rent, it is hard to see any useful incentive effects. One of the reasons that the general public dislikes inflation is a sense that it makes economic rewards and penalties more arbitrary—and therefore likely to be perceived as unfair – even dangerous, as the next Clear It Up feature shows.

Clear It Up

Is there a connection between German hyperinflation and Hitler’s rise to power?

Germany suffered an intense hyperinflation of its currency, the Mark, in the years after World War I, when the Weimar Republic in Germany resorted to printing money to pay its bills and the onset of the Great Depression created the social turmoil that Adolf Hitler was able to take advantage of in his rise to power. Shiller described the connection this way in a National Bureau of Economic Research 1996 Working Paper:

A fact that is probably little known to young people today, even in Germany, is that the final collapse of the Mark in 1923, the time when the Mark’s inflation reached astronomical levels (inflation of 35,974.9% in November 1923 alone, for an annual rate that month of 4.69 × 1028%), came in the same month as did Hitler’s Beer Hall Putsch, his Nazi Party’s armed attempt to overthrow the German government. This failed putsch resulted in Hitler’s imprisonment, at which time he wrote his book Mein Kampf, setting forth an inspirational plan for Germany’s future, suggesting plans for world domination. . .

. . . Most people in Germany today probably do not clearly remember these events; this lack of attention to it may be because its memory is blurred by the more dramatic events that succeeded it (the Nazi seizure of power and World War II). However, to someone living through these historical events in sequence . . . [the putsch] may have been remembered as vivid evidence of the potential effects of inflation.

Blurred Price Signals

Prices are the messengers in a market economy, conveying information about conditions of demand and supply. Inflation blurs those price messages. Inflation means that we perceive price signals more vaguely, like a radio program received with considerable static. If the static becomes severe, it is hard to tell what is happening.

In Israel, when inflation accelerated to an annual rate of 500% in 1985, some stores stopped posting prices directly on items, since they would have had to put new labels on the items or shelves every few days to reflect inflation. Instead, a shopper just took items from a shelf and went up to the checkout register to find out the price for that day. Obviously, this situation makes comparing prices and shopping for the best deal rather difficult. When the levels and changes of prices become uncertain, businesses and individuals find it harder to react to economic signals. In a world where inflation is at a high rate, but bouncing up and down to some extent, does a higher price of a good mean that inflation has risen, or that supply of that good has decreased, or that demand for that good has increased? Should a buyer of the good take the higher prices as an economic hint to start substituting other products—or have the prices of the substitutes risen by an equal amount? Should a seller of the good take a higher price as a reason to increase production—or is the higher price only a sign of a general inflation in which the prices of all inputs to production are rising as well? The true story will presumably become clear over time, but at a given moment, who can say?

High and variable inflation means that the incentives in the economy to adjust in response to changes in prices are weaker. Markets will adjust toward their equilibrium prices and quantities more erratically and slowly, and many individual markets will experience a greater chance of surpluses and shortages.

Problems of Long-Term Planning

Inflation can make long-term planning difficult. In discussing unintended redistributions, we considered the case of someone trying to plan for retirement with a pension that is fixed in nominal terms and a high rate of inflation. Similar problems arise for all people trying to save for retirement, because they must consider what their money will really buy several decades in the future when we cannot know the rate of future inflation.

Inflation, especially at moderate or high levels, will pose substantial planning problems for businesses, too. A firm can make money from inflation—for example, by paying bills and wages as late as possible so that it can pay in inflated dollars, while collecting revenues as soon as possible. A firm can also suffer losses from inflation, as in the case of a retail business that gets stuck holding too much cash, only to see inflation eroding the value of that cash. However, when a business spends its time focusing on how to profit by inflation, or at least how to avoid suffering from it, an inevitable tradeoff strikes: less time is spent on improving products and services or on figuring out how to make existing products and services more cheaply. An economy with high inflation rewards businesses that have found clever ways of profiting from inflation, which are not necessarily the businesses that excel at productivity, innovation, or quality of service.

In the short term, low or moderate levels of inflation may not pose an overwhelming difficulty for business planning, because costs of doing business and sales revenues may rise at similar rates. If, however, inflation varies substantially over the short or medium term, then it may make sense for businesses to stick to shorter-term strategies. The evidence as to whether relatively low rates of inflation reduce productivity is controversial among economists. There is some evidence that if inflation can be held to moderate levels of less than 3% per year, it need not prevent a nation’s real economy from growing at a healthy pace. For some countries that have experienced hyperinflation of several thousand percent per year, an annual inflation rate of 20–30% may feel basically the same as zero. However, several economists have pointed to the suggestive fact that when U.S. inflation heated up in the early 1970s—to 10%—U.S. growth in productivity slowed down, and when inflation slowed down in the 1980s, productivity edged up again not long thereafter, as Figure 22.7 shows.

This graph illustrates two lines, the growth rate of labor productivity over time, and the rate of inflation. The y-axis shows the growth rate of labor productivity, from –4 percent to 14 percent, in increments of 2 percent. The x-axis shows years from 1968 to 2020. The inflation rate begins at 4 percent in 1968, decreases to 3 percent in 1965, then increases, with spikes to 11 percent in 1974 and 13 percent in 1981, declining to 3 percent in 1984, and generally declining and staying between 1 and 3 percent until 2020. Broadly, the growth rate of labor productivity line moves in the opposite direction of the inflation line. It begins at 4 percent in 1968, then decreases, moving the opposite direction of the inflation rate, and is negative in 1974 and 1982. It increases in 1983 and is generally positive, between 0 and 4 percent, until 2020.
Figure 22.7 U.S. Inflation Rate and U.S. Labor Productivity, 1961–2020 Over the last several decades in the United States, there have been times when rising inflation rates have been closely followed by lower productivity rates and lower inflation rates have corresponded to increasing productivity rates. As the graph shows, however, this correlation does not always exist.

Any Benefits of Inflation?

Although the economic effects of inflation are primarily negative, two countervailing points are worth noting. First, the impact of inflation will differ considerably according to whether it is creeping up slowly at 0% to 2% per year, galloping along at 10% to 20% per year, or racing to the point of hyperinflation at, say, 40% per month. Hyperinflation can rip an economy and a society apart. An annual inflation rate of 2%, 3%, or 4%, however, is a long way from a national crisis. Low inflation is also better than deflation which occurs with severe recessions.

Second, economists sometimes argue that moderate inflation may help the economy by making wages in labor markets more flexible. The discussion in Unemployment pointed out that wages tend to be sticky in their downward movements and that unemployment can result. A little inflation could nibble away at real wages, and thus help real wages to decline if necessary. In this way, even if a moderate or high rate of inflation may act as sand in the gears of the economy, perhaps a low rate of inflation serves as oil for the gears of the labor market. This argument is controversial. A full analysis would have to account for all the effects of inflation. It does, however, offer another reason to believe that, all things considered, very low rates of inflation may not be especially harmful.

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