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Principles of Macroeconomics 2e

9.5 Indexing and Its Limitations

Principles of Macroeconomics 2e9.5 Indexing and Its Limitations
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  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 The Macroeconomic Perspective
    1. Introduction to the Macroeconomic Perspective
    2. 6.1 Measuring the Size of the Economy: Gross Domestic Product
    3. 6.2 Adjusting Nominal Values to Real Values
    4. 6.3 Tracking Real GDP over Time
    5. 6.4 Comparing GDP among Countries
    6. 6.5 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
  8. 7 Economic Growth
    1. Introduction to Economic Growth
    2. 7.1 The Relatively Recent Arrival of Economic Growth
    3. 7.2 Labor Productivity and Economic Growth
    4. 7.3 Components of Economic Growth
    5. 7.4 Economic Convergence
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  9. 8 Unemployment
    1. Introduction to Unemployment
    2. 8.1 How Economists Define and Compute Unemployment Rate
    3. 8.2 Patterns of Unemployment
    4. 8.3 What Causes Changes in Unemployment over the Short Run
    5. 8.4 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
  10. 9 Inflation
    1. Introduction to Inflation
    2. 9.1 Tracking Inflation
    3. 9.2 How to Measure Changes in the Cost of Living
    4. 9.3 How the U.S. and Other Countries Experience Inflation
    5. 9.4 The Confusion Over Inflation
    6. 9.5 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
  11. 10 The International Trade and Capital Flows
    1. Introduction to the International Trade and Capital Flows
    2. 10.1 Measuring Trade Balances
    3. 10.2 Trade Balances in Historical and International Context
    4. 10.3 Trade Balances and Flows of Financial Capital
    5. 10.4 The National Saving and Investment Identity
    6. 10.5 The Pros and Cons of Trade Deficits and Surpluses
    7. 10.6 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
  12. 11 The Aggregate Demand/Aggregate Supply Model
    1. Introduction to the Aggregate Supply–Aggregate Demand Model
    2. 11.1 Macroeconomic Perspectives on Demand and Supply
    3. 11.2 Building a Model of Aggregate Demand and Aggregate Supply
    4. 11.3 Shifts in Aggregate Supply
    5. 11.4 Shifts in Aggregate Demand
    6. 11.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
    7. 11.6 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
  13. 12 The Keynesian Perspective
    1. Introduction to the Keynesian Perspective
    2. 12.1 Aggregate Demand in Keynesian Analysis
    3. 12.2 The Building Blocks of Keynesian Analysis
    4. 12.3 The Phillips Curve
    5. 12.4 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
  14. 13 The Neoclassical Perspective
    1. Introduction to the Neoclassical Perspective
    2. 13.1 The Building Blocks of Neoclassical Analysis
    3. 13.2 The Policy Implications of the Neoclassical Perspective
    4. 13.3 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
  15. 14 Money and Banking
    1. Introduction to Money and Banking
    2. 14.1 Defining Money by Its Functions
    3. 14.2 Measuring Money: Currency, M1, and M2
    4. 14.3 The Role of Banks
    5. 14.4 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
  16. 15 Monetary Policy and Bank Regulation
    1. Introduction to Monetary Policy and Bank Regulation
    2. 15.1 The Federal Reserve Banking System and Central Banks
    3. 15.2 Bank Regulation
    4. 15.3 How a Central Bank Executes Monetary Policy
    5. 15.4 Monetary Policy and Economic Outcomes
    6. 15.5 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
  17. 16 Exchange Rates and International Capital Flows
    1. Introduction to Exchange Rates and International Capital Flows
    2. 16.1 How the Foreign Exchange Market Works
    3. 16.2 Demand and Supply Shifts in Foreign Exchange Markets
    4. 16.3 Macroeconomic Effects of Exchange Rates
    5. 16.4 Exchange Rate Policies
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  18. 17 Government Budgets and Fiscal Policy
    1. Introduction to Government Budgets and Fiscal Policy
    2. 17.1 Government Spending
    3. 17.2 Taxation
    4. 17.3 Federal Deficits and the National Debt
    5. 17.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation
    6. 17.5 Automatic Stabilizers
    7. 17.6 Practical Problems with Discretionary Fiscal Policy
    8. 17.7 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
  19. 18 The Impacts of Government Borrowing
    1. Introduction to the Impacts of Government Borrowing
    2. 18.1 How Government Borrowing Affects Investment and the Trade Balance
    3. 18.2 Fiscal Policy and the Trade Balance
    4. 18.3 How Government Borrowing Affects Private Saving
    5. 18.4 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
  20. 19 Macroeconomic Policy Around the World
    1. Introduction to Macroeconomic Policy around the World
    2. 19.1 The Diversity of Countries and Economies across the World
    3. 19.2 Improving Countries’ Standards of Living
    4. 19.3 Causes of Unemployment around the World
    5. 19.4 Causes of Inflation in Various Countries and Regions
    6. 19.5 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
  21. 20 International Trade
    1. Introduction to International Trade
    2. 20.1 Absolute and Comparative Advantage
    3. 20.2 What Happens When a Country Has an Absolute Advantage in All Goods
    4. 20.3 Intra-industry Trade between Similar Economies
    5. 20.4 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
  22. 21 Globalization and Protectionism
    1. Introduction to Globalization and Protectionism
    2. 21.1 Protectionism: An Indirect Subsidy from Consumers to Producers
    3. 21.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions
    4. 21.3 Arguments in Support of Restricting Imports
    5. 21.4 How Governments Enact Trade Policy: Globally, Regionally, and Nationally
    6. 21.5 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
  23. A | The Use of Mathematics in Principles of Economics
  24. B | The Expenditure-Output Model
  25. 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
  26. References
  27. Index

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

  • Explain the relationship between indexing and inflation
  • Identify three ways the government can control inflation through macroeconomic policy

When a price, wage, or interest rate is adjusted automatically with inflation, economists use the term indexed. An indexed payment increases according to the index number that measures inflation. Those in private markets and government programs observe a wide range of indexing arrangements. Since the negative effects of inflation depend in large part on having inflation unexpectedly affect one part of the economy but not another—say, increasing the prices that people pay but not the wages that workers receive—indexing will take some of the sting out of inflation.

Indexing in Private Markets

In the 1970s and 1980s, labor unions commonly negotiated wage contracts that had cost-of-living adjustments (COLAs) which guaranteed that their wages would keep up with inflation. These contracts were sometimes written as, for example, COLA plus 3%. Thus, if inflation was 5%, the wage increase would automatically be 8%, but if inflation rose to 9%, the wage increase would automatically be 12%. COLAs are a form of indexing applied to wages.

Loans often have built-in inflation adjustments, too, so that if the inflation rate rises by two percentage points, then the interest rate that a financial institution charges on the loan rises by two percentage points as well. An adjustable-rate mortgage (ARM) is a type of loan that one can use to purchase a home in which the interest rate varies with the rate of inflation. Often, a borrower will be able receive a lower interest rate if borrowing with an ARM, compared to a fixed-rate loan. The reason is that with an ARM, the lender is protected against the risk that higher inflation will reduce the real loan payments, and so the risk premium part of the interest rate can be correspondingly lower.

A number of ongoing or long-term business contracts also have provisions that prices will adjust automatically according to inflation. Sellers like such contracts because they are not locked into a low nominal selling price if inflation turns out higher than expected. Buyers like such contracts because they are not locked into a high buying price if inflation turns out to be lower than expected. A contract with automatic adjustments for inflation in effect agrees on a real price for the borrower to pay, rather than a nominal price.

Indexing in Government Programs

Many government programs are indexed to inflation. The U.S. income tax code is designed so that as a person’s income rises above certain levels, the tax rate on the marginal income earned rises as well. That is what the expression “move into a higher tax bracket” means. For example, according to the basic tax tables from the Internal Revenue Service, in 2017 a single person owed 10% of all taxable income from $0 to $9,325; 15% of all income from $9,326 to $37,950; 25% of all taxable income from $37,951 to $91,900; 28% of all taxable income from $91,901 to $191,650; 33% of all taxable income from $191,651 to $416,700; 35% of all taxable income from $416,701 to $418,400; and 39.6% of all income from $418,401 and above.

Because of the many complex provisions in the rest of the tax code, it is difficult to determine exactly the taxes an individual owes the government based on these numbers, but the numbers illustrate the basic theme that tax rates rise as the marginal dollar of income rises. Until the late 1970s, if nominal wages increased along with inflation, people were moved into higher tax brackets and owed a higher proportion of their income in taxes, even though their real income had not risen. In 1981, the government eliminated this “bracket creep”. Now, the income levels where higher tax rates kick in are indexed to rise automatically with inflation.

The Social Security program offers two examples of indexing. Since the passage of the Social Security Indexing Act of 1972, the level of Social Security benefits increases each year along with the Consumer Price Index. Also, Social Security is funded by payroll taxes, which the government imposes on the income earned up to a certain amount—$117,000 in 2014. The government adjusts this level of income upward each year according to the rate of inflation, so that an indexed increase in the Social Security tax base accompanies the indexed rise in the benefit level.

As yet another example of a government program affected by indexing, in 1996 the U.S., government began offering indexed bonds. Bonds are means by which the U.S. government (and many private-sector companies as well) borrows money; that is, investors buy the bonds, and then the government repays the money with interest. Traditionally, government bonds have paid a fixed rate of interest. This policy gave a government that had borrowed an incentive to encourage inflation, because it could then repay its past borrowing in inflated dollars at a lower real interest rate. However, indexed bonds promise to pay a certain real rate of interest above whatever inflation rate occurs. In the case of a retiree trying to plan for the long term and worried about the risk of inflation, for example, indexed bonds that guarantee a rate of return higher than inflation—no matter the level of inflation—can be a very comforting investment.

Might Indexing Reduce Concern over Inflation?

Indexing may seem like an obviously useful step. After all, when individuals, firms, and government programs are indexed against inflation, then people can worry less about arbitrary redistributions and other effects of inflation.

However, some of the fiercest opponents of inflation express grave concern about indexing. They point out that indexing is always partial. Not every employer will provide COLAs for workers. Not all companies can assume that costs and revenues will rise in lockstep with the general rates of inflation. Not all interest rates for borrowers and savers will change to match inflation exactly. However, as partial inflation indexing spreads, the political opposition to inflation may diminish. After all, older people whose Social Security benefits are protected against inflation, or banks that have loaned their money with adjustable-rate loans, no longer have as much reason to care whether inflation heats up. In a world where some people are indexed against inflation and some are not, financially savvy businesses and investors may seek out ways to be protected against inflation, while the financially unsophisticated and small businesses may suffer from it most.

A Preview of Policy Discussions of Inflation

This chapter has focused on how economists measure inflation, historical experience with inflation, how to adjust nominal variables into real ones, how inflation affects the economy, and how indexing works. We have barely hinted at the causes of inflation, and we have not addressed government policies to deal with inflation. We will examine these issues in depth in other chapters. However, it is useful to offer a preview here.

We can sum up the cause of inflation in one phrase: Too many dollars chasing too few goods. The great surges of inflation early in the twentieth century came after wars, which are a time when government spending is very high, but consumers have little to buy, because production is going to the war effort. Governments also commonly impose price controls during wartime. After the war, the price controls end and pent-up buying power surges forth, driving up inflation. Otherwise, if too few dollars are chasing too many goods, then inflation will decline or even turn into deflation. Therefore, we typically associate slowdowns in economic activity, as in major recessions and the Great Depression, with a reduction in inflation or even outright deflation.

The policy implications are clear. If we are to avoid inflation, the amount of purchasing power in the economy must grow at roughly the same rate as the production of goods. Macroeconomic policies that the government can use to affect the amount of purchasing power—through taxes, spending, and regulation of interest rates and credit—can thus cause inflation to rise or reduce inflation to lower levels.

Bring It Home

A $550 Million Loaf of Bread?

As we will learn in Money and Banking, the existence of money provides enormous benefits to an economy. In a real sense, money is the lubrication that enhances the workings of markets. Money makes transactions easier. It allows people to find employment producing one product, then use the money earned to purchase the other products they need to live. However, too much money in circulation can lead to inflation. Extreme cases of governments recklessly printing money lead to hyperinflation. Inflation reduces the value of money. Hyperinflation, because money loses value so quickly, ultimately results in people no longer using money. The economy reverts to barter, or it adopts another country’s more stable currency, like U.S. dollars. In the meantime, the economy literally falls apart as people leave jobs and fend for themselves because it is not worth the time to work for money that will be worthless in a few days.

Only national governments have the power to cause hyperinflation. Hyperinflation typically happens when government faces extraordinary demands for spending, which it cannot finance by taxes or borrowing. The only option is to print money—more and more of it. With more money in circulation chasing the same amount (or even fewer) goods and services, the only result is increasingly higher prices until the economy and/or the government collapses. This is why economists are generally wary of letting inflation spiral out of control.

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