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