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Keeping The Lid On INFLATION

It's Thursday! It's 2:30 in the afternoon! IT'S PRETZEL TIME!! We must make a brief stop at one of Shady Valley's most acclaimed business establishments -- Max Mulroney's Pretzel Haven. My favorite, of course, is pretzel-on-a-stick. An ample supply of barbecue sauce is standard fair. I'm taken aback! Max has raised his pretzel prices once again -- for the third Thursday in a row. What sort of chicanery is at work here? Is Max trying to gouge the pretzel lovers of Shady Valley? Max says, quite emphatically, NO! His pretzel producing cost has risen. It seems, he explains, to be a pervasive problem throughout Shady Valley. He's not alone in pumping up prices. A quick price checking, window shopping expedition through the Shady Valley Central Town Sprawling Hills Shopping Mall, Mega-Mart Discount Warehouse Super Center, Manny Mustard's House of Sandwiches, and even Dr. Nova Cain's dental office reveals truth to Max's claim. Prices all over Shady Valley are rising. I suspect that there's only one way to unravel the intricacies of this mystery, we're need to examine the topic of inflation.

On the Rise

Inflation is one of those on again, off again topics that sometimes catches politicians' and the public's fancy, then falls by the wayside in favor of another. Inflation stirred much public interest in the 1970s, but was barely heard from in the 1980s. It comes, it goes. Before we can figure out why the beast is so erratic, we need to figure out what it is.

Here's a straightforward definition of inflation (one of the few straightforward definitions you'll get outside of the glossary): Inflation is a rise in the economy's average price level. Well, that seems to be a simple, straightforward definition, yet it raises an additional question. What is "the economy's average price level?"

Measuring Our Elusive Price Level

The price level is, quite simply, an average of the prices of goods and services in the economy. In other words, it is the "price" at which our economy's gross domestic product is sold. It's typically measure with an index, such as the consumer price index and the GDP price deflator. Each measures the average of thousands of different prices. During most periods, some prices are rising and some are falling. Inflation occurs when most, but not necessarily all, prices are rising.

The two most common price indexes are:

  • Consumer price index. This is the average of prices of the sorts of goods purchased by consumers. As such, it includes the prices of stuff like VCRs, cars, toothpaste, appendectomies, granola bars, Colorado ski vacations, and Hot Mamma Fudge Bananarama Ice Cream sundaes.

  • GDP price deflator. The good pointy-headed people of the Department of Commerce give us a more comprehensive index of prices than the CPI -- the GDP price deflator. When these folks measure gross domestic product, they measure it in both in nominal dollars and real dollars. The ratio of nominal GDP to real GDP gives us an our price index.

While there are some differences between the CPI and the GDP price deflator that can be found in the glossary, they're pretty consistent most of the time.

Crunching Some Inflation Rate Numbers

So how is inflation measured from either of these indicators of the average price level? Whether we use the CPI or the GDP price deflator, the procedure is the same. For the sake of argument and illustration, let's say that the CPI for one year (call it Year 1) is 100 and for a second year (call it Year 2) it is 105. (Note that indexes are set up such that a so-called base year -- our Year 1 -- gets a number of 100.) To find the rate of inflation from Year 1 to Year 2, we simply calculate the percentage change from 100 to 105. Our example is a pretty easy one, giving us 5 percent inflation. If we wanted the inflation rate from Year 2 to Year 3 (with a number of 107), then the computation isn't quite simple. The rate in this case is (107 - 105)/105, or 1.9 percent.

This method is used for an annual price index. However, the CPI and the GDP price deflator numbers come out monthly or quarterly. For example, when the newsguys get the monthly CPI numbers, the inflation rate that's calculated is annual rate. In other words, if we calculate the percentage change using this procedure, we would have an inflation rate for one month only. The monthly rate needs to be multiplied by 12 to give us an annual inflation rate -- sort of the rate that would exist if the rest of the year was exactly like this one month. Annualized rates make it easy to compare periods of differing lengths, such as this month with last year ago or six month period two years ago.

Here's an example: Let's say the CPI is 125.6 in March and 126.2 in April. The percentage change for one month is then (126.2 - 125.6)/125.6, or 0.47 percent. However, the annualized inflation rate is 12 times as great, or 5.7 percent. When you hear a newsguys talk about a 5.7 percent inflation rate last month, it doesn't mean prices went up by 5.7 percent last month, they actually increased by only 0.47 percent. The 5.7 percent is the annualized inflation rate.

Keeping an Eye Out for Inflation

Throughout the 200-plus year history of the good old U. S. of A., we've had very few years with NO inflation. On occasion we see prices holding steady for a few months, or even a few years. We might even see a decline in prices, what the pointy-headed economists term deflation. Rising prices, though, tend to be the norm.

Yet, there are some periods when we can expect prices to rise more rapidly than others. As we noted in Fact 7, our economy is prone to experience business cycles. Our pie expands for a few years, then it contracts for a year or two. Then it begins to expand once more. When the economy contracts unemployment rises, when the economy expands unemployment falls.

Inflation is also inclined to rise and fall over the course of business cycles -- moving, though, in the opposite direction of unemployment. When the economy contracts, the inflation rate tends to drop (and occasionally giving us some of that deflation). When the economy expands, the inflation rate tends to increase. While you might not care to wager your entire life savings on this relationship, you might want to keep track of the business cycle if your plans over the next few years depend on the inflation rate.

The Why of Inflation

Inflation is out there, usually lurking near the expansion of a business cycle. The question is: Why? What causes inflation? The simple answer is money. Our average price level tends to rise when we have too much money.

Here's the story. Money is used to buy stuff. (Without money, we would need a barter system -- trading one good for another.) Prices of the stuff you buy and sell depend directly on the total amount of money in the economy. For example, let's consider the situation in the quaint and courteous Republic of Northwest Queoldiola. Their currency of choice is the queold. Suppose that the Northwest Queoldiolan government has issued a total of 10 billion queolds. Given this number of queolds in circulation, you can purchase a sundial (a product that has made Northwest Queoldiola famous worldwide) for 50 queolds. What would happen, though, if the Northwest Queoldiolan government decided to bump the number of queolds in circulation to 20 billion?

Although Queoldiolians would have twice as much money, there's no increase in the production of sundials. The going price for sundials would therefore jump up to 100 queolds. Inflation, as such, is nothing more than too much money chasing after too little stuff.

Throughout the history of our planet, inflation has followed lockstep with increases in money. More money means higher prices.

Over the course of business cycles, money tightens up during a contraction, so inflation declines, then money becomes more plentiful during expansions, thus inflation rises. Part of this is by the design of the first estate leaders, but part is just a natural part business cycles.

Your Worst Nightmare?

The records clearly show that inflation is considered by many to be one of the most serious problems facing our economy. Why?

  • Trade a lot, produce a little. With high inflation rates, people devote more effort to buying, selling, and exchanging and less to producing. For example, if prices are expected to double by the end of the day (an inflation rate that is actually pretty mild compared to some historical examples), then you will want to spend your money as fast as you can. If you don't spend it in the morning, then it's worth half as much by nightfall. You end up using more time buying and selling stuff every day, with less time left for actual working. High inflation rates (10 percent or more per year) usually trigger a fall off in production.

    This production drop, however, is not the biggest problem of inflation. That honor is bestowed on the distribution of wealth and income.

  • Haphazardly transferring wealth around. Income and wealth are redistributed when prices rise at different rates. Suppose, for example, that our economy has two goods, health care and food, with each constituting an equal share of our economic pie. If health care prices rise by 10 percent and food prices don't change, then the average inflation rate is 5 percent. However, consumers with resources employed in health care get 10 percent more income while those resources in food production get no additional income. The result is that health care resources get 55 percent of the income and wealth and food production resources end up with 45 percent. We have a redistribution of income and wealth to health care resources.Let's wrap up this inflation excursion -- giving me a chance to enjoy my pretzel-on-a-stick -- with a few tips:


    Inflation Tips

    • Inflation tends to be most deadly to those who are caught unaware. While no one can predict the future with any certainty, you can keep an eye out for assorted forecasts of the economy's conditions for coming years. One of the main things to watch is the money supply. When it starts rising a bunch, then brace yourself for higher inflation rates.

    • The redistribution of wealth caused by inflation is usually a bigger problem for the second estate (who have the wealth) than it is for the third estate. As such, the businesses leaders of the second estate, think inflation is a greater problem than unemployment. However, in that underappreciated consumers and workers are the ones most likely to be unemployed, inflation tends to be the lesser of these two evils for the third estate. This difference should be considered when politicians champion their favorite anti-inflation or anti-employment policy. Which estate are they most interested in helping?

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