Tag Archives: inflation

Ask an Economist: Why do prices have to go up?

Why is it inevitable that prices go up? In other words, why do we just /assume/ that it makes sense for everything to cost twenty (or so) times today what it cost a hundred years ago?

In theory, the Fed could try and manage the money supply in a way that tries to hit a 0 percent inflation mark. But there are lots of problems with this, and aiming instead for a 2 to 2-and-a-half rate arguably has advantages.

First, it’s important to realize that managing the money supply with regard to inflation is an imperfect science. It’s like trying to steer an aircraft carrier looking out of a warped and blurry porthole. It takes months to turn the ship, CPIand you’re never sure of what ahead or what the currents really look like. Even with some of the best macroeconomic minds in the business working on this full-time, it’s impossible to anticipate everything that could happen.

A big problem with aiming for 0 percent inflation is that there’s a big risk that at some point you’d have deflation, when prices are actually decreasing. This might sound like a good thing, but it’s actually traumatic for an economy – just ask Japan. If consumers believe that prices will be lower next month than they are today, they delay purchases – which can lead to even more deflation. When 70 percent of GDP is driven by consumers, this can be devastating for the economy and lead to prolonged recessions and higher unemployment.

Another point to remember is that when average prices are rising by 2 percent a year, some prices are rising much more, and some are actually falling. This is always the case. The inflation numbers reported in the news are just the overall, Price Changes by Categoryweighted averages for urban consumers. There’s always actual deflation occurring in some product categories, and depending on what you buy, the average prices you pay could actually be decreasing overall.

There’s also an (arguable) advantage to having prices increase by 2 or 3 percent a year. This allows employers to give some workers pay cuts by holding their (nominal) wages constant. This actually can be helpful to the economy in declining industries, or with poorly-performing workers. It’s very difficult to give employees actual (nominal) pay cuts, even when it’s necessary and appropriate. Having inflation allows employers to freeze wages and give employees (real) pay cuts. The workers know what’s happening, of course, but they’re less likely to riot than they would be if their nominal wages were cut.

Finally, having low, steady rates of inflation do very little harm to an economy. Borrowers, lenders, firms, consumers, and everyone else expects prices to rise by small amounts, and they build them into prices, contracts, and decisions. The small “menu costs” involved with changing prices every year or so are a small price to pay for the relative advantages of having low inflation.

Whatever Happened to Inflation, Anyway?

Remember inflation?

If you’re an American under, say, 35, then you probably don’t. Or at least, you don’t remember inflation as a big economic concern. Yeah, prices rise, and prices fall, and they always seem to rise more and fall less than we’d prefer. But inflation hasn’t been in the news the way unemployment has been. It’s not that inflation isn’t important. It just hasn’t been a big problem.

That wasn’t always the case. Back in the 70s and early 80s, inflation was a very big concern in the U.S., on a par with unemployment and slow GDP growth. But inflation hasn’t been above 6 percent since 1990.

What happened?

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First, some background. Inflation is an increase general price levels in an economy over a period of time.

The U.S. Bureau of Labor Statistics (BLS) collects price data on a wide array of goods and services purchased by urban consumers every month. Based on this information, the BLS calculates the Consumer Price Index (CPI), weighting the prices based on how much of them a typical urban consumer buys. Cabbage prices might jump 30 percent, but since few household buy a lot of cabbage, that won’t affect the CPI all that much. On the other hand, people spend a lot of their incomes on gasoline, so gas price increases tend to have a pretty big effect.

The CPI is just a number that indicates average price levels relative to some base year. The BLS uses 1982-1984 as the base years, and set the CPI value for the middle of that period to 100. Since the CPI value for August 2012 was 230.1, that tells you that prices have increased by (203.1/100) – 1 = 130 percent since July/August of 1983. That comes out to an average of about 3 percent per year, when include compounding.

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There are always some prices increasing and some prices decreasing. What matters is the overall average. In particular, goods that are manufactured tend to decrease in price over time. This is because improved technology and training increase productivity for manufactured goods like cell phones and computers, so these prices decrease compared with others. Manufactured goods also are easier to import from countries that can make them more cheaply than we can.

On the other hand, it’s much harder to increase productivity in healthcare and education. A doctor’s exam still takes a one-on-one meeting with a doctor, and the most effective education still requires a teacher in a classroom with 20 to 40 students. Thus, healthcare and education prices tend to increase faster than other prices. (There’s obviously more to healthcare and education price increases, but that would take many pages to cover.)

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Some of you may be thinking, “All those numbers are nice, but I know that prices have been increasing more than that.”

And you may be right. Everyone buys different things, and if the things you buy are the ones whose prices increased the most, then you’ve experienced a higher rate of inflation than other people. The CPI only reflects the average prices paid by the average urban consumer. If you happen to have been in college for the past 5 or 10 years, for instance, you’ve likely seen your personal prices increase by much more than 2 or 3 percent a year.

But for most of the rest of us, prices probably haven’t risen as much as we may think. This is because we’re human, and as such, we notice price increases more than decreases. The prices of the clothes you buy may have decreased by 10 or 20 percent over the years, but you’re less likely to notice that than, say, when gas prices jump 10 or 20 cents.

On top of that, humans have a natural way of mitigating the effects of price increases. We do this by substituting away from goods whose prices have risen. Chicken prices up? Buy more hamburger. Steak prices up? Buy more chicken. We might not even realize we’re doing this, but this substitution process also reduces the effective average prices we pay.

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But the fact is that, overall, inflation has been pretty tame for the past few decades in the U.S. I credit the Federal Reserve – and government economists in general – for this improvement. To a large degree, economists have figured out not just what causes high inflation rates, but also how to prevent it.

Which is why I find it confusing that some politicians are still hollering about inflation and even going so far as to call for a return to the Gold Standard to prevent further devaluation of the dollar.

Yes, the dollar has decreased in value substantially over the past 100 years or so. In fact, a dollar today is only worth about 4 cents in terms of dollars in 1913.

That might sound pretty serious, but the fact is that most of that devaluation came during World War II, as well as in the 1970s and 80s. Very little of it – less than 5 percent – has happened since then.

The fact of that matter is that inflation isn’t a big problem in the U.S., and is unlikely to become one, as long as the Fed maintains its focus on price levels. Calling for radical reform to address this non-existent problem is not only silly, it’s counter-productive. We have more important economic issues to deal with.