In a market economy, prices play a leading role in allocating scarce resources. Prices fulfill this function by conveying information to buyers and sellers about the relative scarcity or abundance of goods and services. With price information, buyers and sellers alter their behavior in ways that bring about equilibrium – the state in which a market is in neither oversupply nor undersupply.
While supply and demand determines prices for individual goods and services, monetary policy largely determines aggregate prices. When policy is too loose, inflation may result. When policy is too tight, deflation may result. The ideal state is an economy in which prices are stable.
Inflation
Economists define inflation as a state of persistently rising prices. The key term here is persistently. In the short run, prices can increase for numerous reasons. Food and energy prices are notoriously volatile as they are subject to short-term factors, such as weather and supply-chain problems.
In the short-run, inflation can create the illusion of prosperity and advancement. For example, if the inflation rate is 6%, a worker receiving a 5% raise may feel better off despite a 1% net decline in purchasing power. Likewise, a merchant who is able to raise prices may interpret the higher prices for their goods as a sign of robust demand, even if the higher prices are the result of general inflation. Economists refer to this tendency of economic actors to confuse nominal and real prices as the “money illusion.” In other words, inflation can make people feel better off – at least for a time. Over the long run, the adverse effects of inflation become clearer.
Complicating matters further is that inflation affects people differently. Consider the following simplified scenario: A real estate investor buys a building for $1,000,000, financing the purchase with $300,000 of equity and a $700,000 mortgage. Suppose the rental income equals the interest expense on the mortgage. The investor holds the property for three years. At the time of purchase, the inflation rate is zero, but unexpectedly jumps to 5% per year and stays at 5% over the three-year holding period. The property appreciates in-line with inflation and is sold for the purchase price and appreciation. What is the investor’s total return after holding the property for three years?
To find the appreciation (inflation) factor for three years of 5% yearly inflation, we add 1 to .05 and take the sum to the 3rd power (the number of years), for a result of 1.1567. The selling price for the property is thus 1.1567 x 1,000,000 = $1,156,700. Out of these proceeds (ignoring taxes and transaction costs), the investor must pay back the $700,000 mortgage, leaving $456,700 to the equity. Out of this amount, $300,000 is the return of the investor’s equity investment and $156,700 is the investor’s gain, for a percentage return of $156,700 / $300,000 = 52.23%.
This return, of course, is the investor’s nominal return – the return unadjusted for inflation. To calculate the real return – the return adjusted for inflation – we can adjust the calculations accordingly. To adjust the dollar-gain for inflation, we adjust the equity contribution by multiplying by the inflation factor. The inflation adjusted equity is thus $300,000 x 1.1567 = $347,010. The inflation adjusted gain is $456,700 – $347,010 = $109,690. The percentage return adjusted for inflation is $109,690 / $347,010 = 31.61%.
In the above example, the real estate investor has earned a positive, real return despite the property only appreciating at the inflation rate. This is so because the loan balance is unadjusted for inflation. In other words, inflation has reduced the real value of the investor’s mortgage. If the mortgage were adjusted for inflation, the mortgage balance would be $700,000 x 1.1567 = $809,690. Notice that the difference between the adjusted and unadjusted mortgage balances is $109,690, which is exactly equal to the real gain on the equity.
While it may be tempting to assume that the borrower’s gain is the lender’s loss, this is not necessarily so. In addition to the borrower and the lender, the other party in this scenario is the tenant. As stated in the example, the rental income equals the interest expense. There are two scenarios in which this is true: (1) the lender adjusts the interest rate for inflation and the investor passes the added cost on to the tenant in the form of higher rent, or (2) both the interest rate and the lease rate are fixed. In scenario (1), the lender is compensated for inflation by adjustment in the interest rate. But the added capital costs are passed on to the tenant, who may or may not be able to pass those costs on to their customers. In scenario (2), the lender is uncompensated for the unexpected inflation. In that case, both the borrower and the tenant have benefited in that they can pay their obligations in depreciated dollars.
From the above example, we can make two observations. First, when interest rates are fixed and inflation is unexpected, inflation benefits borrowers and punishes lenders. Second, more generally, inflation affects parties in economic transactions differently.
How is Inflation Measured?
Inflation is measured using a price index – a weighted average of prices. In the U.S., the most widely cited price index is the Consumer Price Index for All Urban Consumers (CPI-U), better known as the Consumer Price Index (CPI). This index is constructed by the Bureau of Labor Statistics (BLS) based on monthly price surveys. Another important measure is the Personal Consumption Expenditure (PCE) index. The PCE is constructed by the Bureau of Economic Analysis (BEA), an agency of the U.S. Department of Commerce.
Another important price index which the BLS constructs is the Producer Price Index (PPI). The PPI is a weighted average of producer’s input costs. The PPI is a particularly important measure for at least two reasons. First, a rising PPI could mean higher consumer inflation later as firms pass along higher costs to consumers. Second, producer prices rising faster than consumer prices indicates lower profits for firms and can foreshadow a slowdown in the economy.
Real vs. Nominal Variables
Economists make the distinction between real and nominal variables. A nominal variable is a variable expressed in terms of monetary units. A real variable is a variable in physical units.
In some sense, defining money as a medium of exchange recognizes that money is merely an indirect means of exchanging goods and services for other goods and services. We can see this by using relative prices. For example, assume that in an economy of stable prices and wages, you make $60 per hour. You also happen to like pizzas and often purchase a large pepperoni pizza from your favorite restaurant for $20. In nominal terms, you are exchanging $20 for a pizza. In real terms, however, you are exchanging 1/3 of a labor hour for one pizza. Now suppose that prices double in unison so that you are now earning $120 per hour and the pizza costs $40. The transaction has changed in nominal terms, but in real terms, the transaction is still an exchange of 1/3 of a labor hour for one pizza.
The Relationship Between Money and Prices
What exactly causes inflation? Earlier in the post, we defined inflation as a persistent state of rising prices. In the short term, individual prices can fluctuate for various reasons. In the long run, however, the cause of inflation is clear – the money supply has increased faster than real economic output (the physical quantity of goods and services).
In the above example in which labor hours are traded for pizza, the real exchange does not change with a change in the price level. This is an example of what economists call monetary neutrality. In this sense, neutrality means that money affects nominal variables but not real variables. However, in the above example prices adjusted symmetrically. This may be true in the long run but not the short run. In the short run, money supply changes do affect real variables.
The economist Milton Friedman famously described inflation as “always and everywhere monetary phenomenon.” In this quote, Friedman refers to the impact of money supply growth on prices. To see the impact of money on the price level, economists use the basic monetary equation:
MV = PY
Where M is the quantity of money, V is the velocity of money (the rate at which money is spent), P is the price level, and Y is the economy’s real output. The right side of the equation, P x Y, is nominal economic output. Thus, the equation relates the quantity and velocity of money to nominal economic output.
If velocity and real output are constant, then changes in the money supply (M) cause proportional changes in prices (P). This is referred to as the quantity theory of money.
While the quantity theory of money may suggest that inflation can be managed by directly targeting money supply growth, this is difficult in practice. Rather, the Federal Reserve uses the Federal Funds Rate as its key policy instrument. When the Fed sees inflation heating up, they increase the federal funds rate which tightens credit in the economy. When the Fed wants to stimulate the economy, they lower the federal funds rate which loosens credit in the economy. Through the federal funds rate, the Fed can indirectly influence the money supply and prices.
The Inflationary Bias in Monetary Policy
In 1978, Congress passed The Full Employment and Balanced Growth Act, known as the Humphrey-Hawkins Act, so named after its sponsors. This act further detailed the Fed’s unemployment and inflation mandates which Congress first established in the 1946 Employment Act. The Humphrey-Hawkins Act also required the Fed to submit a biannual report to Congress. Corresponding to this report, the Fed Chair provides live testimony to the Senate Banking Committee and the House Financial Services Committee.
Anyone watching the Fed Chair’s “Humphrey-Hawkins” testimony is reminded of a sobering fact: although the Federal Reserve is an independent government agency, the Fed is under enormous political pressure. As former Fed Chair Paul Volker stated, the Fed is “independent within the government, not independent of the government.”
Political pressure comes from both parties and politicians can be critical of monetary policy and the Fed’s supervisory responsibilities. Generally, however, political bias favors looser policy (lower rates). I recall listening to an interview with former Fed Chair Alan Greenspan in which he told that in his 18-year tenure he received many letters from politicians and not one of those letters suggested the Fed increase rates.
The issue is that the mandates of maximum employment and price stability can be at odds. When inflation heats up, the Fed raises rates, which tightens credit, slows the economy, and generally leads to higher unemployment. Obviously, higher unemployment and slower growth do not sit well with politicians who are concerned with their poll numbers and chances of reelection. Although I would like to believe otherwise, it would be ignorant to suggest that the Fed is completely immune to political influence.
Also, the Fed does not interpret price stability as a state of zero inflation. Since 2012, the Fed has maintained a target of 2% annual inflation. Originally, this inflation target was 2% per year.
The Fed’s inflation target is 2% rather than zero for at least two reasons. First, because the Fed views deflation as worse than inflation (more on that below), a low but positive inflation target provides the Fed with a margin of error to the upside. Second, as we’ll see in our next post, interest rates incorporate inflation expectations. By shaping (or attempting to shape) inflation expectations at a positive level, the Fed can give itself room to cut rates in a downturn.
In 2020, the Fed announced two policy changes which have important implications. First, the Fed changed its inflation target from 2% per year to 2% on average over several years. This means that if inflation falls short of 2%, the Fed will target higher-than-2% inflation in subsequent years to make up for the shortfall.
The second change concerns the natural rate of unemployment, which is the minimum unemployment rate consistent with stable prices. Along with the change in the inflation target, the 2020 statement indicates that the Fed believes that the economy can support lower unemployment without inflationary consequences. In other words, the Fed would accept tighter labor conditions before raising rates.
The 2020 policy changes (in my opinion) introduced further inflation bias into policy as evidenced by the Fed’s slow response to the inflationary pressures of late 2020 and 2021.
Deflation and Disinflation
Just as rising prices arise from excessive monetary growth, persistently falling prices arise from monetary contraction.
Economists define deflation as a sustained state of falling prices. Given the modern tools of monetary policy, significant deflation is highly unlikely. Central bankers are committed to avoiding deflation at almost any cost, mostly because historical episodes of deflation have been so painful.
To see why deflation can be so bad, we’ll briefly examine the most severe deflation in American history, which occurred from 1930 to 1933. The wave of bank panics and bank runs (such as the one depicted in It’s a Wonderful Life) led to a sharp decline in the money supply. Recall from an earlier post the concept of the money multiplier, which describes how (when reserves are limited) an increase in reserves leads to a multiple-fold increase in the money supply. Unfortunately, the reverse is also true. If reserves decline, the money supply will decline by an even greater amount.
As depositors withdrew funds from banks, the money supply fell sharply. The falling money supply dragged down incomes. With incomes falling, firms and households were unable to service their debts (which remained fixed). With more borrowers becoming insolvent, more banks failed, which led to more bank runs. This “deflationary spiral” persisted for several years and greatly contributed to, if not caused, the massive drop in industrial output during this period. Particularly hard hit were the perpetually indebted farmers, who borrowed heavily in the World War 1 commodities boom.
[We should note that the Federal Reserve could have conducted large-scale open market operations and propped up the money supply. For reasons beyond the scope of this article, the Fed during this time was mostly idle.]
After the depression, economists and policymakers crafted tools which made severe deflation unlikely. However, it is still important to note the destruction which substantial deflation can bring.
Disinflation, on the other hand, is a more likely condition which can also be painful. Disinflation is a decrease in the rate of inflation, and it occurs when the Fed tightens credit conditions in response to a period of high inflation. The higher the rate of inflation, the greater the policy response needed to bring it down. In the early 1980s, for example, the greatly tightened credit conditions in response to runaway inflation in the 1970s. The result was a severe recession, and an unemployment rate which peaked at nearly 11% by the end of 1982. However, the economy began to grow robustly once the Fed began to loosen credit conditions.
One of the reasons why policy was so tight during this period was that years of inflation had increased inflation expectations. When consumers anticipate higher prices, they spend their income faster than they would otherwise (the velocity of money increases). Similarly, higher inflation expectations cause businesses to raise prices and employees to demand higher wages. Inflation expectations, in other words, can be a feedback loop which drives inflation itself. In the early 1980s, the Fed had to not only fight inflation by tightening monetary conditions but also by restoring its inflation-fighting credibility.
Conclusion
If all prices in an economy were to rise in perfect unison, then inflation would be little more than a nuisance. This is never the case. Consumer prices may rise faster than wages, in which case households see a decline in their real purchasing power. Businesses may be unable to pass along higher costs to consumers which can threaten that business’s solvency. With inflation, there are always winners and losers, but society on the whole is usually the loser. To paraphrase a quote attributed to Vladimir Lenin, there is no surer way to destroy an economy than to debase its currency.
Sources:
Mankiw, Gregory. Principles of Macroeconomics, 7th ed. Stamford: Cengage Learning, 2015.
Mishkin, Frederic. The Economics of Money, Banking, and Financial Markets, 2nd ed. New York: Addison-Wesley, 2010.
Wheelan, Charles. Naked Money: A Revealing Look at Our Financial System. New York: Norton, 2016.
2020 Statement on Longer-Run Goals and Monetary Policy Strategy. www.federalreserve.gov
