Inflation and Money: Key Concepts and Costs
Inflation Measurement and CPI Biases
Key idea: Problems in measuring inflation can cause overestimation of the true price level rise.
Substitution bias: consumers switch to cheaper options when relative prices change; the basket doesn’t reflect this shift, pushing measured inflation up.
Unmeasured quality change: products improve over time, providing more value; harder to gauge exactly how much extra benefit buyers get from better versions.
Introduction of new goods: the basket ignores new products that people buy today, so sticking with the old basket misses important changes in consumption.
These three biases lead to an overestimate of inflation using the traditional CPI approach.
Correction approach: continuously recalibrate the basket and push estimates backwards in time to account for substitutions, quality changes, and new goods.
Practical message: Knowing these biases exist helps economists adjust calculations; main takeaway is that these biases tend to push measured inflation higher than true inflation.
Inflation is a macroeconomic indicator used for more than the cost of living; it enables comparisons over time and across locations.
Price level measures like the CPI are used to adjust purchasing power across years and different areas.
Real-world relevance: salary decisions across cities (e.g., Boulder vs. Pittsburgh) or multistate employers rely on cost-of-living adjustments to make fair comparisons.
CPI and related calculations underpin many equations and decisions (e.g., inflation rates, money conversion across years/locations).
The general idea is to replace amounts with equivalent values in different dollars (today’s dollars or past dollars) using the CPI.
Cost of Living Differences Across States and Pay Adjustments
The government uses a heat map to show wage differences by location; brighter colors indicate higher pay for the same job in different states.
The federal government uses a standardized pay grade system; pay varies by location due to cost-of-living differences, not responsibilities.
Explanation: the goal is to match standard of living across locations, not to make individuals in expensive areas better off simply due to higher nominal pay.
Example logic: If LA is ~30% more expensive than Philadelphia, the pay for the same job would be ~30% higher in LA to equalize purchasing power.
The federal government (a major employer) adjusts location pay to reflect cost of living. However, even with offsetting salary and cost-of-living adjustments, other factors (local amenities, entertainment options, regional opportunities) influence actual living standards beyond price levels alone.
Other employers may use similar location-based pay adjustments; many large corporations adjust salaries by location.
Box office and movie industry example: even with price comparisons adjusted for purchasing power, other dynamics (streaming, number of theaters, population, alternative entertainment) affect revenues year to year.
Streaming services, number of locations, and population growth can all influence box office revenue independently of price level changes.
The number of theaters and changing consumer behavior (streaming vs. theater-going) are cited as factors affecting revenues over decades.
Inflation Costs and Why They Matter
Two broad tasks: costs of inflation (negative effects) and sources of inflation (what causes inflation).
Costs of inflation (real costs grow with higher inflation, often exponentially rather than linearly):
Shoe leather costs: the time and effort to manage money during inflation (historically significant; now less so due to digital banking and instant transfers). Practical point: today, money can be moved quickly between accounts, reducing the burden of frequent cash management.
Menu costs: costs of frequently changing prices (menus, price boards). Food industry and retailers incur these changes; updates can be costlier if done manually, but technology (QR codes, online menus) reduces some of these costs.
Money illusion: people misinterpret nominal gains as real gains, thinking a higher wage means they’re better off when it may just offset inflation; misperception can lead to inefficient resource use by consumers and firms.
Uncertainty: inflation forecasts are uncertain, affecting long-term decisions (e.g., contracts, wages with fixed terms). The Fed’s transparency (meeting notes and projections) aims to guide expectations, though forecasts are imperfect.
Decision-making under uncertainty: individuals and firms must cope with uncertain inflation; more information helps but cannot eliminate uncertainty.
Other costs: focus on the distributional effects of inflation (redistribution effects) and tax distortions (see below).
Time horizon: the higher the inflation rate, the larger and faster these costs accumulate (nonlinear/compounding effects).
Long-run perspective: over long horizons, inflation’s effects on wages tend to align with price level changes, but short-run frictions create costs (e.g., wages lag behind price increases, but in the long run wages tend to rise with inflation).
Decision-Making, Uncertainty, and Expectations
Inflation forecasts are inherently uncertain; individuals and institutions adjust decisions as new information arrives (e.g., Federal Reserve projections).
Uncertainty affects contracts (salary terms, wage negotiations) because future price levels are unknown.
The Fed releases projections to guide expectations, reducing but not eliminating uncertainty.
The next chapters will explore decision making with uncertainty more deeply.
Redistributions of Wealth and Tax Distortions
Inflation and interest rates are connected via the Fisher equation, linking nominal interest rates, real rates, and inflation.
Fisher equation concept:
Nominal interest rate i ≈ Real interest rate r + expected inflation π^e (for many pedagogical settings; exact form uses i = r + π).
Real vs. nominal rates:
Nominal rate: stated rate (e.g., on savings or loans).
Real rate: purchasing power change; accounts for inflation.
After-tax nominal and real rates (tax distortions):
After-tax nominal rate: where au is the tax rate on interest income.
After-tax real rate:
Numerical example (illustrative method): two economies with the same real return but different inflation and taxes.
Base setup (no taxes): fixed nominal rate i and inflation π. If inflation is higher than expected, real rate falls; if lower than expected, real rate rises.
With taxes: use after-tax nominal rate i^{AT} and then subtract actual inflation π to get r^{AT}.
Example method (structure):
Suppose i = 5% and π^e = 2% (expected); with τ = 25%, i^{AT} = 0.75 × 5% = 3.75%; for π = 2%, r^{AT} = 3.75% − 2% = 1.75%.
If π turns out to be 4%, r^{AT} = 3.75% − 4% = −0.25% (you’re worse off).
Takeaway: taxes on nominal interest create additional distortion, especially when inflation is volatile; higher inflation can reduce after-tax real returns, and vice versa.
How to fix tax distortions (idea): tax interest income based on real interest rates rather than nominal rates. Challenges:
Real-time measurement of inflation is difficult and often delayed; adjusting tax systems to real rates would require timely, accurate inflation data, which is not feasible for annual tax filings.
As a result, tax distortions persist, contributing to the cost of inflation.
Sources and Causes of Inflation
Two main sources with a third semi-claim:
Primary source: increases in the money supply.
Secondary source: rapid changes in aggregate demand or rapid decreases in aggregate supply (i.e., demand-pull and supply-side shocks) – these are more episodic and are discussed later with the AD-AS framework.
The Quantity Theory of Money (classical money theory) – long-run description:
The basic equation: where
M = money supply
V = velocity of money (how often a dollar is used in transactions per period)
P = price level
Y = real GDP
Velocity: defined as the rate at which money changes hands; an intuitive view is the average number of transactions a dollar bill is used for in a year.
In growth form, taking growth rates:
Simplifications often used in the long run:
Velocity is relatively stable:
Money neutrality: in the long run, changes in money supply do not affect real variables (e.g., real GDP Y).
With these simplifications, the growth version reduces to:
i.e., inflation is largely driven by money growth in the long run.
Mechanisms of monetary policy (proximate driver of money supply): central banks (e.g., the Federal Reserve) influence money supply through tools like changing interest rates, rather than printing money directly in most modern economies.
Velocity and real GDP: velocity is considered relatively stable in many treatments; real GDP is treated as a real variable not directly controlled by money supply in the long run (money neutrality).
Short run vs long run caveats:
The long run is the direction in which the economy tends to move; the exact time frame is not fixed (it could be years, decades, or even shorter in some contexts).
In the short run, changes in money supply can affect real variables temporarily, particularly through demand-side effects.
Connection to inflation: if the money supply grows faster than real GDP grows (and if velocity is stable), inflation tends to rise; if the money growth is slower, inflation tends to fall or deflate.
Important policy takeaway: inflation is tied to monetary policy, but inflation forecasting is imperfect; the Fed publishes notes and projections to guide expectations, though outcomes are uncertain.