The Price Level and Inflation: The Distortions and Costs of Price Instability

The Distortions and Costs of Price Instability Why all the concern about price instability? Who gains and who loses as a result of inflation or deflation? What distortions in decision making are associated with price instability? Inflation can significantly affect the national standard of living. It can also cause changes in behavior that can have serious effects on resource use and the functioning of the economy. To analyze the costs of inflation we must examine its effects on both incomes and decisions. There are always gainers and losers from inflation, but it is not always easy to predict who will lose and who will gain. Although you might think it would be great to live in an economy in which deflation rather than inflation is the norm, you'll soon see that deflation can be just as damaging to the economy as inflation! Real Income: Using the CPI to Deflate Nominal Income Fluctuations in the price level affect the quantity of goods and services that can be purchased with a given sum of money. The purchasing power of a dollar (or any other unit of currency) is a measure of how much it can buy. An increase in the price level means a decrease in the purchasing power of a dollar. For example, if the price level were to double over a year, the purchasing power of a dollar would be cut in half because it would take $2 to purchase what in the past could have been bought for $1. In any given year, the greater the rate of inflation, the greater the decline in the purchasing power of a dollar for the year. To measure changes in the purchasing power of income over time it is necessary to adjust nominal income for changes in the price level. Nominal income is the actual number of dollars of income received over a year. Real income is the purchasing power of nominal income. Real income is usually expressed in terms of the market value of final products it can purchase when those products are valued in base period rather than current period prices. Real income is obtained by deflating nominal income by the CPI to adjust for rises in the price level since the base period. To deflate nominal income, divide it by the CPI/100. For example, suppose your nominal income in 1989 was $10,000. To find out what your real income was in 1989, first divide the 1989 CPI of 124 by 100, which gives 1.24. This tells you that the price of a market basket of goods purchased by a typical urban family was 1.24 times higher in 1989 than it was on average between 1982-1984. Your real income is Real income measures income in base period in this case 1982-1984) dollars rather than current dollars. Your $10,000 nominal income for 1989 has the same purchasing power that $8064.52 had on average between 1982 and 1984! A person who earned $10,000 in 1989 had the same purchasing power as a person who earned about $8,000 in 1983 when the CPI was 99.6. Knowing how to deflate nominal values is extremely important in making comparisons of salaries from one period to another. For example, suppose your sister graduated from college in 1983 and got a job paying $12,000 per year. In 1983, the CPI was approximately equal to 100 so her real salary was also $12,000. Now suppose you graduate from college in 1993 and you get a job that pays $16,000 per year. Suppose that the value of the CPI in 1993 is 150. It is clear that your nominal starting salary is greater than your sister's. However, your real salary deflated to 1983 dollars is only $16,000/1.50 = $10,666. Your sister's starting salary, therefore, had greater purchasing power 10 years ago than your starting salary does today. You can also use the preceding formula to deflate $1 to find out the purchasing power of a dollar after adjusting for inflation since the base year: In 1989 the purchasing power of a dollar was On average each dollar in 1989 bought what could have been purchased for only about 80 cents at the prices that prevailed, on average, over the period 1982-1984. The 1989 purchasing power of a dollar was a bit less than one third the purchasing power of a dollar in 1969. The graph in Box 4 shows how the purchasing power of a dollar has varied from 1960 to 1989. Because the price level has increased substantially since 1960, the purchasing power of the dollar has fallen. The more rapid the rate of inflation in a given year, the greater the decline in the purchasing power of the dollar. Of course, conclusions about the impact of inflation on the dollar's purchasing power for particular consumers must be qualified. Not all consumers buy exactly the same mix of goods. If you spent more of your income than the average urban consumer on electronic items, such as televisions, calculators, stereo equipment, and other goods whose prices have not increased as fast as the average, inflation is less of a problem for you than for the typical urban consumer. Also, because not all prices rise by the same percentage during inflationary periods, consumers adjust their buying habits in response to changes in prices. They buy more goods whose prices have increased less than average and fewer goods whose prices have increased more than average. To say that the purchasing power of the dollar in 1989 was one third what it was in 1967 means that a dollar bought only one third as many goods as it did in 1967 for the consumer who bought exactly the same goods in the CPI market basket year after year. When the rate of inflation of consumer prices exceeds the rate of increase of a person's nominal income, a person buying the standard market basket of goods used to calculate the CPI will find that his money income buys less this year than the year before. When a person's annual rate of increase in nominal income lags behind the annual rate of increase in the price level, the person's real income will decline.