9.5Indexing and Its Limitations

Any Benefits of Inflation?

Although the economic effects of inflation are primarily negative, two countervailing points are worth noting. First, the impact of inflation will differ considerably according to whether it is creeping up slowly at 0% to 2% per year, galloping along at 10% to 20% per year, or racing to the point of hyperinflation at, say, 40% per month. Hyperinflation can rip an economy and a society apart. An annual inflation rate of 2%, 3%, or 4%, however, is a long way from a national crisis. Low inflation is also better than deflation which occurs with severe recessions. Second, economists sometimes argue that moderate inflation may help the economy by making wages in labor markets more flexible. The discussion in Unemployment pointed out that wages tend to be sticky in their downward movements and that unemployment can result. A little inflation could nibble away at real wages, and thus help real wages to decline if necessary. In this way, even if a moderate or high rate of inflation may act as sand in the gears of the economy, perhaps a low rate of inflation serves as oil for the gears of the labor market. This argument is controversial. A full analysis would have to account for all the effects of inflation. It does, however, offer another reason to believe that, all things considered, very low rates of inflation may not be especially harmful.

9.5 Indexing and Its Limitations

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Explain the relationship between indexing and inflation
• Identify three ways the government can control inflation through macroeconomic policy

When a price, wage, or interest rate is adjusted automatically with inflation, economists use the term indexed. An indexed payment increases according to the index number that measures inflation. Those in private markets and government programs observe a wide range of indexing arrangements. Since the negative effects of inflation depend in large part on having inflation unexpectedly affect one part of the economy but not another—say, increasing the prices that people pay but not the wages that workers receive—indexing will take some of the sting out of inflation.

Indexing in Private Markets

In the 1970s and 1980s, labor unions commonly negotiated wage contracts that had cost-of-living adjustments (COLAs) which guaranteed that their wages would keep up with inflation. These contracts were sometimes written as, for example, COLA plus 3%. Thus, if inflation was 5%, the wage increase would automatically be 8%, but if inflation rose to 9%, the wage increase would automatically be 12%. COLAs are a form of indexing applied to wages. Loans often have built-in inflation adjustments, too, so that if the inflation rate rises by two percentage points, then the interest rate that a financial institution charges on the loan rises by two percentage points as well. An adjustable-rate mortgage (ARM) is a type of loan that one can use to purchase a home in which the interest rate varies with the rate of inflation. Often, a borrower will be able to receive a lower interest rate if borrowing with an ARM, compared to a fixed-rate loan. The reason is that with an ARM, the lender is protected against the risk that higher inflation will reduce the real loan payments, and so the risk premium part of the interest rate can be correspondingly lower. A number of ongoing or long-term business contracts also have provisions that prices will adjust automatically according to inflation. Sellers like such contracts because they are not locked into a low nominal selling price if inflation turns out higher than expected. Buyers like such contracts because they are not locked into a high buying price if inflation turns out to be lower than expected. A contract with automatic adjustments for inflation in effect agrees on a real price for the borrower to pay, rather than a nominal price.

Indexing in Government Programs

Many government programs are indexed to inflation. The U.S. income tax code is designed so that as a person’s income rises above certain levels, the tax rate on the marginal income earned rises as well. That is what the expression “move into a higher tax bracket” means. For example, according to the basic tax tables from the Internal Revenue Service, in 2020, a married person filing jointly owed 10% of all taxable income from $0 to $19,750; 12% of all income from $19,751 to $80,250; 22% of all taxable income from $80,251 to $171,050; 24% of all taxable income from $171,051 to $326,600; 32% of all taxable income from $326,601 to $414,700; 35% of all taxable income from $414,701 to $622,050; and 37% of all income from $622,051 and above. Because of the many complex provisions in the rest of the tax code, it is difficult to determine exactly the taxes an individual owes the government based on these numbers, but the numbers illustrate the basic theme that tax rates rise as the marginal dollar of income rises. Until the late 1970s, if nominal wages increased along with inflation, people were moved into higher tax brackets and owed a higher proportion of their income in taxes, even though their real income had not risen. In 1981, the government eliminated this “bracket creep”. Now, the income levels where higher tax rates kick in are indexed to rise automatically with inflation. The Social Security program offers two examples of indexing. Since the passage of the Social Security Indexing Act of 1972, the level of Social Security benefits increases each year along with the Consumer Price Index. Also, Social Security is funded by payroll taxes, which the government imposes on the income earned up to a certain amount—$137,700 in 2020. The government adjusts this level of income upward each year according to the rate of inflation, so that an indexed increase in the Social Security tax base accompanies the indexed rise in the benefit level. As yet another example of a government program affected by indexing, in 1996 the U.S., government began offering indexed bonds. Bonds are means by which the U.S. government (and many private-sector companies as well) borrows money; that is, investors buy the bonds, and then the government repays the money with interest. Traditionally, government bonds have paid a fixed rate of interest. This policy gave a government that had borrowed an incentive to encourage inflation, because it could then repay its past borrowing in inflated dollars at a lower real interest rate. However, indexed bonds promise to pay a certain real rate of interest above whatever inflation rate occurs. In the case of a retiree trying to plan for the long term and worried about the risk of inflation, for example, indexed bonds that guarantee a rate of return higher than inflation—no matter the level of inflation—can be a very comforting investment.

Might Indexing Reduce Concern over Inflation?

Indexing may seem like an obviously useful step. After all, when individuals, firms, and government programs are indexed against inflation, then people can worry less about arbitrary redistributions and other effects of inflation. However, some of the fiercest opponents of inflation express grave concern about indexing. They point out that indexing is always partial. Not every employer will provide COLAs for workers. Not all companies can assume that costs and revenues will rise in lockstep with the general rates of inflation. Not all interest rates for borrowers and savers will change to match inflation exactly. However, as partial inflation indexing spreads, the political opposition to inflation may diminish. After all, older people whose Social Security benefits are protected against inflation, or banks that have loaned their money with adjustable-rate loans, no longer have as much reason to care whether inflation heats up. In a world where some people are indexed against inflation and some are not, financially savvy businesses and investors may seek out ways to be protected against inflation, while the financially unsophisticated and small businesses may feel it the most.

A Preview of Policy Discussions of Inflation

This chapter has focused on how economists measure inflation, historical experience with inflation, how to adjust nominal variables into real ones, how inflation affects the economy, and how indexing works. We have barely hinted at the causes of inflation, and we have not addressed government policies to deal with inflation. We will examine these issues in depth in other chapters. However, it is useful to offer a preview here. We can sum up the cause of inflation in one phrase: Too many dollars chasing too few goods. The great surges of inflation early in the twentieth century came after wars, which are a time when government spending is very high, but consumers have little to buy, because production is going to the war effort. Governments also commonly impose price controls during wartime. After the war, the price controls end and pent-up buying power surges forth, driving up inflation. Otherwise, if too few dollars are chasing too many goods, then inflation will decline or even turn into deflation. Therefore, we typically associate slowdowns in economic activity, as in major recessions and the Great Depression, with a reduction in inflation or even outright deflation. The policy implications are clear. If we are to avoid inflation, the amount of purchasing power in the economy must grow at roughly the same rate as the production of goods. Macroeconomic policies that the government can use to affect the amount of purchasing power—through taxes, spending, and regulation of interest rates and credit—can thus cause inflation to rise or reduce inflation to lower levels. BRING IT HOME Inflation in a Pandemic—A Return to the 1970s, or a Temporary Adjustment? The pandemic-induced recession caused all sorts of disruptions to our economy, including inflation. During the pandemic, the prices for goods like gas and cars fell as people shifted to remote work and canceled travel plans. But as the economy started to recover from the pandemic in early 2021, we started to see large increases in these prices. Higher prices were also fueled by the injections of cash into the economy through stimulus checks and unemployment benefits. The pandemic also caused shortages throughout the global supply chain, further pushing prices up (you'll learn more about this idea in a few chapters when we talk about aggregate supply and demand). With headline annualized inflation rates in 2021 exceeding 6%, the question in the next few years is whether we'll see permanently high inflation rates of 9%, 10%, or more, like we did in the 1970s and early-1980s. Some economists believe the pandemic-induced inflation is just a transitory adjustment—indeed, used car and gasoline prices rose dramatically in 2010 and 2011 as well, as we were recovering from the Great Recession. Others are more concerned that the inflation is permanent. Shortages continue to exist throughout the economy as of early 2022, and if consumers expect higher inflation, it can be a self-fulfilling prophecy, as they start buying things now in order to avoid future bouts of inflation. As you learned about earlier, inflation is a major concern of consumers, if less of an issue among economists. But inflation should be matched by increases in living standards, otherwise there could be major implications for the economy.

Key Terms

adjustable-rate mortgage (ARM) a loan a borrower uses to purchase a home in which the interest rate varies with market interest rates base year arbitrary year whose value as an index number economists define as 100; inflation from the base year to other years can easily be seen by comparing the index number in the other year to the index number in the base year—for example, 100; so, if the index number for a year is 105, then there has been exactly 5% inflation between that year and the base year basket of goods and services a hypothetical group of different items, with specified quantities of each one meant to represent a “typical” set of consumer purchases, used as a basis for calculating how the price level changes over time Consumer Price Index (CPI) a measure of inflation that U.S. government statisticians calculate based on the price level from a fixed basket of goods and services that represents the average consumer's purchases core inflation index a measure of inflation typically calculated by taking the CPI and excluding volatile economic variables such as food and energy prices to better measure the underlying and persistent trend in long-term prices cost-of-living adjustments (COLAs) a contractual provision that wage increases will keep up with inflation deflation negative inflation; most prices in the economy are falling Employment Cost Index a measure of inflation based on wages paid in the labor market GDP deflator a measure of inflation based on the prices of all the GDP components hyperinflation an outburst of high inflation that often occurs (although not exclusively) when economies shift from a controlled economy to a market-oriented economy index number a unit-free number derived from the price level over a number of years, which makes computing inflation rates easier, since the index number has values around 100 indexed a price, wage, or interest rate is adjusted automatically for inflation inflation a general and ongoing rise in price levels in an economy International Price Index a measure of inflation based on the prices of merchandise that is exported or imported Producer Price Index (PPI) a measure of inflation based on prices paid for supplies and inputs by producers of goods and services quality/new goods bias inflation calculated using a fixed basket of goods over time tends to overstate the true rise in cost of living, because it does not account for improvements in the quality of existing goods or the invention of new goods substitution bias an inflation rate calculated using a fixed basket of goods over time tends to overstate the true rise in the cost of living, because it does not take into account that the person can substitute away from goods whose prices rise considerably

Key Concepts and Summary

9.1 Tracking Inflation

Economists measure the price level by using a basket of goods and services and calculating how the total cost of buying that basket of goods will increase over time. Economists often express the price level in terms of index numbers, which transform the cost of buying the basket of goods and services into a series of numbers in the same proportion to each other, but with an arbitrary base year of 100. We measure the inflation rate as the percentage change between price levels or index numbers over time.

9.2 How to Measure Changes in the Cost of Living

Measuring price levels with a fixed basket of goods will always have two problems: the substitution bias, by which a fixed basket of goods does not allow for buying more of what becomes relatively less expensive and less of what becomes relatively more expensive; and the quality/new goods bias, by which a fixed basket cannot account for improvements in quality and the advent of new goods. These problems can be reduced in