Inflationary Expectations

"Inflation is the one form of taxation that can be imposed without legislation."

-Milton Friedman

"The history of the twentieth century - America's century! - has been pretty much a history of rising prices... inflation is itself a problem. But the legitimate and hysterical fears of inflation are - quite aside from the evil of inflation itself - likely, in their own right, to be problems. In short, I fear inflation. And I fear the fear of inflation."

-Paul A. Samuelson, 1958

"Inflation is bringing us true democracy. For the first time in history, luxuries and necessities are selling at the same price."

-Robert Orben

"If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered."

-Thomas Jefferson, Letter to the Secretary of the Treasury Albert Gallatin (1802)

My father always told me that all businessmen were sons of bitches, but I never believed it till now. -- (Comment made 10 April 1962 in reaction to news that U.S. Steel was raising prices by $6 per ton, right after the unions negotiated a modest new contract under pressure from JFK to keep inflation down.)

-John F. Kennedy (1917 - 1963), "A Thousand Days," by Arthur Schlesinger Jr. [1965]

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It is hard to live in today's society and not be aware of inflation. Every year it makes the money we have stashed away in our mattresses worth less than it was last year. The inflation rate is therefore an important indicator that influences our general expectation for the future. Classically, inflation and unemployment are the two bugbears of macroeconomic policy. High inflation can seriously hurt an economy. At extreme levels, very high inflation is known as hyperinflation. This is bad for firms and consumers, but it's even worse for polititians.

So if everybody wants low inflation, why does it exist? One cause of inflation is inflationary expectations. We all have certain expectations for what the next year will bring. These expectations are usually based on the recent past. Therefore, if inflation has been very high the last couple of years, it may take a while for people to begin to expect lower inflation.

"So what?" you say. The problem is that through these inflationary expectations, people can actually cause inflation, whether other economic conditions predict it or not.

Inflation and Uncertainty

"[Inflation is]...a force that operates year-in and year-out, whenever we are at high employment, to push up prices. It's a price creep, not a price gallop; but the bad thing about it is that, instead of setting in only after you have reached overfull employment, the suspicion is dawning that it may be a problem that plagues us even when we haven't arrived at a satisfactory level of employment."

-Paul A. Samuelson, (interview), "U.S. News World Report", 1960

There are three kinds of inflation:

• Demand-Pull inflation
• Cost-Push inflation
• Built In inflaiton

Before the 1970s, Classical economic theory of inflation predicted a negative empirical relationship between unemployment and inflation. This relationsihp is known as the Phillips curve. Such a relationship is an important concept with regard to economic policy. It means that policy makers can effectively force a tradeoff between inflation and unemployment. For example, by increasing the monetary supply, the Federal Reserve Bank can influence the inflation rate, and therefore also the employment rate.

Irving Fisher

VS.

William Phillips

Ironically, though it was named after Alban William Phillips, a New Zealand economist, the relationship was first observed by Irving Fisher in 1926, in a paper titled "A statistical Relation between Unemployment and Price Changes" that was published in the International Labour Review.

Milton Friedman

Edmund Phelps

For the most part, the Phillips curve appeared to be a good predictor of the relationship between inflation and unemployment. However, after the large oil supply shocks in the early 1970s, this relationship broke down. Two economists, Milton Friedman and Edmund Phelps predicted the breakdown in the relationship between the phillips curve. They argued over two distinctions, or refinements to the Phillips curve. They said that there was actually a negative relationship between unanticipated inflation and cyclical unemployment.

The equation for the phillips curve, with the integration of Friedman and Phelps' contributions became:

pi=pi^e-h(u-u_n)

The Phillips Curve Breaks Down!

The change in the relationship between inflation and unemployment left policy makers with a sticky situation. The period between 1971 and 1984 was known as "stagflation". Stagflation was a situation in which both the inflation rate and the uneployment rate were relatively high. One of the major reasons that stagflation was such a problem was that since the relationship between the inflation and unemployment had broken down, monetary policy could not be used to control the situation without causing a recession. In the end, this is what Fed Chairman Paul Volker had to do. It was crucial to "wring out" the inflationary expectations that had been built into the economy by such a long period of inflationary increase.

The History of Inflation in the United States

File:300px-Consumer Price Index US 1913-2004.pngInflation is measured by the Consumer Price Index (CPI).

The CPI is a statistical measure of the average prices of a specified bundle of goods and services. This "bundle" of goods and services consists of basic items and is broken up into categories such as Food and beverages, Housing, Apparel, Transportation, Medical care, Recreation, Education and communication, and Other goods and services. The CPI is calculated on a monthly basis. The most recent CPI report can be found through the Bureau of Labor Statistics. It can also be accessed directly here.

One of the major effects of stagflation was an unusually high inflation rate. For example, in a normal twenty year span, from 1950 to 1970 (before the Phllips curve broke down), what cost $100 dollars in 1950's money, cost 153.87 in 1970. After 1970, however, this moderate inflation was no more. What cost $100 dollars in 1970s money, cost $338.72 in 1990.

Inflation in the US in the 20th Century

Policy Tools

The Federal Reserve Bank can influence the inflation rate through two major routes: changing the interest rate, and adjusting the supply of money. By raising the interest rates, or contracting the supply of money, the Fed can slow the pace of growth, checking inflation through increased unemployment and a slowdown in productivity.

Economies can get into real trouble by printing money. One of the most dangerous policies a government can undertake is to pay for expenses or debt by printing new money. In many situations in many countries this has appealed as a great short-run solution, but the price is paid in inflation. As the government prints more and more money, the money rapidly loses value, thus inflation. Examples of high inflationary periods influde post World War I Germany, where hyperinflation was so bad that people were purportedly exchanging wheelbarrows full of money for a single loaf of bread, and feeding their stoves with paper bills because it was cheaper than buying wood.

External Links

Inflation Calculator

Official CPI Data

Bureau of Labor Statistics

Fed Credibility? What's the Big Deal?

References

Abel, Abel and Bernanke, Ben. 2005. Macroeconomics: Fifth Edition. Boston: Addison Wesley.

Ferguson, Naill. 1995. "Keynes and the German Inflation." The English Historical Review, 110(436):368-391.

Fisher, Irving. 1973. "I Discovered the Phillips Curve: 'A Statistical Relation between Unemployment and Price Changes.'" The Journal of Political Economy, 81(2):496-502.