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Inflation 101

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Wednesday, Feb. 16, 2011

In 1977, the year I took my first economics course, I could buy two McDonald's Quarter Pounder hamburgers -- with cheese -- and a small order of fries for exactly $2. But if the dollar had been worth then what it's worth today, that very same meal would have set me back $7.28.

The unhappy fact is that, over the past 34 years, the dollar has lost 73 percent of its value to inflation.

Inflation was once defined as an increase in the money supply, and the result of any such increase was understood to be a lower value of each currency unit. Just as the value of diamonds would fall significantly if a strange meteorological event caused real diamonds to rain down in bucketfuls the world over, the value of the dollar falls significantly when the Federal Reserve injects large amounts of new dollars into the economy.

Purchasing power

Another term for the lower value of the dollar is "lower purchasing power of the dollar." Merchants will demand higher prices for their goods and services; workers will demand higher wages for their time on the job.

Today, inflation is defined as a general increase in the prices of goods, services, labor and anything else sold for money.

Why is inflation bad?

I simplify only a bit when I answer that economists are divided into three schools of thought on this question.

Keynesian economists answer that the question itself is mistaken: In mild doses, inflation isn't bad; it's good . Gently rising prices and wages caused by inflation fool firms, workers and consumers into thinking that the economy is stronger than it really is. So consumers spend more and firms produce more. To produce more, firms hire more workers. By fooling people into thinking that the economy is stronger than it really is, mild but consistent inflation actually makes the economy stronger.

Keynesians applaud mild inflation also because they believe that prices (and especially wages) are "sticky downward."

"Real" prices

For a variety of reasons -- including human psychology -- suppliers resist cutting the prices they charge and workers, especially, resist cuts in the wages they are paid. But falling prices often are necessary to keep markets working well.

Inflation does the trick of pushing "real" prices -- inflation-adjusted prices -- down without causing "nominal" prices -- the actual prices written on cans of beans or on workers' contracts with their employers -- to fall.

Suppose, for example, that cutting wages by 10 percent, from $20 per hour to $18 per hour, would inspire firms to hire many unemployed workers. But all workers resist working for $18 per hour. No problem. By decreasing the value of the dollar by 10 percent, an inflation rate of 10 percent achieves the same cut in real wages without forcing workers actually to agree to a pay cut.

In contrast to Keynesians, monetarist economists (such as the late Milton Friedman) aren't so keen on inflation. Having a more optimistic take on the way markets work, monetarists argue that government should strive to keep the annual inflation rate at zero percent.

Unlike Keynesians, monetarists believe that prices and wages that should fall actually will fall without having to resort to inflation to achieve the decline.

Monetarists also believe that people aren't so easily fooled as Keynesians think they are. People have "rational expectations." If the money supply rises by 10 percent annually, people learn that the result will be an annual inflation rate of 10 percent. And workers who refuse to work today for any wage lower than $20 per hour will refuse to work a year from now at any wage lower than $22 per hour. The reason is that workers understand that the extra $2 per hour reflects nothing more than inflation; it does not really reflect a higher wage.

Monetarists understand that inflation sometimes is unanticipated -- and unanticipated inflation does cause people to behave differently. But whatever benefits unanticipated inflation might have are outweighed by its costs.

Wealth redistribution

One chief cost of unanticipated inflation is that it redistributes wealth from creditors to debtors. If you and I expect that the rate of inflation over the next year will be zero percent, you might agree to lend me $1,000 at an interest rate of 3 percent. I might agree to borrow from you on these terms.

But if the inflation rate turns out to be positive -- say, 10 percent -- you lose and I gain. I wind up paying you back with dollars that have 10 percent less purchasing power. Inflation transfers wealth from you (the creditor) to me (the debtor).

This wealth transfer isn't the only problem with inflation. In my next column, I'll explain even more serious harms that inflation unleashes on the economy.

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