Author: John Bouman

What’s in This Chapter? A country’s overall price level is an important factor affecting its economic health. Most countries experience rising prices (inflation), but falling prices means more affordable products, which is especially important for lower income households. It also means more certainty for people that their savings and investments retain their value, and more certainty for businesses that their investments will yield a positive return in the future. This increases incentives to invest and produce. Falling prices increase consumer and business confidence in the future value of the currency. People, therefore, have more incentive to save. Greater savings leads to more available funds in the financial markets. This leads to lower interest rates, which encourages increased businesses expansions, investments, and innovations. No inflation or falling prices relative to other countries’ inflation rates, ceteris paribus, means lower prices in comparison to foreign goods. This makes our products more competitive and increases our exports. So what is the secret to achieving no inflation or falling prices? The answer: Keep the nation’s money supply constant. Many people believe that in order to achieve economic growth, the money supply needs to increase. This is a misconception. With reasonably low taxation, reasonable regulations, and a government that provides essential services (strong legal system, protection of individuals and private property), a constant money supply environment will lead to rising production. If the money supply...

Ways to Measure Inflation Common indices to measure inflation include the Consumer Price Index (CPI), the Producer Price Index (PPI), and the GDP Price Deflator. The Consumer Price Index (CPI) The most common measure of inflation is the CPI, or Consumer Price Index. This figure is a weighted average of price increases of a typical basket of consumer products. The term “weighted” means that price increases of products that are bought in large quantities increase the CPI more than products that are not consumed as commonly. If the price of a commonly purchased product, such as a movie theater ticket, increases, it will have a greater impact on the CPI than if the price of an infrequently purchased product, such as a bag of salt, increases. The CPI also takes into account the price of the product. For example, a 10% increase in the price of a car affects buyers more than a 10% increase in the price of a pack of bubblegum. Government accountants at the Bureau of Labor Statistics include the following categories in the representative “market basket” of consumer products for CPI calculation purposes: housing (41%), transportation (17%), food and beverages (16%), medical care (6%), recreation (6%), apparel (4%), and other (4%). Please visit the Bureau of Labor Statistics (then click on CPI tables) for inflation data from 1913 until the present. Below is an example...

Money Demand and Supply In the long run, the value of money, like the price of any good or service, is determined by the demand and supply of money in circulation. The following example illustrates this concept. Problem: Let’s say that the nation’s money supply is $1,000 and that during a short, fixed period of time, buyers spend all of this $1,000. Let’s assume that production during this period is 10 units. What will be the average price per unit if all 10 units are purchased during this period? Solution: The average, equilibrium price will be $100 per unit. If the price is $100 and all 10 units are purchased, then total spending will equal the amount of money in circulation (for simplicity, we will assume that savings are zero). At a higher price, surpluses occur, because buyers don’t have enough money to buy all 10 units. At a lower price, shortages of the product occur. Surpluses and shortages in the long run are not stable. They are corrected through price changes (see also Unit 2). A surplus will make the price come down. A shortage will drive the price up. At equilibrium, the price is stable, unless demand or supply change. Problem: If the government increases the quantity of money in circulation (the money supply) by $200, then the total amount of available spending during this period of...

Long Run Consequences of Inflation In addition to higher consumer prices which especially harms lower income households, inflation has the following harmful macroeconomic consequences: 1. Higher interest rates. Inflation leads to higher interest rates in the long run. Initially when the government increases the money supply, the increased availability of money lowers interest rates. However, the higher equilibrium prices and lower value of the money due to the increased money supply leads banks and other financial institutions to raise rates in order to compensate for the loss of the purchasing power of their funds. Higher long-term rates discourage business borrowing, which leads to less investment in capital goods and technology. 2. Lower exports.  Higher prices of goods mean that other countries will find it less attractive to purchase our goods. This will lead to a decline in exports and lower production and higher unemployment in our country. 3. Lower savings. Inflation encourages consumption instead of saving. Higher prices induce people to purchase more products now, before they become more expensive. They discourage people from saving, because money saved for future use will have less value. Savings are needed to increase funds in the financial markets. This allows businesses to borrow money for investments in capital goods and technology. Increases in technology and capital goods create long-run economic growth. Inflation leads to increased consumption, which discourages savings and slows down...

Effects of a Constant Money Supply  If no additional money is printed, the nominal value of spending in our economy remains constant (assuming no leakage of money to other countries and assuming a constant velocity (see Unit 9) of money). The only long-run variable that then affects the price level is the total (aggregate) real supply of products. Thus, if supply increases, prices decrease. In the short run, it is possible that cost factors, such as the price of imported oil, or other raw materials, cause prices to increase. However, experience teaches us that these factors fluctuate in the short run only. It is unlikely that the prices of these resources experience sustained increases, especially if the countries in which these resources are produced keep their money supply constant. In fact, it is mathematically impossible for the overall price level in the world to increase if all countries keep their money supply constant. If the demand for one product increases, the price of this product can increase over time. However, given a constant money supply, this means that the demand for other products will have to decrease. Thus, the overall price level must remain constant. Only a decrease in aggregate supply can increase the overall price level in a constant money supply economy. A decrease in real aggregate supply is highly unlikely in free market economies that have experienced...