How Changes in Price Affect the Economy

If you are on a fixed income, then there is only so much altering you can do to your budget before you realize that high prices are affecting your finances.

Inflation is a phenomenon that you need to understand if you want to comprehend how the economy works.

Inflation affects everyone in the economy. Governments, businesses, and households are subject to inflation’s influence.

It is either created by excessive demand or increases in producers’ per-unit costs, but it is sustained by too much money in circulation in the economy.

Inflation is associated with a sustained increase in the cost of living or the general price level, leading to a fall in the purchasing power of money.

Economists have come up with different ways to measure the general price level in the economy, and therefore, inflation.

The most often cited measure of inflation is the change in the Consumer Price Index (CPI). In addition, economists and policymakers pay attention to changes in the Producer Price Index (PPI) and Personal Consumption Expenditure (PCE) deflator.

1) Consumer Price Index (CPI)

CPI is a market basket approach to measuring price level and inflation. Changes in the CPI indicate inflation or deflation.

The CPI measures the average cost of food, clothing, shelter, energy, transportation, and healthcare that the average urban consumer buys.

CPI is the most widely used measure of inflation in an economy.

PPI is a measure of producer price inflation that acts as a leading indicator of future consumer price inflation. It is similar to CPI but instead of consumer prices, the PPI looks at producer prices.

The PPI includes all domestic production of goods and service as well as the prices of goods sold by one producer to another.

Changes in the PPI can be used as a predictor of future changes in the CPI (before consumer prices change, the producer price changes).

Because it predicts changes in the CPI, the government and central bank use the PPI to create fiscal and monetary policy in anticipation of possible consumer inflation.

Understanding which type of inflation is occurring at any point in time is important if policymakers want to respond appropriately.

These two types are not mutually exclusive, so it is possible for both to occur simultaneously.

Demand-pull inflation occurs when spending on goods and services drives up prices. In other words, aggregate demand is greater than aggregate supply.

This type of inflation is fueled by income, so efforts to stop it involve reducing consumers’ income or giving consumers more incentive to save than to spend.

Demand-pull inflation persists if the public or foreign sector reinforces it. Low taxes, profligate government spending, and a failure of the central bank to reign in money supply also worsen demand-pull inflation.

Cost-push inflation occurs when the price of inputs increases.

Businesses must acquire raw materials, labor, energy, and capital to operate. If the price of these were to rise, it would reduce the ability of producers to generate output because their unit cost of production had increased.

If these increases in production cost are relatively large, the effect is to simultaneously create higher inflation, reduce real GDP, and increase the unemployment rate.

Thus, cost-push inflation is associated with decreases in GDP.

The combination of high inflation, reduced real GDP, and increased unemployment is known as stagflation.

This phenomenon is associated with stagnant economic growth and rising inflation.

In this situation, it becomes difficult to manage the economy. On one hand, companies and employees are suffering from slow-growing or falling production (which can lead to weaker profits and job losses), whilst prices are rising quickly (which threatens the real standard of living).

Inflation harms more than helps. Lenders and savers both lose when inflation exceeds expectations. Both earn interest rates that assume some rate of inflation, and when the actual rate exceeds the expected rate, savers and lenders are harmed.

Disinflation is beneficial to an economy for several reasons.

Disinflation reduces pressure to increase wages, as prices are more stable. It also results in lower, more stable interest rates, which makes capital investment less costly and easier to plan.

Arguably the most important outcome of disinflation is that producers’ inflationary expectations are lowered, which results in a profoundly more stable economic environment.

Deflation occurs when the average price level is declining and money’s purchasing power is increasing.

Why is this a problem? 
The problem with deflation is that it creates a perverse set of incentives in an economy. If prices are steadily declining, then consumers delay their purchase of durable goods, as the deals just keep getting better as time passes. If this behavior continues, manufacturing stops and widespread unemployment results.

The unemployment would then reinforce the deflation, as fewer consumers would be willing and able to purchase goods and services. Producers respond similarly to deflation by delaying investment and compounding the effects of the delayed consumption.

Economist Milton Friedman suggested that in economies with an inconvertible fiat money standard, deflation should never be a problem.

All the monetary authorities would need to do is print money, or in the case of economies with independent central banks, monetize the debt, and the deflation would end.

A small amount of inflation is considered healthy for the economy, as the anticipation that prices will rise, increases demand. This increased demand helps the economy expand.

But when inflation goes higher, demand increases too much (as people anticipate much higher prices), creating demand-pull inflation and ever-higher prices.

The optimal number seems to be 2%. At a 2% annual rate of inflation, prices are relatively stable and slow-growing. This rate of inflation results in prices doubling about every 36 years.