Inflation is an increase in the average price level. Some prices are going up, some are decreasing, and some remain the same, but the average price level is rising. In the modern U.S. economy, a small amount of inflation is normal and expected, perhaps about 1% to 4% per year. This is sometimes referred to as creeping inflation. During the past few years, the Consumer Price Index (CPI) has been rising about 2% to 3% per year.

The last time the U.S. had some truly objectionable inflationary results was in the late 1970s and very early 1980s when the price level rose more than 10% per year. The result was a serious erosion of the purchasing power and stability of the dollar. In recent years, the amount of inflation has been much lower and has stayed within a normal range.

There are examples of countries facing inflation far worse than what confronted us in the 70s. Hyperinflation, an increase in the price level of 100% + per year, faced Russia recently as it struggled to convert to a free market economy. Germany also had this problem shortly after W.W.I and this economic disaster may have been one contributing factor to the rise of the Third Reich. Fortunately, we have not had an episode of hyperinflation in well over one hundred years.

During the Vietnam War, a demand-pull inflation occurred as the federal government spent extra money to finance the war effort while consumption spending at home remained strong. The additional spending in these two sectors was enough to cause a demand-pull inflation.

A cost-push inflation could also occur if a needed commodity such as natural gas or oil went up sharply in price. These price increases would be passed on to consumers and business firms, both directly (e.g., gasoline prices) and indirectly (e.g., the prices of goods with plastic and rubber parts). The overall price level would go up beyond a normal, expected amount.

Sometimes the market structure of an industry can lead to significant price increases. Would it be fair to say that Microsoft has a monopoly or virtual monopoly on personal computer operating systems? Has Microsoft’s dominant position led it to charge more than what it would be able to charge if more competition existed in this market?

Although oil price increases may be classified as a cost-push type of inflation, was the Organization of Petroleum Exporting Countries’ (OPEC) dominant market position in the 1970s a factor in inducing it to quadruple prices in 1973 and then double them in 1979? The twelve countries that comprise OPEC constitute a cartel that has significant market power. With the advent of more non-OPEC producers in the 1980s and 90s, the market supply of oil increased substantially. Still, the structure of the industry is a factor in causing inflationary results from time to time.

Several years ago, the sluggish performance of many countries’ economies (not the U.S.) has resulted in less demand for oil than had been predicted. The outcome was downward pressure on oil prices. Lately, though, oil prices have been going back up.

At the end of W.W.II, the U.S. economy had a structural inflation problem in that our entire governmental, business, and economic system was geared toward military production. Yet when the war ended, there was tremendous purchasing power ready to be spent on consumer goods. It took the economy several years to "retool" itself so that it could produce more cars, washing machines, radios (soon to be TVs), etc. Until this adjustment was made, there was a mismatch between the production capability of the economy and the kinds of goods and services demanded by consumers. There was upward pressure on the price level at this time.

There are variations in the subsets of the consumer price index. Without question, the category which has had the most inflation is medical care, although some would say that the index does not sufficiently take into account the quality improvements in medical care as well as in other subsets of the index and therefore the CPI overstates the amount of inflation. Is it possible that while there have been a number of quality improvements for many products over the past fifteen years, there are also examples of loss of quality in certain goods and services? Do HMOs and other managed care systems provide better or worse medical care than the old-fashioned fee for service system where patients had unfettered individual choice of physicians? If you have to wait longer for referral to a specialist, is that a loss of quality?

It is also asserted that the CPI overstates inflation because it does not properly take into account the fact the consumers make substitutions when the item they originally planned on buying went up in price. You make a trip to the grocery store to buy steak but notice the price has gone up by 10%. So you buy chicken instead, which has not increased in price. But what if you really wanted steak? Yes, you avoided the price increase by making a substitution, but you’re not getting as much for your money because you preferred steak. So the bureaucrats who oversee the CPI may have the right idea in measuring the prices of a fixed market basket of goods and services because they are measuring the prices we pay for a certain lifestyle. The substitution argument fails to take into account that this may result in a lower standard of living.

The CPI has also been criticized for not taking into account the extent to which consumers purchase their goods today from discount retailers instead of the traditional full service retailers. But presumably the level of sales service and advice at a discount retailer is lower than it would be at a traditional retailer.

Suppose a retiree receives a company retirement check of $1,000 per month plus Social Security of $800 per month. Since Social Security checks are adjusted each year based on the amount of inflation as per the CPI, this person will have some protection from price increases due to the cost of living adjustment, or COLA. If his medical bills are large and medical price inflation continues to increase at about twice the rate of the overall index, then this protection may be limited. But what if his $1,000 per month company pension is fixed, that is, there is no cost of living adjustment. We could say that his stated, or nominal income, remains the same each month because the amount of the check is in fact $1,000. However, his real income, that is, his nominal income minus inflation, is clearly diminishing. In a year with 5% inflation, his nominal check of $1,000 may have actual purchasing power of about $950. The exact loss is uncertain because certain substitute purchases may be made that may involve little loss of utility, such as food and clothing, although other price increases, such as medical care, rent, and utilities, may be difficult to avoid. (Regarding substitutions, see the discussion above about the CPI and substitute purchases.) It is clear that to the extent a person is on a fixed income, his or her standard of living is diminished by inflation.

Inflation also produces distortions for various types of personal financial investments. Suppose you have a plain vanilla savings account that pays a simple nominal interest rate of 3% per year. If inflation = 2%, then your real interest rate, that is, the nominal rate minus inflation, = 1%. Of course, you didn’t have much of a return in the first place, even before subtracting inflation.

What if we went back in time to when plain savings accounts paid 6% as the nominal interest rate? If the inflation rate rose to 8%, then you would actually earn a real interest rate of –2%! This looks pretty bad, although at least you earned +6% before subtracting for inflation. There are some interest dollars paid to the depositor, even though it would be difficult to avoid all the price increases.

It seems that in a time of high inflation your best option would be to own real estate and perhaps certain other tangible, physical items of property. Real property historically has been an excellent hedge against inflation. In fact, real estate seems to go up even faster than the inflation rate in a time of high inflation. The 1970s was an inflationary decade and this would have been a good time to own real estate. Other physical assets such as precious metals or vintage cars might also hold their value very well during inflationary times.

When inflation is low, financial assets such as stocks and bonds are a better choice. For most of the 1980s and 1990s, these assets, especially stocks (although you have to adjust for the extra risk) have performed well. When inflation rates are down, nominal interest rates are down and investors and business firms like low interest rates. It is true that economists pay a lot of attention to real interest rates, but most normal people just talk about interest rates, and they are referring to the nominal rates. So if you could predict the future, you would have loaded up on real property during the 70s and then switched to stocks for the 80s and 90s!

Inflation can also distort economic results depending on whether you are a debtor or a creditor and on whether or not the inflation was predicted or not. Assume you buy a home financed by a thirty-year mortgage at an interest rate of 7%. Shortly thereafter, inflation shoots up from 2% to 10% per year and stays there for years. Your real interest rate is now –3% (+7% - 10%) and you have the pleasure of repaying your loan with dollars that are not worth as much as the creditor predicted. You, the debtor, gain. On the other hand, if, after taking out the mortgage, the inflation rate drops from 2% to 1%, your real interest rate has risen from 5% (7% - 2%) to 6% (7% - 1%). The creditor gains by receiving repayment of dollars whose purchasing power has increased. Kudos to you for completing the Unit Two Reading Assignments.