What is inflation?

Posted: 31 August 2014 in Uncategorized
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Inflation appears at first sight an extremely obvious, trivial thing. But its analysis brings out that it is a very strange thing…

One one level, inflation is extremely obvious: it’s an increase in the prices of the commodities people buy. Bread, gasoline, housing, and so on. When their prices go up, we are witnessing (and, for many, suffering) inflation. (The opposite, when prices fall, is deflation.)

Why is inflation important? Well, for most of us, our money (or nominal) incomes are eaten away by increases in prices. Therefore, over time, our real incomes are less than our nominal incomes, thus permitting us to purchase less.

Here’s an illustration of the difference:

household-income-monthly-median-growth-since-2000

According to calculations by Doug Short, while nominal income of the average household in mid-2014 was about 32 percent higher than it was in 2000, real household income had actually declined by about 6 percent. In other words, just because median household income had grown in nominal terms doesn’t mean that their standard of living—in terms of commodities they could purchase—had actually gone up. In fact, it went down (and had been going down for most of the 2000s, even before the Second Great Depression began).

But then there’s a second issue. Friends and acquaintances often complain to me that, while “the government” is reporting relatively low inflation (of less than 2 percent in recent years), the prices of the commodities they’re purchasing seem to be going up more than that. (It’s a complaint that is aggravated by a whole host of liberal economists arguing that economic policy should encourage a level of inflation higher than the official rate.)

Part of the problem is that there are different measures of inflation. The headline number is the Consumer Price Index, calculated by the Bureau of Labor Statistics. (Technically, the measure most reported in the press is CPI-U, the Consumer Price Index for urban consumers.) Why is the CPI (or CPI-U) so important? Because it’s often used to “deflate” (i.e., correct for price changes) a wide variety of government programs, such as Social Security. And it’s often used by employers to justify small wage and salary increases—as in “Inflation is low, so your expectation of a larger increase in what I pay you is simply not justified.”

The major problem with the BLS measure of inflation is that it’s not based on a fixed basket of goods. Instead, the presumption is that people substitute some commodities for others they had been purchasing.(As the BLS explains, “The ability to substitute means that the increase in the cost to consumers of maintaining their level of well-being tends to be somewhat less than the increase in the cost of the mix of goods and services they previously purchased.) So, the CPI is not really measuring what is costs us to purchase the commodities we’re used to consuming.

As Perianne Boring explains for Forbes,

the CPI is not a measurement of rising prices, rather it tracks consumer spending patterns that change as prices change. The CPI doesn’t even touch the falling value of money. If it did the CPI would look much different.

The issue gets even more complicated because there are lots of different measures of inflation out there. In addition to the BLS measure (which is used for government programs like Social Security as well as the Federal income tax structure), there’s the Personal Consumption Expenditure (PCE) index collected by the Bureau of Economic Analysis, which is closely followed by the Federal Open Market Committee; the core PCE price index, which excludes the more volatile and seasonal food and energy prices; the Producer Price Index (PCI), which measures the average changes in prices receive by domestic producers for their output; the GDP deflator, the measure of prices calculated by the Bureau of Economic Analysis that used to calculate the “real” amount of goods and services produced in the U.S. economy; and many others.*

My own view, for what it’s worth, is the real rate of inflation for consumer goods is higher than the official rate of 2.2 percent (over the past 12 months), thereby understating the extent to which working people are facing rising prices for the commodities they need to purchase in order to maintain themselves and their families. In addition, most people are receiving wages and salaries that simply are not rising much more, from one year to the next, than the official inflation rate.

Therefore, it’s not surprising that people are feeling squeezed and find the kinds of economic policies advocated by mainstream economists quite strange—both the call for austerity by conservative economists (based on the idea that galloping inflation is right around the corner) and the call for more inflation (based on the idea that real interest rates should be negative, in order to boost economic activity). Neither policy—abounding as they are in metaphysical subtleties and theological niceties—would help working people who, right now, are facing both rising prices and stagnant incomes.

 

*And then, of course, there’s the measure of inflation produced by John Williams for Shadow Government Statistics. The ShadowStats measure is much higher than the official rate: anywhere from 6 to 10 percent, compared to the official (CPI) rate of 2 percent. Doug Short notes a problem with the ShadowStats price index: a 1967 median household income of, let’s say, $7,143 in 2012 dollars would have had the purchasing power of $185,588.

Comments
    • David F. Ruccio says:

      My view, for what it’s worth, is Marx only assumed commodity money at the start of the analysis (in volume one of Capital) in order to analyze the value (and exchange-value) of capitalist commodities. In other words, it was a convenient analytical device at a particular stage in the analysis. But commodity money is not at all intrinsic to Marxian value theory.

      As for my post on inflation, the aim was to make sense of how price changes are measured in the United States. It would be a whole other matter to determine the causes of inflation (and, of course, deflation). And for that it is crucial to integrate fiat money into Marxian value theory.

  1. Frank Wolstencroft says:

    Increases in the cost of living are often conflated with inflation of the currency, which are not quite the same thing. Increases in the money supply beyond the capacity of the economy to absorb it will cause an overall increase in prices, since more money is chasing the same number of goods on offer. If the money supply remains constant, then a price increase on one commodity will automatically mean a price reduction in some other commodity.

  2. […] in 2014, in a post on inflation, I revealed my suspicion […]

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