If this result sounds too good to be true, that’s because it is. And the reason is inflation. When people start spending all that new money, it drives up prices. Eventually, the only effect of the government’s good intentions is that prices rise and no additional goods are sold. For example, if the govern- ment doubles the money supply, businesses double the prices they charge because each piece of money is worth half as much as before. Consequently,
the total amount of goods and services sold is the same as before because, although twice as much money is being spent, prices are also twice as high.
The sad upshot is that an increase in the money supply stimulates the econ- omy only when the increase is a surprise.
If the government can print the money and start spending it before people can raise prices, you get an increase in the amount of goods and services sold. Eventually, of course, people figure it out and raise prices, but until they do, the monetary stimulus works.
Unfortunately, continuing to fool people is difficult. You can surprise people once, but the second time is harder and the third time harder still. In fact, if the government keeps trying to surprise people, people begin to anticipate the government and raise prices even before the government prints more money. Consequently, most modern governments have decided against using this sort of monetary stimulus and now strive for zero inflation or very low inflation.
Tallying up the effects of inflation
In recent years in the UK, prices have risen only a small amount each year (about 2.5 per cent annually, although the figure has been much higher in the past). However, even moderate inflation causes problems by cutting into the practical benefits of using money instead of barter. You can get a better sense of this fact by looking at the four functions that economists generally ascribe to money and the ways in which inflation screws up each of them:
✓ Money is a store of value. If you sell a cow today for one gold coin, you should be able to turn around and trade that gold coin back for a cow tomorrow or next week or next month. When money retains its value, you can hold it instead of holding cows, or property or any other asset.
Inflation weakens the use of money as a store of value because each unit of currency is worth less and less as time passes.
✓ Money is a unit of account. When money is widely accepted in an economy, it often becomes the unit of account in which people write contracts. People start using phrases like ‘£50 worth of timber’ rather than ‘50 square metres of timber’.
This practice makes sense if money holds its value over time, but in the presence of inflation, using money as a unit of account creates problems because the value of money declines. For example, if the value of money is falling fast, how much timber, exactly, is ‘£50 worth of timber’?
✓ Money is a standard of deferred payment. If you want a cow, you probably wouldn’t borrow a cow with the promise to repay two cows next year. Instead, you’d be much more likely to borrow and repay in terms of money. That is, you’d borrow one gold coin and use it to buy a cow, after promising to pay back two gold coins next year.
The progressive devaluing of money during a period of inflation makes lenders reluctant to use money as a standard of deferred payment.
Suppose a friend asks to borrow £100, promising to pay you £120 in a year. That seems like a good deal – after all, the interest rate is 20 per cent. But if prices are rapidly rising and the value of money is falling, how much are you going to be able to buy with that £120 next year?
Inflation makes people reluctant to lend money. They fear that when the loans are repaid, the repayment cash isn’t going to have the same purchasing power as the cash that was lent. This uncertainty can have a devastating effect on the development of new businesses, which rely heavily on loans to fund their operations.
✓ Money is a medium of exchange. Money is a medium (literally meaning
‘something in the middle’) of trade between buyers and sellers because it can be directly exchanged for anything else, making buying and selling much easier. In a barter economy, an orange farmer who wants to buy beer may have to first trade oranges for apples and then apples for beer because the guy selling the beer wants only apples. Money can eliminate this kind of hassle.
But if inflation is bad enough, money is no longer an effective medium of exchange. During hyperinflations, economies often revert to barter so that buyers and sellers don’t have to worry about the falling value of money. For example, in a healthy economy, the orange seller can first sell oranges for cash and then trade the cash for beer. But during a hyperinflation, between the time he sells the oranges for cash and buys the beer, the price of beer may have skyrocketed so high that he can’t buy very much beer with the cash. During a hyperinflation, economies have to resort to cumbersome bartering. At the very least, if one cur- rency becomes debased, people often tend to use a trusted foreign cur- rency, usually the US dollar, as the medium of exchange.
Another effect of inflation is that it functions as a giant tax increase. This seems strange because you normally think of governments taxing by taking away chunks of people’s money, not by printing more money. But a tax is basically anything that transfers private property to the government.
Debasing the currency or printing more money can have this effect.
Suppose that the government wants to buy a £20,000 van for a village. The honest way to go about this is to use £20,000 of tax revenues to buy a van.
But a sneakier way is to print £20,000 in new cash to buy the van. By printing and spending the new cash, the government has converted £20,000 of private
property – the van – into public property. So, printing new cash works just like a tax. Because printing new money ends up causing inflation, this type of taxa- tion is often referred to as an inflation tax.
Not only is the inflation tax sneaky, but also it unfairly targets the poor because they spend nearly all their income on goods and services, the costs of which go up greatly during an inflation. By contrast, because the rich have the opportunity to save a lot of their incomes instead of spending everything they take in, proportionately they’re less affected by an inflation tax. By investing their savings in assets (like property) whose prices go up during inflation, the rich can insulate themselves from a great deal of the harm caused by inflation.
Measuring Inflation: Price Indexes
Inflation can cause lots of problems, so in order for the government to keep inflation under control, it needs a way to measure inflation accurately.
As we explain in the earlier section ‘Buying an Inflation: The Risks of Too Much Money’, the value of money is determined by the interaction of the supply of money with the demand for money. The supply of money is under the government’s control, but the government can’t directly ascertain the demand for money, so it has to look at how supply and demand interact in order to determine how much to increase or decrease the money supply:
✓ If an inflation is in effect, the government knows that the supply of money is increasing faster than the demand for money. If it wants to tame the inflation, it needs to reduce the supply of money.
✓ If a deflation is in effect, the government knows that the demand for money is increasing faster than the supply of money. If it wants to end the deflation, it needs to increase the supply of money.
Because inflation is a general increase in prices, the best way to look for it is to see whether the cost of buying a large collection of many different things changes over time. If, instead, you look at only one or two prices, you may end up confusing a relative price change for a general price change. (A rela- tive price change is when one price goes up relative to the others, which remain unchanged.)
Economists arbitrarily define some large collection of goods and services and refer to this collection as a market basket. They then find out how much money is necessary to buy this basket at various times to measure inflation.
In the UK several different measures have been used to try to capture the
effect of inflation. Until recently the headline measure was the RPI-X; that is, the Retail Price Index less mortgage interest (to strip out the effect of interest rates, which otherwise complicate the picture too much). Recently, though, a new measure, called the CPI (Consumer Price Index), does roughly the same thing. You can find the CPI figure at the UK National Statistics website (www.
statistics.gov.uk). The CPI captures the price of a basket of goods, and is often tweaked to take into account the change in consumer purchases over time. Sometimes products are dropped from the index and sometimes new products replace them, for example, the price of flights replacing the price of hotels in Margate. Other bodies such as the Organization for Economic Cooperation and Development (OECD) produce figures that are internation- ally comparable (that is, defined on the same basis across countries).
In the following sections, we show you how this process works by creating a market basket, seeing how this basket can be used to measure inflation and normalising it to a given base year so that calculating inflation rates between any two years is a piece of very agreeable cake.
Creating your very own market basket
The Consumer Price Index involves a large number of products and services – and is a big market basket. Understanding price indexes is easier if you create a simplified index with a very small market basket. In this section, we look at a very small market basket containing pizza, beer and textbooks. Because these three items are typical purchases of the undergraduate student population, we shall call it the Undergraduate Price Index.
For each of the three items in the Undergraduate Price Index, we create prices for 2007, 2008 and 2009 and list them in Table 5-1.
Table 5-1 The Undergraduate Price Index
Item Number Bought 2007 2008 2009
Pizza 10 £10 £9 £9
Beer 60 £2 £2 £2.25
Textbooks 1 £120 £160 £170
In 2007, one medium cheese pizza costs £10, a pint of subsidised student union brown ale £2 and an overly long, poorly written, incomprehensible introductory economics textbook costs £120. The next year, the price of a medium cheese pizza actually falls to £9 because a new pizza outlet opens up
next to the old one, causing a price war. Beer still costs £2, but the university bookshop decides that it can really take advantage of the students, raising the price of the textbook to £160. (Don’t worry about the 2009 column yet.
We give you a chance to dig in and calculate inflation using the 2009 numbers later in the chapter.)
So far, so good. But in evaluating the index, you also have to keep track of how many of each item the typical student buys each year. For the sake of simplicity, assume that a typical student buys ten cheese pizzas, 60 beers and one economics textbook each year.
Calculating the inflation rate
To calculate how much inflation your university economy has (or deflation, if the cost of living happens to go down), first total up how much the market basket costs each year. In 2007, it costs £340: £100 on pizza (ten pizzas at £10 each), £120 on beer (60 beers at £2 each), and £120 on economics textbooks (one textbook at £120). The cost of buying the same market basket in 2008 is
£370. So the cost of buying the same market basket has gone up by £30.
Now that you’ve done the adding, you need to do some simple algebra.
Economists use the capital letter P to denote how many pounds the defined market basket costs. So in this case, P2007 means the cost of buying the market basket in 2007 and P2008 is the cost of buying the market basket in 2008. Because P as a letter is now in use, we’re going to use pi, the Greek letter π (pronounced ‘pie’) as shorthand for the rate of inflation.
To calculate the rate of inflation, you use a very simple formula:
π = (PSecond Year – PFirst Year) / PFirst Year (1) In this case, the formula becomes:
π = (P2008 – P2007) / P2007 (2)
Substituting in P2007 = £340 and P2008 = £370, you find that π = 0.088. Multiply by 100 to convert this number into a percentage, and inflation in the Under- graduate Price Index is 8.8 per cent between 2007 and 2008. So, on the basis of this number, a student needs 8.8 per cent more money in 2008 to buy the simple market basket.
Setting up a price index
The undergraduate market basket is a simple example, but when government statisticians compute the Consumer Price Index, they basically do the same thing, just using a lot more goods. They also introduce the concept of a price index (or price level index) to make calculating and interpreting inflation rates over several years much easier. To set up a price index, they first estab- lish a base year, or index year. Continuing our example, suppose that 2007 is the base year for the Undergraduate Price Index. You can then make a handy mathematical transformation so that the price level in 2007 is fixed at the number 100 and the price levels of every other year are set up so that they’re relative to the 100 of the base year.
To make P2007 = £340 your base year, divide it by itself. That, of course, gives you 1, which you then multiply by 100 to get 100 (100 × 1 = 100). This may seem like an idiotic thing to do until you realise that if you do the same thing to the other years, you end up with something very useful. Divide P2008 by P2007 and then multiply that product by 100 to get 108.8. This number is easy to interpret: it’s 8.8 per cent larger than 100. Or, put differently, the price level in 2008 is 8.8 per cent larger than the price level in 2007. (Of course, you already discovered this inflation rate using equation (1) in the previous section.) You can keep going, using the numbers for 2009 that appear in Table 5-1. For example, P2009 = £395. If you divide P2009 by P2007 and multiply by 100, you get 116.2; the price level in 2009 is 16.2 per cent bigger than the price level in 2007.
Working out the rate of inflation between 2008 and 2009 using these index numbers is also easy. Because the price index level for 2008 is 108.8 and the price index level for 2009 is 116.2, inflation is simply (116.2 – 108.8) / 108.8 = 0.068, or 6.8 per cent. (You’re using equation (1) here, but you’re inputting index numbers instead of actual costs of market baskets.)
Figure 5-1 charts the actual values of the Retail Price Index from 1987 to 2006.
The index was set to a level of 100 using prices that consumers paid on aver- age over the two-year period ending January 1987.
You can see that the Retail Price Index grew from its initial level of 100 in 1987 to a level of 200 in 2006. That is, to buy what a typical household con- sumes, you would have needed double the money in 2006 compared to what was needed in 1987, with the worst of the increases occurring in the late 1980s and early 1990s. Or to put it another way, increases in the money supply drove prices to double over this 20-year period.
Figure 5-1:
Retail Price Index, 1987–2006. Jan-87
RPI (Headline)
Year 0
50 100 150 200 250
Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06
Determining the real standard of living with the price index
Beyond making inflation easy to measure and interpret, price indexes also make it simple to measure the very important difference between real prices and nominal prices. Nominal prices are simply money prices, which can change over time due to inflation. Because nominal prices can change, econo- mists like to focus on real prices, which keep track of how much of one kind of stuff you have to give up to get another kind of stuff, no matter what happens to nominal prices.
For example, suppose that in 2008 you make £10 an hour working at a youth camp and the cost of a DVD is £20. The real cost of a DVD to you is two hours of work. Suppose that the next year, the prices of all goods double, but your wages also double so that you are earning £20 an hour and a DVD costs £40.
The result is that you still have to work two hours to buy a DVD. So although the nominal price of a DVD has doubled, its real price in terms of labour – how much labour you have to give up to get a DVD – hasn’t changed.
By constructing price indexes such as the CPI, economists can tell how the real standard of living changes for people from year to year. In the example of the previous section (using data from Table 5-1), inflation is 8.8 per cent between 2005 and 2006, meaning that the cost of living of a typical undergrad- uate student went up 8.8 per cent. So if at the same time student incomes go up only 5 per cent, students are actually worse off because costs have gone up faster than incomes. Real living standards – living standards measured in terms of how much stuff you can buy with your income – have fallen.
Identifying price index problems
Using price indexes to track the cost of living isn’t a flawless system. Here are three big issues:
✓ The market basket can never perfectly reflect family spending.
National Statistics tries to keep track of what a typical family of four purchases when calculating the Consumer Price Index (CPI). But families differ greatly, not only in terms of what they buy, but also in terms of how many of each thing they buy.
✓ The market basket becomes outdated. When to replace one product with another in the list is a fine judgement call. Suppose, for example, that National Statistics was deciding whether to include in the market basket DVD players instead of older VCRs. If Britain’s national statisti- cians wait too long, they aren’t capturing the change in purchases, but if they do it too soon, they may find that DVDs don’t actually catch on and join the museum of dead technology (right next to the Sinclair ZX81 and the Betamax), in which case the figures would also be wrong.
✓ The market basket can’t account for quality. Price isn’t the only thing that matters to consumers. For example, what if a beer stays the same price but improves in quality from one year to the next? You’re getting better beer for the same price, but this quality isn’t reflected in the data.
This problem is especially severe for things like computers, mobile phones and video games. For these products, quality improves dramati- cally year after year while prices stay the same or go down.
Each of these problems troubles government statisticians, who are con- stantly coming up with better price indexes and statistical methods to try to overcome them. The Federal Reserve Bank (the US government agency charged with determining the money supply) has recently come out with an estimate suggesting that the US CPI overstates inflation by 1 to 2 percentage points per year. Most of the overstatement comes from the failure of the CPI to account for new goods and quality improvements.