Inflation

Definition: Inflation is the rate of change of the general price level over a period of time.

In other words inflation is a measure of how much prices, on average, change over time, usually specified intervals. Inflation is usually given as an annual rate after year-end, but is measured throughout the year. Iím sure that many of you have heard talk about prices and price levels on the news or read about them in magazines.

What causes inflation?

Many of the causes of inflation have to do with the discussion we had regarding the Federal Reserve. Monetary and Fiscal policy are often targeted to effect inflation. Fiscal policy can cause an increase in government deficit, which will eventually lead to inflation. [Since the government is demanding more money, the demand curve will shift to the right. This causes the interest rate to increase and as this occurs more people will be willing to supply money in the form of savings. The only way for the money supply to return to equilibrium is for prices to increase, or inflation. (These results are derived from economic theory that you will be getting in future courses.) ] Monetary Policy can also cause inflation.

What can be done to curb inflation?

Government tries to control inflation through monetary policy. It is the Fedís job to try to keep inflation at low levels. It uses the tools discussed yesterday to do this.

What does inflation do to you and me?

As prices go up (inflation), our buying power is reduced. That means our income is worth less and we cannot buy the same amount as we used to. For example, if our income is $100 and the average price level is $10 we can buy 10 items. If inflation causes the price level to go up 5%, we can now only buy approximately 9 items. This is a very simplified example just to show you how inflation reduces buying power.

How can the effect of inflation be reduced by employers?

Many companies offer a cost of living wage increase every year. What this means is that our salaries are tied to inflation and rise as inflation rises. For example, if our income is $30,000 for 1996 but inflation is 3% in 1997, our income will now rise to $30,900 for 1997 due to inflation adjustments. Such increases are only aimed to make sure that employees are as well off as they were the prior year. Employees may get other raises above inflation adjustments, but many get cost of living (col) increases every year.