7.4 Inflation and Price Changes

Two Definitions of Inflation

1. 1. Classical Definition – Inflation is an increase in the money supply and credit relative to goods and services.

      • Cause-Focused: Emphasizes the expansion of money supply as the root cause.
      • Symptom: Rising prices are seen as the result of monetary inflation.
      • Accountability: Highlights the role of central banks and governments in driving inflation through excessive money printing and credit creation.

   2. Modern Definition – Inflation is the general increase in prices over time, resulting in a decline in the purchasing power of money.

      • Effect-Focused: Tracks price changes in consumer goods and services using indices like CPI and PCE.
      • Obfuscation of Cause: Shifts attention away from monetary policy to external factors such as supply chains, wages, or corporate pricing strategies.

Why the Shift in Definitions?

Governments and central banks moved away from the classical definition to the modern definition for strategic reasons:

• • Deflecting Responsibility: By defining inflation as rising prices, governments can blame corporations for being “greedy” or “price gouging,” while obscuring the role of monetary policy in driving inflation.
  • Political Narrative: Rising prices can be attributed to external crises (e.g., supply chain disruptions, labor shortages) or market behaviors, shifting blame from policymakers to businesses.
  • Underreporting Inflation: Tools like CPI are designed to track price changes but can be manipulated to downplay inflation’s true impact through substitution bias, hedonic adjustments, and exclusion of housing prices.
  • Public Perception: The modern definition aligns with what people feel—higher grocery bills and gas prices—while leaving the root cause of inflation hidden behind complex monetary mechanics.

7.4.1 How Is Inflation Measured?

1. Consumer Price Index (CPI):

Measures the average change over time in prices paid by urban consumers for a market basket of goods and services.

Categories Measured:

• • • • • Food and Beverages: Groceries, dining out.
        • Housing: Rent, utilities.
        • Transportation: Gasoline, vehicles.
        • Healthcare: Medical services, prescriptions.
        • Education and Recreation: Tuition, entertainment.

Formula:

Source: U.S. Bureau of Labor Statistics (BLS)

CPI Measurement (2024):

https://fred.stlouisfed.org/series/CPILFESL

2. Producer Price Index (PPI):

Measures price changes from the producer’s perspective—tracks costs of raw materials, intermediate goods, and finished products.

• • • • • Often a leading indicator of future consumer inflation as producers pass higher costs to consumers.

3. Personal Consumption Expenditures (PCE):

The Federal Reserve’s preferred metric because it adjusts for consumer substitution (e.g., switching to cheaper products when prices rise).

• • • • • Reflects actual spending patterns more accurately than CPI.

7.4.2 Core Inflation vs. Headline Inflation

• • Headline Inflation: Includes all CPI categories, including volatile food and energy prices.
  • Core Inflation: Excludes food and energy to focus on underlying trends.

Example:
A temporary spike in gasoline prices raises headline inflation, while core inflation may remain stable, reflecting long-term trends better.

7.4.3 Limitations of Inflation Metrics

1. 1. Substitution Bias:
      • Assumes consumers switch to cheaper alternatives, understating the real impact of inflation.
   2. Hedonic Adjustments:
      • Hedonic adjustments aim to account for improvements in product quality when measuring inflation. For example, if a new iPhone model is released at the same price as the previous model but includes better features—such as a faster processor or improved camera—these enhancements are treated as a price reduction, even if the actual price remains unchanged or increases slightly. This adjustment suggests that consumers are getting more value for their money, effectively lowering the measured inflation rate.
   3. Exclusion of Housing Prices:
      • CPI uses rent equivalents instead of actual home prices, failing to capture housing inflation accurately.
   4. Geographic Differences:
      • CPI reflects urban prices, ignoring rural areas where inflation might differ.

7.4.4 Alternative Measures of Inflation

1. 1. ShadowStats (Shadow Government Statistics):
      • Recalculates inflation using pre-1980s methodologies.
      • Often reports higher inflation rates than official CPI.
   2. Chained CPI:
      • Adjusts for consumer behavior changes, like switching to cheaper goods.
      • Critics argue it downplays inflation, reducing cost-of-living adjustments.

7.4.5 Real-World Impacts of Inflation

1. 1. Hidden Tax on Savings:

      • Savings lose value over time due to inflation.
      • Example: A 1% interest savings account loses purchasing power if inflation is 6%.

   2. Blame Shifting:

      • Governments often blame businesses for rising prices, portraying corporations as “greedy” or “price-gouging.”
      • Reality Check: Rising prices are often a direct consequence of monetary expansion, with businesses merely adjusting to higher input costs or maintaining margins.

   3. Wages and Cost of Living Adjustments (COLA):

      • Social Security, pensions, and wages are adjusted using CPI.
      • Understated CPI reduces real income for retirees and workers.

   4. Wealth Redistribution:

      • Inflation disproportionately impacts low-income households who spend more on necessities like food and housing.
      • Asset holders benefit as inflation drives up prices for stocks and real estate.

   5. Weaponizing Inflation Metrics:

      • Misrepresenting inflation through flawed metrics enables governments to justify poor policies, like excessive money printing or delayed interest rate hikes.

Key Takeaways

• • Two Perspectives:
    • Classical View: Inflation begins with monetary expansion, leading to price increases.
    • Modern View: Inflation is measured through rising prices but often ignores monetary origins.
  • Government Manipulation:
    • By focusing on prices rather than money supply, governments evade accountability and shift blame to businesses.
  • Economic Consequences:
    • Misdiagnosing inflation risks poor policy decisions, exacerbating inequality and economic instability.
  • Transparency and Trust:
    • Understanding the root causes of inflation is critical for holding policymakers accountable and protecting savings from erosion.