. Inflation is the third broad area of major concern in macroeconomics. It deals with price changes. We discussed price changes earlier in our overview of demand, supply, and equilibrium price. Those price changes were for individual commodities. Inflation is used in economics to refer to increases in the overall or average price level.
The most common measure of changes in prices and hence inflation in the U.S. is the Consumer Price Index (CPI), a monthly indicator of the cost of a fixed "market basket" of goods and services. The CPI is expressed in terms of the prices of a base period, and its level today indicates how much one would have to pay now to acquire goods and services costing $100 in the base period. Hence, changes over time in the CPI yield a direct measure of changes in the general level of prices.
The base period is presently the three-year span from 1982-84. In July 1996 the CPI was 157.0, meaning that it cost $157 to buy the same amount of goods and services that $100 could buy in 1982-84. In July 1995 the CPI was equal to 152.4; thus, the CPI increased by 4.6 points (157.0 - 152.4) during the period from July 1995 to July 1996.
To calculate the inflation that took place between July 1995 and
July 1996 in percentage terms, we need to take the change in the
CPI, divide it by the value of the CPI at the beginning, and multiply by 100.
That is, .
For periods of longer than a year, we can calculate average
inflation rates by using the formula 
, where
the left hand side of the equation is the value of the CPI at the end of a period of t
years, and the last term is the value of the CPI at the beginning of the
period, and r equals the average annual rate of inflation. Based
on this formula, the average inflation from mid-1983 to mid-1996
was approximately 3.5 percent.
In the U.S., as shown in Parkin's Fig. 5.8, annual inflation rates have generally been from about 2-5 percent over much of the past 35 years. However, in some years inflation has risen to the double-digit level (13-14 percent in 1980). Inflation rates are often higher in other countries, and especially in developing economies. In some cases, hyperinflation has become a real problem (cf., Zaire, with daily price changes in stores, price codes, and investment in search for delayed price increases).
Our interest in inflation stems from the fact that inflation results in a falling value of money, and as we'll see later, this has some adverse consequences for the economy. We'll also see later that there are concerns about the ability of the CPI to adequately reflect changes in the price level, particularly because of the introduction of new goods and quality changes in existing goods. These concerns have led many economists to argue that the CPI in fact overstates inflation.
Interest rates are closely related to inflation rates, as can be seen in Parkin's Fig. 5.10. Interest rates reflect returns to lenders, expressed as payments by buyers as a percentage of the loan. For example, if you borrow $1,000 today and repay it in one year along with a payment of $100, you've paid an interest rate of 10 percent (100/1000).
If lenders expect prices to rise, they will want to be compensated for the loss of purchasing power resulting from receiving payments that have less value than when the original loan was contracted. Hence, with expectations of inflation lenders restrict the supply of loanable funds (require higher interest rates for any given amount of loan funds) and thereby put upward pressure on the price of borrowed money (the interest rate).
The nominal interest rate on a loan reflects the interest payments expressed as a percentage of the principal (loan amount). The example above of $100 interest on a $1,000 loan gave us a nominal interest rate of 10 percent. However, this rate fails to allow for the decline in the purchasing power of money that accompanies inflation. Hence, we also calculate the real interest rate, defined as the nominal interest rate minus the inflation rate.
Thus, for example, if you'd borrowed $1,000 in July of 1995 and repaid the loan plus $100 interest one year later, your real interest rate would have been 7 percent -- the nominal interest rate of 10 percent minus the inflation rate of 3 percent.
One other concept that is relevant here is that of the foreign exchange rate. A foreign exchange rate is the rate at which one country's currency exchanges for that of another country. For example, at present one dollar can buy 5.1-5.2 French francs. However, I've seen that rate range from as low as four to as high as ten. Why the variation? Differences in inflation rates across countries are one reason, because such differences ultimately necessitate adjustments in foreign exchange rates.
For example, if inflation in France is greater than that in the U.S., the dollar will become more valuable relative to the French franc, because it will have greater relative purchasing power than before. That is, the amount by which the value of the dollar falls due to inflation will be smaller than the amount by which the value of the franc declines (remember that inflation reduces the value of money, so greater inflation in France would reduce the value of the franc by more than the reduction in the values of the dollar). This effect is most evident in extreme cases -- cf., the Zaire.
International Payments
In an open economy with imports and exports, international payments are important. The current account and the capital account are relevant considerations here. The current account incorporates the trade balance (exports minus imports) and more. More formally, it measures export receipts plus interest income from other countries against payments for imports, interest payments to other countries, and gifts and other transfers (e.g., aid) going abroad. If the former exceeds the latter, then we have a current account surplus; while if imports plus interest payments made abroad plus other transfers exceed the value of exports plus interest received, we have a current account deficit.
As shown in Parkin's Fig. 5.11, the U.S. had a small current account surplus for most of the 1960s and 1970s, and has experienced large current account deficits for most of the period since 1980. This is primarily due to a large trade deficit (our exports are exceeded by our imports). There is a cyclical aspect here as well: imports fall during recessions and rise during expansions, so the current account deficit shrinks during recessions and grows during expansions.
The complement to the current account is the capital account, which measures the receipts from foreign investment in the U.S. minus U.S. investments in the rest of the world. A current account deficit results in borrowing from foreigners or selling U.S. assets to pay for it -- resulting in a capital account surplus. Conversely, when we have a current account surplus (e.g., exports exceed imports) we use the surplus to buy foreign assets or loan our surplus to the rest of the world.
Macroeconomic Policy Challenges and Tools
The principal goals of macroeconomics as a policy science consist of boosting long-term growth (raising the slope of the curve showing the time series of real GDP) and stabilizing economic fluctuations (dampening the deviations from trend). Because of the importance of labor incomes for the economic well-being of the population (they represent about 2/3 or more of national income), lowering unemployment rates is also a policy objective, as are keeping inflation under control (inflation has adverse consequences for growth) and lowering the current account deficit (cf., issue of "selling of America").
The key macroeconomic policy tools are fiscal and monetary policy. Fiscal policy is reflected in government policies that establish tax levels and structure, government spending levels, and hence the government's deficit and debt. The government budget deficit is simply the annual difference between tax receipts and government expenditures (as a nation, we are not living within our means, and balancing the budget must necessarily entail some combination of reducing expenditures and/or raising tax revenues).
The annual budget deficit then adds to the national debt, the cumulative net deficit. The large deficits and corresponding growth in the national debt that have characterized most of the past 15 years are responsible for the current emphasis on reducing and eliminating the budget deficit.
Monetary policy refers to decisions under control of the Federal Reserve (the Fed) concerning the growth of the money supply and changes in interest rates. Along with fiscal policy, it has the potential for being used to combat recessions, but as we shall see later, there are many perils in attempting to fine-tune the macroeconomy.
© 1996 David Shapiro
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