Understanding Inflation Essay Example for Free

Understanding Inflation Essay The amount a product costs should be the first decision a consumer has to make before they purchase a good or service. Consumers may find themselves asking what exactly makes a price rise and why their money can purchase less and less. The answer to this question is inflation. What is inflation and why should any consumer care about inflation? A general overview of the inflation phenomenon, the main measures of inflation, and how inflation plays a role in the economy will all help a person better understand why their money seems to be worth less each year. Overview of Inflation In order to truly understand inflation, the first step is listing the main cause of inflation pressures on the economy. Inflation begins initially and continues to occur due to sustained excess of spending in the economy. (Wilson 27) This amounts to spending over and above what is considered average spending for the economy in past months. The type of spending that would cause inflation is when people, groups, businesses, government, and foreigners all together demand or try to spend more than the economy can produce at full employment, prices in general will be bid up. (Ibid) Basically what this amounts to is people all wanting to buy products and services, but there are not enough products or services to fulfill all the buyers. The prices will go up because manufacturers can sell the product at a much higher rate because there are so many buyers. The solution to the problem is really two separate incidences that must happen in order for prices to begin falling. One of these solutions is excess demand for goods and services is reduced† and the other solution is for â€Å"capacity of the economy to produce is expanded, the price level will continue to rise. (Ibid) Thinking about these two situations makes sense. If the demand for goods or services decreases then less people will want to buy and there will be more of the product for the remaining consumers. Also, if a manufactured item is rising because it is not manufactured in many factories and suddenly factories spring up all over to manufacture the product then the price will fall. The demand and supply capacity are the cornerstones of inflation, but what also plays into inflation’s fluctuations is the money supply. The Federal Reserve Bank sets interest rates for borrowing of money. The lower the interest rate the greater amount of money that is borrowed, and the higher the interest rate the lesser amount of money that is borrowed. (Wilson 103) For example, if borrowing $1000 would cost 10% a year, a borrower would be paying $100 a year for the use of that initial $1000. If, however, the Federal Reserve Bank lowers the interest rate to 5%, the amount the borrower would be paying per year would be cut in half. In the latter example, a borrower would be willing to take out a larger amount of money because it would cost them less. So, with a larger amount of cheaper money in the market, prices will begin to rise because the cost of that money would cause more people to borrow as compared to a higher rate of interest. Money would essentially be worth less because the Federal Reserve allows it to be worth less by dropping the interest rate. The rise in prices would continue until the Federal Reserve once again decides to raise the interest rate. (Ibid) The Federal Reserve utilizes these money techniques in order to help spur growth in the economy, but the downside to economic growth is always inflation. Measures of Inflation An important concept of inflation is to pay close attention to inflation indicators. These â€Å"indicators† are indexes that signal a potential arrival of inflation for the country. Many measures of inflation exist, but the main types are the Consumer Price Index (CPI), Bureau of Labor Statistics (BLS), and the Bryan-Cecchetti model. The CPI is perhaps the most important indicator because it is the model that all other inflation models emulate in some way. The first step in understanding the CPI is to decipher the calculation of the index. The CPI is constructed from basic component indexes. Component indexes are those goods and services that a consumer purchases and those â€Å"components† are split into 207 items. (Moulton 13) Also, there are 44 more items included for the urban areas of the United States, and these two sets of items are multiplied together to a total of 9,108 components for the CPI. (Ibid) For example, dairy products are considered just set of the components within the 9,108 components used to calculate the CPI. A problem arises with the CPI in that many products come and go in the market and it is up to the CPI to document these types of changes. This problem is overcome by the economists allowing for products to enter and leave the market as well as estimating the indexes on the basis of samples used from all the items that consumers buy for a given period. (Ibid) This type of calculating gives economists as comprehensive a picture as one can get. The resulting figure is compared to previous time periods and an increase percentage or decrease percentage is discovered from the calculations. This increase or decrease percentage is the amount that general prices have risen or fallen in between those time periods. If the prices rise then the CPI will show the American public that inflation has occurred. It is important that the CPI stay current with the ever-changing American economy. This is why the CPI is updated once every 10 years, and the last update occurred in 1998. (Greenlees, and Mason 3) This aspect of the CPI is important because of its relation to inflation. The CPI is used in many government programs including entitlements for school lunches and food stamps as well as the amount figured for tax deductions. (Ibid) If the CPI is not allowed to evolve with the evolving economy, many people would not be allowed government benefits or tax deductions that they otherwise would deserve. Thus, the CPI is examined and revised so inflation pressures do not have as much an impact on government programs. Another measure of inflation that is essentially a CPI number but factored with a different set of variables is the BLS model. The BLS model highlights the fact that some parts of the CPI are considered volatile due to outside pressures such as weather and international conflicts. Cogley suggests, the Bureau of Labor Statistics computes a ‘core inflation’ measure that consists of a weighted average of all CPI components except for food and energy, which are removed because their prices tend to be more volatile. (94) Energy can be affected by international conflicts and food supplies can be affected by the weather. Thus, the BLS model will demonstrate a less drastic change in inflation numbers if these events do occur. A final measure of inflation that utilizes the CPI is the Bryan-Cecchetti model. This model takes the BLS model one step further. The Bryan-Cecchetti system still uses the CPI as a basis, because the economists that developed this model understand that the CPI is the greatest general measure to be utilized. However, the Bryan-Cecchetti model extends the BLS approach by automatically excluding large price changes from the CPI basket regardless of the sector in which they arise. (Ibid) Bryan-Cecchetti correctly identifies that other sectors besides energy and food are affected by outside influences and can have a drastic rise or fall. However, the CPI is still considered the main standard for deciding the amount of inflation in the economy. The Role Inflation Plays in the Economy Inflation would essentially mean nothing to the average consumer if it had no bearing on the economy. It is in the economy that inflation can either hinder a person’s ability to purchase or cause a lack of growth for businesses. The role inflation plays in the economy is substantial. One of the main consequences of unwanted inflation is to the American worker. The first negative impact is a consumer’s shopping patterns and amount of money spent on goods and services. Inflation â€Å"causes consumers to shift the timing of their shopping closer to the receipt of income and creates incentives for shop owners to decrease their inventories. (Frenkel, and Mehrez 616) Less of a product in the store and less purchasing power of consumers combines to create even more inflation in the economy to occur. It is a cycle that ultimately raises prices to a harmful degree. So, a consumer is left with little alternatives to combat the harm that inflation causes. A person with less money will possibly lose their job (because of the lack of buying by other consumers), will consume less (because of the higher prices and lower supplies), invest less (because of the lack of money to invest), and finally rely more on credit (because the purchasing power of credit does not have to be paid until later). (Ibid) Another problem with inflation in the economy is it decreases the value of the dollar. As discussed previously, more dollars in the stream of commerce or rising prices due to limited supplies will help lower the value of the dollar. In this country, for example, â€Å"the dollar lost about three-fourths of its value between 1965 to 1985; between 1985 and 2005, it lost a bit over one-third of its value. (Hoar 42) This dramatic decrease in dollar value is due to inflation. This occurrence is precisely why older Americans will reminisce about how a movie and a Coke cost them less than a dollar. The dollar is still the same, but the amount it can purchase has decreased and will more than likely continue to decrease in the future. Conclusion If a person is purchasing goods or services in America then inflation and the CPI are important concepts to understand. Understanding these two concepts will help a person better plan their future and allow them to stay calm when their money cannot buy them as much as before. Works Cited Cogley, Timothy. A Simple Adaptive Measure of Core Inflation. Journal of Money, Credit Banking 34. 1 (2002): 94+.Frenkel, Michael, and Gil Mehrez. Inflation and the Misallocation of Resources. Economic Inquiry 38. 4 (2000): 616-628. Greenlees, John S. , and Charles C. Mason. Overview of the 1998 Revision of the Consumer Price Index. Monthly Labor Review 119. 12 (1996): 3+. Hoar, William P. Myths about Inflation. The New American 12 Dec. 2005: 42+. Moulton, Brent R. Basic Components of the CPI: Estimation of Price Changes. Monthly Labor Review 116. 12 (1993): 13+. Wilson, George W. Inflation Causes, Consequences, and Cures. 1st ed. Bloomington, IN: Indiana University Press, 1982.