The Economics of Inflation: Simple but Complicated

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Inflation! Over the past few months, as we continue to navigate the pandemic, we have also been beset by rising prices. Inflation occurs when the average prices of goods increase. It was also said that it was too much money for too few goods. Essentially, high consumer demand, low supply and rising prices.

The Bureau of Labor Statistics reported that inflation hit a 40-year high of 8.5% last month. There are several reasons for the rise in inflation.

Let’s first see how the inflation rate is calculated. There are three measures of inflation. The two most frequently cited indexes are the Consumer Price Index (CPI) and the Personal Consumption Expenditure (PCE) Price Index. These two measures take different approaches to measuring inflation. There is also a third, known as the gross domestic product (GDP) deflator.

The US Bureau of Labor Statistics (BLS) calculates CPI inflation by looking at the weighted average cost of a “basket” – a large number of goods and services that consumers normally purchase during a given month. The BLS does a survey to determine what people are buying.

About 24,000 consumers across the United States are surveyed by the BLS each quarter, and another 12,000 consumers keep an annual diary of their purchases. The composition of the basket of goods and services gradually changes over time, following consumer buying habits, but overall CPI inflation is calculated from a fairly stable or fixed set of goods and services. The CPI is the most common measure of inflation. The PCE tracks the prices at which businesses report selling goods and services. The GDP price deflator is much more comprehensive and measures the prices of all the goods and services that people buy. It has an advantage over the CPI because it covers all goods. Its trends are similar to those of the CPI.

Now, why are the prices rising? There are several reasons, all related to tight supply and/or higher demand. Almost all of them are related in some way to the pandemic.

The pandemic: Many producers closed or produced less, which restricted supply, so that demand exceeded supply. Gasoline prices, which impact the cost of almost everything we buy, have risen exponentially over the past few months.

Supply chain issues further restricting supply: The fact that the products do not reach us in a timely manner drives up their prices.

Billions of stimulus dollars in the hands of consumers: As the economy began to contract in early 2020, the federal government enacted several stimulus packages. The more money people have, the more likely they are to spend. The more people spend, the higher the prices go. Too much money, chasing too few goods.

Low interest rates: When interest rates are low, people borrow more, save less, and can spend more.

Labor shortages driving up wages: As a direct result of the pandemic, production is low, fewer people were working to drive and unload trucks, supply is lower, and people are willing to pay more. Also, companies pay more for people to work. With more money in their hands, again, too much money, chasing too few possessions.

War in Ukraine: This international crisis has also meant that goods are not flowing as freely around the world. Again, a restriction of supply, which drives up prices.

In order to control inflation, there must be a restriction on the amount of money circulating in the economy to decrease demand. One way to do this is to raise interest rates (the price of money), so that people borrow less and spend less, which lowers demand and therefore prices for goods and services.

The danger here is that if demand drops too much, we could end up with a recession. So which do you prefer, recession or inflation? Full employment with higher prices or high unemployment with lower prices? Unemployment and inflation are two evils, and when the two are combined they are known as the “Misery Index”. I let you choose.

But I’ll try to live with inflation, which can’t last forever, and be thankful for my job.

Kojo A. Quartey is president of Monroe County Community College and a former professor of economics. He can be reached at kquartey@monroeccc.edu.

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