Download Economic Fluctuations: Unemployment and Inflation

Economic Fluctuations: Unemployment and Inflation
Inflation
Inflation, Deflation, Stagflation, and Hyperinflation
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When I was a kid, we’d go to the grocery store and buy a bag of groceries for about twenty dollars.
Nowadays, I go to the grocery store and buy the same stuff for sixty dollars. Prices have risen
generally across the economy. That’s what we mean by inflation. When prices rise the value of a
dollar shrinks. Inflation means a reduction in purchasing power. Let’s look in this lesson at the
different forms inflation can take and get ready to consider the question of the relationship between
inflation and performance in an economy.
In general, inflation means an increase in the price level, a change from one year to the next, of the
overall level of prices in an economy. If we look at the inflation rate from 1970 to the present, we’ll
see that the inflation rate has averaged about six percent over this period. There have been some
notable highs: in 1980 we had inflation rates of thirteen, fourteen percent; whereas, since 1990 the
inflation rate has averaged about three and a half percent. Inflation rates around the year 1999
reached levels that they hadn’t seen since the 1960’s.
The reverse of inflation is deflation, when prices in an economy are generally falling. This is very
rare and much more dangerous for an economy. In the United States, we had a period of deflation
in the 1890’s. During that recession, prices fell at a rate of about twenty three percent a year. Also
during the Great Depression, we had deflation at an annual rate of about fourteen percent along
with a severe recession. In Japan, there has been deflation during the 1990’s and four long painful
recessions. Deflation is dangerous because of the psychology of falling prices. When you see prices
falling, you ask yourself, “Why buy today when everything’s going to be cheaper tomorrow?” But
when people are not spending money then stuff piles up on the shelves at the store, and merchants
lower prices in hopes of moving their goods and services. It becomes a vicious spiral. Deflation
tends to cripple an economy.
Another troubling possibility is stagflation – a combination of inflation and economic stagnation –
often resulting from supply shocks, such as occurred in the U.S. economy in 1974 and again around
1980 when the price of oil rose rapidly and dramatically. In these cases, we got the combination of
reduction in economic output and higher prices. In 1974, output fell by about .6% at the same time
that prices were rising at 11% annually. In 1980, we had output falling by .3% at the same time
that the inflation rate was about thirteen 13.5%.
The final possibility to consider is hyperinflation, an extraordinarily rapid increase in prices.
Hyperinflation is very rare and when it happens it makes the headlines. Hyperinflation is typically a
result of a government rapidly printing money to cover debts or deal with some other economic
crisis. In a recent example, in 1985 the Wall Street Journal reported that the rate of price increase
in Bolivia over one six-month period was almost thirty eight thousand percent. Imagine now that
you went to the vending machine to buy a soda in January and paid one dollar. When you went
back in June to buy the same soda in this hyperinflationary environment, you were paying three
hundred and eighty one dollars. That’s what hyperinflation does. In extraordinary cases such as
Germany after WWI, people would sit down in a restaurant to order lunch and by the time their food
arrived the prices had all changed on the menu. People would revert from trading in money to
trading in actual real goods and services; that is, bartering in order to avoid carrying around money
that would rapidly lose value. Hyperinflation is dangerous for an economy because it tends to lead
people to not use money at all and revert to barter in order to protect their purchasing power.
Inflation, deflation, stagflation, and hyperinflation: four variants on the same theme that prices can
do crazy things: rising rapidly, falling, rising when output is dropping, or occasionally spiraling out of
control. We’re now ready to consider how inflation can affect broader performance in an economy:
how it affects unemployment, how it affects output, and how it affects savings.