The Importance of Low Inflation when price changes are expected and predictable, but not uniform.

Type 2: Expected & predictable price changes that are not uniform

Wages & salaries rise less frequently than the prices of goods & services

A bigger problem with inflation is that prices do not rise uniformly. Inflation causes most people to lose purchasing power because their income lags behind increases in the prices of goods and services. Purchasing power refers to the value of the products a person is able to buy with a given amount of money. People are not able to purchase as many goods and services with their income as prices rise.




How Purchasing Power Has Changed in the Last Century
$100 in 1915 had the same purchasing power as $1913.86 in 2005
$100 in 1920 had the same purchasing power as $ 966.50 in 2005
$100 in 1925 had the same purchasing power as $1104.57 in 2005
$100 in 1930 had the same purchasing power as $1157.49 in 2005
$100 in 1935 had the same purchasing power as $1410.95 in 2005
$100 in 1940 had the same purchasing power as $1380.71 in 2005
$100 in 1945 had the same purchasing power as $1073.89 in 2005
$100 in 1950 had the same purchasing power as $ 802.07 in 2005
$100 in 1955 had the same purchasing power as $ 721.27 in 2005
$100 in 1960 had the same purchasing power as $ 653.04 in 2005
$100 in 1965 had the same purchasing power as $ 613.65 in 2005
$100 in 1970 had the same purchasing power as $ 498.20 in 2005
$100 in 1975 had the same purchasing power as $ 359.29 in 2005
$100 in 1980 had the same purchasing power as $ 234.59 in 2005
$100 in 1985 had the same purchasing power as $ 179.65 in 2005
$100 in 1990 had the same purchasing power as $ 147.90 in 2005
$100 in 1995 had the same purchasing power as $ 126.84 in 2005
$100 in 2000 had the same purchasing power as $ 112.25 in 2005
$100 in 2005 had the same purchasing power as $ 100.00 in 2005
Table . Inflation causes a significant loss of purchasing power.
Source: U.S. Bureau of Labor Statistics
http://data.bls.gov/cgi-bin/cpicalc.pl




People do not lose purchasing power if their incomes are indexed. Indexation is using a law or contract to automatically correct a dollar amount for the effects of inflation. For example, Social Security benefits use cost-of-living adjustments (COLAs), which are indexed to the Consumer Price Index (CPI) and automatically increase with increases in inflation.

Year
COLA
Year
COLA
1975
8.0%
1991
3.7%
1976
6.4%
1992
3.0%
1977
5.9%
1993
2.6%
1978
6.5%
1994
2.8%
1979
9.9%
1995
2.6%
1980
14.3%
1996
2.9%
1981
11.2%
1997
2.1%
1982
7.4%
1998
1.3%
1983
3.5%
1999
2.5%*
1984
3.5%
2000
3.5%
1985
3.1%
2001
2.6%
1986
1.3%
2002
1.4%
1987
4.2%
2003
2.1%
1988
4.0%
2004
2.7%
1989
4.7%
2005

1990
5.4%
2006

Table . Cost-of-living adjustments (COLAs) automatically increase Social Security benefits to compensate for the loss in purchasing power caused by inflation as measured by the Consumer Price Index (CPI).
Source: The Social Security Administration
http://www.ssa.gov/OACT/COLA/colaseries.html

*The COLA for December 1999 was originally determined as 2.4 percent based on CPIs published by the Bureau of Labor Statistics. Pursuant to Public Law 106-554, however, this COLA is effectively now 2.5 percent.

Most people's incomes are not indexed, however. Consequently inflation harms most people by reducing their purchasing power, at least temporarily.




Expectations of future price increases

Another damaging component of inflation is its effect on expectations. If people think the prices of goods and services will increase before their incomes rise, then workers may push for higher wages and salaries now in anticipation of higher prices of goods and services in the future. Higher labor costs represent higher costs of production for businesses. These companies are then forced to raise product prices to cover these higher labor costs. This pushes inflation even higher, forcing another round of expectations of higher prices. Expectations of higher prices cause the price level to rise more rapidly than it would otherwise.

Inflation creates confusion that leads to inefficient purchasing decisions

Inflation also creates confusion and makes if difficult for people to have accurate price information when making purchasing decisions. When inflation is low, prices remain relatively constant. This allows people to develop a sense of the appropriate prices of products. Is one dollar per pound a good price for bananas? How about two dollars per gallon of gasoline? Is five dollars per gallon of milk a bargain price? During periods of high inflation, prices change rapidly so it is difficult for people to learn appropriate prices. People may not know if the price of a product has gone up because the seller is seeking excess profits or just because it reflects current inflation.


In the real world, prices do not change uniformly. Individual companies make decisions about when to change prices and by how much. These changes are usually in response to market conditions. Nonetheless, prices in various markets do not change by the same amount every day. This can lead to a misallocation of resources.