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Sunday, April 11, 2010

Inflation: Causes, Costs, and Current Status

Marc Labonte
Specialist in Macroeconomic Policy

Since the end of World War II, the United States has experienced almost continuous inflation— the general rise in the price of goods and services. It would be difficult to find a similar period in American history before that war. Indeed, prior to World War II, the United States often experienced long periods of deflation. It is worth noting that the Consumer Price Index (CPI) in 1941 was virtually at the same level as in 1807. 

During the last two economic expansions, March 1991-March 2001 and November 2001- December 2007, the inflation rate remained low by the standards of previous decades, and has remained low since this recession began. This is true regardless of which index is used to calculate the rate at which the price of goods and services rose. A low inflation rate is especially significant since the U.S. economy was fully employed, if not over fully employed, according to many estimates for the last three years of the 1991-2001 expansion and during 2006-2007. Yet, contrary to expectations, the inflation rate accelerated only modestly. Keeping an economy moving along a full employment path without igniting a burst of inflation is a difficult policy task. 

Because labor costs make up nearly two-thirds of total production costs, the rate at which they rise is often regarded as an indication of future inflation at the retail level. They tended to rise in the latter stage of the 1991-2001 expansion and to moderate during the subsequent contraction, recovery, and expansion that ended in December 2007. 

Rather than measure inflation by using the rate at which prices overall are rising, some economists prefer a measure that reflects primarily the systematic factors that raise prices. This yields the "underlying" or "core" rate of inflation. Price increases over this period have been especially sharp in food and energy, which are not included in the core rate. 

Why should the United States be concerned about inflation? This study reports the distilled knowledge of economists on the real cost to an economy from inflation. These are remarkably more varied than the outlays for "shoe leather," long reported to be the major cost of inflation ("shoe leather" being a shorthand term for the resources that have to be expended on less efficient methods of exchanges). 

The costs of inflation are related to its rate, the uncertainty it engenders, whether it is anticipated, and the degree to which contracts and the tax system are indexed. A major cost is related to the inefficient utilization of resources because economic agents mistake changes in nominal variables for changes in real variables and act accordingly (the so-called signal problem). Inflation in the United States during the post-World War II era may not have been high enough for this cost to be significant. 

Date of Report: March 29, 2010
Number of Pages: 16
Order Number: RL30344
Price: $29.95

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