Consumer Price Index (CPI)
Connections

Connections to Key Topics with Additional Resources

Topic Connections and Additional Resources
Scarcity, Choice, and Opportunity Cost

High rates of inflation tend to raise opportunity cost for lenders, because they are being paid back in money that has declining purchasing power. In order to assure lenders of a return above opportunity cost, interest rates will also have to rise.

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Labor Markets

During times of accelerating and unstable inflation, workers may be unable to negotiate adequate wage increases, which means that their standard of living declines. This is particularly true of wages that are rigidly set in collective-bargaining agreements between unions and management. In contrast, during times of deflation these same wage contracts make workers much better off.

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Productivity and Growth

Rising wages are not always inflationary. If worker productivity is rising, then more output is produced for a given hour of a worker's time. Thus the firm can afford to raise the worker's pay without having to raise the price of what the worker is making to finance the pay raise.

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Unemployment, Employment, and Inflation

The Consumer Price Index (CPI) is one of the most prominent measures of inflation in the cost of living experienced by the typical household. The CPI is calculated by selecting a fixed "market basket" of goods and services-groceries, electricity, shoes, and so on--and tracking the overall price of this fixed market basket over time.

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Output, Income, and the Price Level

If gross domestic product (GDP) rises, we may not know whether this is due to an increase in output, or an increase in the price level. We can find out by computing real GDP, which adjusts for inflation by holding prices constant over time. Increases in real GDP reflect increases in output, or economic growth. Likewise we can adjust income by inflation to determine real income, from which we can determine whether our material standard of living is rising or falling.

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Monetary Policy

A key goal of monetary policy is to maintain low rates of inflation. If the Federal Reserve concludes that economic conditions are favorable for accelerating inflation, such as when wage growth is outpacing productivity, then the Fed will move toward contractionary monetary policy. In contrast, expansionary monetary policy is far more likely when inflation pressures are light, and economic growth has slowed and unemployment rates have increased.

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Fiscal Policy

A key goal of fiscal policy is to maintain low rates of inflation. Policy makers conclude that economic conditions are favorable for accelerating inflation, such as when wage growth is outpacing productivity, then they will move toward contractionary fiscal policy (reduced government spending and higher taxes). In contrast, expansionary fiscal policy is far more likely when inflation pressures are light, but economic growth has slowed and unemployment rates have increased.

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Money and the Financial System

Inflation implies a declining purchasing power of money. If inflation rates are relatively stable, then the financial system can adapt to the inflation rate by setting appropriate interest rates on borrowed money. When inflation rates become unstable and suddenly rise to unanticipated levels, lenders are made worse off, and can even experience negative real interest rates. While interest rates on new loans can rise, some banks may fail if the high inflation rate persists and they are receiving negative real interest rates on much of their loan portfolio.

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Taxes, Spending, and Deficits

The U.S. and many other countries have progressive income taxes, meaning that people in higher income brackets pay a higher percentage of their income as tax than do people in lower income brackets. If the income brackets are not indexed to the inflation rate, then the result is "bracket creep," in which wage inflation pushes more and more people into the higher income brackets, even though their real wages may not have increased at all. Today, many taxpayers are finding themselves subject to the AMT (Alternative Minimum Tax) due to inflation and stagnant tax brackets. The AMT was originally intended for upper income taxpayers.

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International Finance If a country is experiencing an accelerating inflation rate that is considerably higher than its trading partners, then the value of that country's currency will tend to fall in world currency markets. One reason is that investors experiencing accelerating inflation will look for a safe haven for their money, and one strategy is to take their domestic savings and convert them into a foreign currency such as the U.S. dollar that is experiencing considerably lower inflation. This has recently happened in Russia. As world currency markets get flooded with the inflating currency, more and more of it must be exchanged for a given amount of foreign currency.

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Oligopoly On April 25, 2001 economist R. Preston McAfee provided testimony on the West Coast petroleum market to the Committee on Commerce, Science and Transportation (Subcommittee on Consumer Affairs, Foreign Commerce, and Tourism) of the United States Senate. He noted that "the most significant gasoline problem facing the West Coast is the lack of new refineries. The West Coast market, which largely operates separately from the rest of the country in terms of gasoline production, has a relatively small number of large firms. The fact that the industry is so stable, with no entry and the small number of firms, creates an oligopoly rather than a perfectly competitive market." McAfee also noted that "demand for gasoline is highly inelastic, meaning that small reductions in supply that are not offset by other increases can lead to significant price increases." Thus if the West Coast oil refining oligopoly were to successfully increase prices over time, the result would be an increase in consumer price inflation for West Coast residents.

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Monopoly Monopoly occurs when a single seller dominates a market. It is a violation of federal and state antitrust law for monopolists to exercise market power by reducing quantity in order to raise price to consumers. The Federal Energy Regulatory Commission's Chief Administrative Law Judge ruled in September 2002 that El Paso Natural Gas Company exercised market power by tightening the supply of natural gas and driving up natural gas prices to California during the winter of 2000-2001. During that winter, the price of natural gas sold at the California border was two-to-three times the price of natural gas sold anywhere else in the U.S. The judge said El Paso "substantially tightened the supply of gas" by withholding capacity from at least 21 percent of its pipelines that delivered natural gas to the California border. Rising energy prices can cause a spike in consumer price inflation.

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Product Markets A combination of market manipulation by energy firms and tight energy supplies resulted in the failure of California's experiment with electricity deregulation. Since electricity is a production input used across the economy, the rising prices of electricity caused a spike in consumer price inflation in California.

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Market Failure, Regulation, and Public
Choice 		A combination of market manipulation by energy firms and tight energy supplies resulted in the failure of California's experiment with electricity deregulation. Since electricity is a production input used across the economy, the rising prices of electricity caused a spike in consumer price inflation in California.

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