Inflation Dips and the Economy Smiles
Subject Inflation
Topic Employment, Unemployment, and Inflation
Key Words Inflation, Recession, Productivity, Economic Growth
News Story

Most analysts are bullish about the economy, believing that the recession, which started in March 2001, is either over or will end shortly. Consumer resilience is the explanation given most often for the economy's resurgence. However, an important reason that consumer spending has been buoyant is the declining rate of inflation. Where the economy goes in the next few months depends importantly on what happens to the rate of inflation.

Inflation, as measured by the Consumer Price Index, decreased from an annual rate of 3.2 percent in June, to 1.1 percent in January. Money wages continued to increase even in the face of increases in unemployment, and the combination of increased money wages and decreased inflation lead to an increase in real wages, that is, money wages adjusted for inflation. Real wages rose in the fourth quarter of 2001 by the largest increase since the boom years of the 1990s. Higher real wages and lower inflation translated into a $91 billion increase in compensation, and higher compensation sustained increases in consumer spending.

Businesses also benefited from the decrease in inflation. Energy costs were sharply lower and these declines allowed firms to resist price increases.

In addition to lower inflation, there were other factors that help explain the economy's strength. Tax rebates put additional money in consumer pockets. Lower interest rates persuaded many consumers to refinance their mortgages, generating considerable savings. Rising labor productivity also lowered costs and allowed business firms to raise wages. Mild winter weather lowered energy usage and enabled construction projects to proceed without seasonal delays. Finally, increased government spending, especially on the part of the military, added to the economy's growth.

If inflation were to increase, the sequence of events outlined above leading to increased economic growth, might be reversed. How likely is higher inflation? Decreased energy prices were partly responsible for the lower inflation; however energy prices have risen lately.

(Updated May 6, 2002)

1. Explain the difference between money wages and real wages. Which measure is appropriate for comparing changes in wages over time?
2. What is the difference between anticipated and unanticipated inflation? Does it benefit or hurt businesses if actual exceeds anticipated inflation?
3. If inflation were to continue to decrease, how would real wages and compensation be affected? What would you expect to happen to consumer spending?
Source Louis Uchitelle, "Wild Card of the Recovery: Inflation," The New York Times, March 17, 2002.

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