Inflation in USA
Inflation in US
Introduction
Inflation refers to the rate at which the country is experiencing the general increase in prices of goods and services. When the rate of inflation is high, the purchasing power of the country’s currency will be low at the same time. This will comparably imply that higher amount of money is needed to purchase items that had been previously purchased at lower amounts of the same currency. The country’s currency would have lost the real value as a unit of account and as a medium of exchange of the economy. The chief measure of inflation is usually the price index; more generally, the consumer price index has been used over time. The contrary to inflation is deflation, and it occurs when the general price levels of a country is decreasing. Economists have generally believed that when the money supply grows excessively, accompanied with excessive growth in consumer demand, prices of goods and services will rise and there will be inflation. Due to the fact that inflation and hyperinflations have had adverse effects of reducing a country’s purchasing power, most economists have maintained their stances in favor of low and steady levels of inflation. However, although the inflations should be low, they should not reach zero mark or even become negative. Zero or negative marks would imply that the economy is plunging into deflation; deflation results in decreased demand for goods and services, and the general recession of the economy. It should be noted that it is the task monetary policy makers to stabilize general prices. This usually happens through monetary policies that may be in form of open market operations, interest rates and banking reserve requirements.
The United States inflation forecasts are projected using the Autoregressive Integrated Moving Average (ARIMA) model. The ARIMA model is based on annualized rates of inflations that are calculated using producer prices, commodity prices, consumer prices and core prices. Thus, the consumer price index (CPI) measures changes in prices of consumer goods and services. The producer price indices (PPIs) measures average changes in prices that domestic producers receive for their output. Commodity price index measures changes in prices of selected commodities. Core price index is concerned with changes in prices of core products such as oil and food, since their demands and price changes are volatile. However, it is important to note that the widely used index for estimating inflation is the Consumer Price Index (CPI). During the calculation of the CPI, there are two sets of data needed: weighting data and price data. These data are data of sample representative items whose price information are collected monthly and annually. For the US case, inclusion of items whose prices are used to calculate CPI considers items in categories of Food Beverage, Housing, Apparel, Transportation, Medical Care, Recreation, Education and Communication and Other Goods and Services. This is well illustrated in the following table below:
Once data prices of the sample of goods and services listed above have been collected, weighting data are obtained by estimating shares of different categories of household expenditures on the goods and services included in the index calculation. Therefore, when calculating CPI for multiple items, one will have to use the following formula.
This is CPI for multiple items, and one will have to realize different weights of component categories that constitute the whole set of consumer prices to compute a CPI of an item for a given category. For instance in case the weight of Housing is 41.4%, the CPI for Housing will be given as:
CPIHousing=(i=1nCPIi*41.4%)/i=1n41.4%
For a CPI of single commodity, the following formula can be applicable:
; Where P1 is the price in the base year (or the year of comparison); CPI1 is usually an index of 100%. P2 Is the current (updated cost). Alternatively, CPI for a single item can be performed as:
It is important to note that the US CPI is computed using items bought by Urban Consumers only, and hence it is denoted as CPI-U. The base year has been set as 1982-84, and it has a CPI-U base of 100%.
US Inflation Trends 1775-2016
In Figure 1 above, it can be noted that the US inflation swung turbulently in the period between the US Revolutionary War and the World War II. During the war periods, prices of commodities swung turbulently, followed by periods of deflation. It is also important to realize that it was not until 1913 that the Federal Reserve came into existence. The US Department of Labor began compiling statistics on inflation from 1919. However, confidence in the Federal Reserve to predict the inflation rose in 1950s when economist A. W. Philips commented that there was a strong link between inflation and unemployment, resulting in the now famous Philips Curve. However, the Philips’s theory seems to have failed to explain inflation phenomena well. In 1974, the then advisor to President Nixon, Herbert Stein, noted that inflation was “a Hydra-headed monster” that emanated from various causes: wages, prices of oil, foods and so forth. He also noted that inflation could be domestic or imported. Just like a mythological monster, any attempt of taming prices resulted in more dangers of inflation. Relatively in 1980s and 1990s, the country had economists increasing in confidence to control inflation with increased precisions. However, the 2007 recession made their claims of inflation control to be questioned, especially on issues that concerned the role of central bank in controlling money supply growth. Before 2007, although most economists believed that prolonged periods of unemployment would induce deflationary effects, that was did not come to pass. Most recent researches by economic scholars have been predicting high levels of inflation, although that has also not come to pass, because the levels of inflation have been going down, as seen in Figure 2 below.
Causes of Inflation in the US
Inflation can be of two types: Cost-push Inflation and Demand Push Inflation.
Cost-Push Inflation: Cost-push inflation result when the costs of production increase. This can originate from increasing costs of inputs such as labor, oil and metal. When the country experiences labor shortages, it will be likely for prices of labor to increase. Poor structural aspects of labor force may also create pressures for higher wages in pertinent sectors. For instance, if individuals in the country are not well trained in specific knowledge and skills, it will be evident that they may not be employed in jobs that require those skills and knowledge. Before the Sherman Anti-Trust Act was passed to outlaw monopolies, input that were produced by the monopolies were much costly. Natural disasters and wars can also cause cost-push inflations. Wars such as World wars and Revolutionary Wars and disasters such as Hurricane Katrina may damage production facilities. They would cause depletion of some inputs, leading to increased prices. Before 2008, subsidies advanced to ethanol resulted in lessened production of corn. As a result, prices of corn increased. When a country allows its currency to fall, it can be evident that goods from other countries will be more costly. The country will experience increased prices of imports.
Demand led inflation: It has been evident that over-expansion of money supply by the Fed can create inflation. It is important to note that money supply is not just cash, but also mortgages, loans and credits. When loans become cheap, the public will have more money chasing few goods. Although the demand may not increase out rightly, it will be evident that prices of goods and services will just increase due to people’s willingness to spend more on goods and services. It is the expansion of money supply that resulted in the 2005-2006 housing sector inflation. Deregulation of investment banks allowed mortgages, even those of second liens, to be available cheaply. Further, at international level, since China pegged its Yuan currency below the US Dollar, it artificially created expensiveness in the dollar. However, expansionary fiscal policies can also lead to increased money supply and public demand of goods and services. Expansionary fiscal policies include capital improvements, government hiring, increased salaries, reduced taxation and so forth. Consumer expectations may result in inflation, when people demanding current goods at high prices. If the public expects prices of certain goods or services to increase, it will rush to take advantage of the current stock, fearing higher prices in future. This may create inflation due to more demand currently created.
Effects of Inflation
Negative Side: If inflation becomes highly unpredictable, it is likely to results in very harmful adversities to the entire economy. It can add a lot of inefficiencies to the economy due to the fact that companies will not be able to project long-term planning outcomes. Lowered purchasing powers will generally discourage companies from saving and investing. There can be cases of hidden tax increases; for instance, incase individuals are pushed into higher earning brackets, they will have to pay tax at higher rates. The country’s export will become expensive, as individuals from other countries will be forced to buy in it. If imports become more expensive, the balance of payment can be affected: there will be more foreign currencies. Cost-push inflation may result in spiraling wages and product hoarding. Inflation can prompt employees to demand more wages to keep themselves with increased general prices in real terms. In hoarding of products, people will prefer buying non-perishable and durable goods as stores of wealth. This is usually done with an aim of reducing likely risk of the money losing real value. Inflation can result in lenders losing while borrowers gaining, if inflation adjustments are not made on the borrowed capital. Inflation can lead to massive social unrest and revolts. This could be seen in countries like Tunisia and Egypt during the ousting of Zine Al Adidine Ben Ali and Hosni Mubarak respectively. Hyperinflation, which is a severe case of inflation, can lead to abandonment of the affected currency. In such a case, (for instance in North Korea) citizens may adopt a foreign currency. Thoughts of allocative efficiency may ensue: buyers and sellers may decide to reallocate their resources to countries whose currencies have more purchasing powers. According to Austrian economists, inflation may adversely affect the business cycles. If individuals stop investing or saving due to lower purchasing power than the currency of a given country, the business cycle would have been interfered with.
Positive Side: Moderate inflation has been noted with positive effects. When a country experiences moderate inflation, savers will begin withdrawing some of their cash to invest in real investments. The extra investment added can be seen as a positive sign when the economy rebounds. In case the country is still facing deflation, any case of inflation during that time will be deemed healthy to the economy. Inflation will increase prices of goods, motivating the production economy again. Incase inflation coincidentally occur during recession, it will be easy for the central bank to control money supply by raising interest rates. When the country’s currency has low purchasing power, as it is the case during inflation, exports will become cheaper and highly demanded.
Controlling Inflation
Government monetary policies: The government’s central bank has to primarily use the monetary policy tools to curb inflation. In this regard, when there is inflation, interest rates should be increased to deter further borrowing. The amount of bank reserve with the central bank can also be increased as a way of mopping out extra liquidity. Other monetary tools may include open market operations and overnight lending with which the central bank can limit excess liquidity in the public.
Fixed currency: Under the Bretton Woods agreement, countries were to have their currencies tagged to more stable currencies like the dollar. Countries with unstable currencies would have the values of their currencies tagged to that of the model currency. In this regard, they would only be supposed to increase the value of their currencies if that of the model currency increases.
Wage and price control: The country has to have a policy that controls wages and prices. This will reduce inflationary effects emanating from cost-side of the economy. In this case, costs of inputs such wages should only grow when there is certainty of better economic performances, in the present and in the future.
Stimulating economic growth: the country should ensure that the growth in money supply matches the growth in economic activities. In this regard, most factors that contribute to economic growth have to be growing for the money supply to be allowed to grow. Such factors may include, but not limited to, education, infrastructure, market production and preventive health care.
Cost-of-living allowance: Although this does not control inflation, it mitigates adverse consequences of inflation. Increased percentage changes in CPI-U should be accompanied with proportionate allowances for employees to cope up in real terms with the general increments in prices. This will convince them not engage in collective bargaining for increased wages that may increase inflation.
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