What you will learn
in this Module:
134 section 3 Measurement of Economic Performance
- The economic costs of
inflation - How inflation creates winners
and losers - Why policy makers try to
maintain a stable rate of
inflation - The difference between
real and nominal values
of income, wages, and
interest rates - The problems of deflation
and disinflation
Module 14
Inflation: An Overview
Inflation and Deflation
In 1980 Americans were dismayed about the state of the economy for two reasons: the
unemployment rate was high, and so was inflation. In fact, the high rate of inflation,
not the high rate of unemployment, was the principal concern of policy makers at the
time—so much so that Paul Volcker, the chairman of the Federal Reserve Board (which
controls monetary policy), more or less deliberately created a deep recession in order to
bring inflation under control. Only in 1982, after inflation had dropped sharply and
the unemployment rate had risen to more than 10%, did fighting unemployment be-
come the chief priority.
Why is inflation something to worry about? Why do policy makers even now get
anxious when they see the inflation rate moving upward? The answer is that inflation
can impose costs on the economy—but not in the way most people think.The Level of Prices Doesn’t Matter...
The most common complaint about inflation, an increase in the price level, is that it
makes everyone poorer—after all, a given amount of money buys less. But inflation
doesnotmake everyone poorer. To see why, it’s helpful to imagine what would hap-
pen if the United States did something other countries have done from time to time—
replaced the dollar with a new currency.
A recent example of this kind of currency conversion happened in 2002, when
France, like a number of other European countries, replaced its national currency, the
franc, with the new Pan -European currency, the euro. People turned in their franc coins
and notes, and received euro coins and notes in exchange, at a rate of precisely 6.55957
francs per euro. At the same time, all contracts were restated in euros at the same rate of
exchange. For example, if a French citizen had a home mortgage debt of 500,000 francs,
this became a debt of 500,000/6.55957 =76,224.51 euros. If a worker’s contract speci-
fied that he or she should be paid 100 francs per hour, it became a contract specifying a
wage of 100/6.55957 =15.2449 euros per hour, and so on.
You could imagine doing the same thing here, replacing the dollar with a “new dol-
lar” at a rate of exchange of, say, 7 to 1. If you owed $140,000 on your home, that
would become a debt of 20,000 new dollars. If you had a wage rate of $14 an hour, it