William_T._Bianco,_David_T._Canon]_American_Polit

534534 Chapter 15 | Economic Policy

Stable Prices

The importance of having stable prices is not as obvious as the need for jobs. Why are

rising prices—inflation—a problem? This is a common question during periods of low

inflation. Especially for workers who have automatic raises (cost of living adjustments,

or COLAs) as part of their basic pay package, moderate inflation isn’t much of a problem.

For example, if your rent goes up 4 percent, the price of groceries goes up 3 percent, and

the cost of entertainment goes up 3 percent, and you get a 4 percent raise, you will likely

be at least as well-off as you were in the previous year. However, it’s possible for inflation

to be much higher: from 1979 to 1980 inflation was running at 12 to 14 percent rather

than the 2 to 3 percent that has been typical in recent years (see Figure 15.1).

Double-digit inflation can have serious effects on the economy. First, because the

entire economy is not indexed to inflation, some people will experience an erosion of

their purchasing power. If your rent goes up 10 percent and groceries go up 15 percent,

but your pay goes up by only 4 percent, you are substantially worse off. Second, high

inflation penalizes savers as inflation outstrips savings interest rates (so savings are

actually worth less over time). On the other hand, inflation may benefit debtors, because

people can repay their debts with dollars that are worth less in the future. Finally,

long-term economic planning by businesses becomes more difficult when inflation

is high: investors will demand high interest rates to compensate for the added risk of

future inflation, and businesses will be reluctant to accept loans at these rates. In 1979

and 1980, for example, short-term interest rates spiked as high as 18 percent. Very few

businesses were willing to take on additional debt at that rate of interest rather than the

more typical 5 to 8 percent for long-term loans, so the economy headed into a recession.

As counterintuitive as it may sound, falling prices, or deflation, may be equally

as devastating for an economy as prices that are rising too quickly. During the Great

Depression, prices fell by 10 percent each year from 1930 to 1933. This trend exacerbated

inflation

The increase in the price of consumer

goods over time.

deflation

A decrease in the general prices of

goods and services.

FIGURE

15.1

5

10

15

20%

−5

0

1960 1975 1990 2005 2018

Misery Index

Annual

unemployment rate

Inflation rate

Source: Data from the U.S. Department of Labor, Bureau of Labor Statistics, http://www.bls.gov (accessed 9/7/18).

Inflation and Unemployment, 1960–2018

The Misery Index is the sum of the unemployment rate and the inflation rate. Which periods have had the highest misery rate

since 1960? Were there any external explanations for the high misery rate? How did the government respond to the high levels of

unemployment and inflation?

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