In view of the inequities, anxieties, and real losses caused by inflation, it’s not surprising that price stability is a major goal of economic policy. As we observed at the beginning of this chapter, every U.S. president since Franklin Roosevelt has decreed price stability to be a foremost policy goal. Unfortunately, few presidents (or their advisers) have stated exactly what they mean by “price stability.” Do they mean no change in the average price level? Or is some upward creep in the price index acceptable?
An explicit numerical goal for price stability was established for the first time in the Full Employment and Balanced Growth Act of 1978. According to that act, the goal of eco- nomic policy is to hold the rate of inflation under 3 percent.
Why did Congress choose 3 percent inflation rather than zero inflation as the benchmark for price stability? One reason was concern about unemployment. To keep prices from ris- ing, the government might have to restrain spending in the economy. Such restraint could lead to cutbacks in production and an increase in joblessness. In other words, there might be a trade-off between declining inflation and rising unemployment. From this perspective, a little bit of inflation might be the “price” the economy has to pay to keep unemployment rates from rising.
Recall how the same kind of logic was used to define the goal of full employment. The fear there was that price pressures would increase as the economy approached its produc- tion possibilities. This suggested that some unemployment might be the “price” the econ- omy has to pay for price stability. Accordingly, the goal of “full employment” was defined as the lowest rate of unemployment consistent with stable prices. The same kind of think- ing is apparent here. The amount of inflation regarded as tolerable depends in part on the effect of anti-inflation strategies on unemployment rates. After reviewing our experiences with both unemployment and inflation, Congress concluded that 3 percent inflation was a safe target.
The second argument for setting our price-stability goal above zero inflation relates to our measurement capabilities. The Consumer Price Index isn’t a perfect measure of inflation. In essence, the CPI simply monitors the price of specific goods over time.
Over time, however, the goods themselves change, too. Old products become better as a result of quality improvements. A plasma TV set costs more today than a TV did in 1955, but today’s television also delivers a bigger, clearer picture, in digital sound and color, and with a host of on-screen programming options. Hence, increases in the price of TV sets tend to exaggerate the true rate of inflation: Most of the higher price represents more product.
The same is true of automobiles. The best-selling car in 1958 (a Chevrolet Bel Air) had a list price of only $2,618. That makes a 2008 Ford Taurus look awfully expensive at
$20,605. The quality of today’s cars is much better, however. Improvements since 1958 include seat belts, air bags, variable-speed windshield wipers, electronic ignitions, rear-window A Numerical Goal
A Numerical Goal
price stability: The absence of significant changes in the aver- age price level; officially defined as a rate of inflation of less than 3 percent.
price stability: The absence of significant changes in the aver- age price level; officially defined as a rate of inflation of less than 3 percent.
Unemployment Concerns Unemployment Concerns
Quality Changes Quality Changes
2000 real GDP (in 1990 prices)
$10 trillion 124 100 nominal GDP
price deflator
$10 trillion
1.24 $8.06 trillion
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C H A P T E R 7 : I N F L AT I O N 135
I N T H E N E W S
Ignoring Cell Phones Biases CPI Upward Cellular telephones have been in commercial operation in the United States for 13 years. Beginning in Chicago in late 1983, and then at the Los Angeles Olympic Games in 1984, cellular telephone usage spread first to the top 30 Metropolitan Statis- tical Areas (MSAs), then to the other 300 or so MSAs, and finally to rural areas. At year-end 1996, there were over 40 mil- lion cellular subscribers in the United States. . . .
Yet the cellular telephone will not be included in the calcula- tion of the Consumer Price Index (CPI) until 1998 or 1999.
“This neglect of new goods leads to an upward bias in the CPI,” NBER Research Associate Jerry Hausman concludes.
Analysis: Since the CPI tracks prices for a fixed basket of goods, it misses the effects of falling prices on new goods that appear between survey periods.
The CPI estimates that since 1988, telecommunications prices have increased by 8.5 percent, or 1.02 percent per year. A corrected index that includes cellular service decreased 1.28 percent per year since 1988, Hausman figures. “Thus, the bias in the BLS [Bureau of Labor Statistics] telecommuni- cations services CPI equals approximately 2.3 percentage points per year.”
Source: National Bureau of Economic Research, NBER Digest, June 1997. www.nber.org/digest
defrosters, radial tires, antilock brakes, emergency flashers, remote-control mirrors, crash- resistant bodies, a doubling of fuel mileage, a 100-fold decrease in exhaust pollutants, and global positioning systems. As a result, today’s higher car prices also buy cars that are safer, cleaner, and more comfortable.
The U.S. Bureau of Labor Statistics does adjust the CPI for quality changes. Such adjust- ments inevitably entail subjective judgments, however. Critics are quick to complain that the CPI overstates inflation because quality improvements are undervalued.
The problem of measuring quality improvements is even more difficult in the case of new products. The computers and word processors used today didn’t exist when the Census Bureau conducted its 1972–73 survey of consumer expenditure. The 1982–84 expenditure survey included those products but not still newer ones such as the cellular phone. As the News above explains, the omission of cellular phones caused the CPI to overstate the rate of inflation. The consumer expenditure survey of 1993–95 included cell phones but not digital cameras, DVD players, flat-screen TVs, or MP3 players—all of which have had declining prices. As a result, there’s a significant (though unmeasured) element of error in the CPI insofar as it’s intended to gauge changes in the average prices paid by consumers.
The goal of 3 percent inflation allows for such errors.
THE HISTORICAL RECORD
In the long view of history, the United States has done a good job of maintaining price stability. On closer inspection, however, our inflation performance is very uneven.
Table 7.5 summarizes the long view, with data going back to 1800. The base period for pricing the market basket of goods is again 1982–84. Notice that the same market basket cost only $17 in 1800. Consumer prices increased 500 percent in 183 years. But also observe how frequently the price level fell in the 1800s and again in the 1930s. These recurrent deflations held down the long-run inflation rate. Because of these periodic deflations, average prices in 1945 were at the same level as in 1800!
Figure 7.3 provides a closer view of our more recent experience with inflation. In this figure we transform annual changes in the CPI into percentage rates of inflation. The CPI
New Products New Products
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136 M E A S U R I N G M A C R O O U T C O M E S
increased from 72.6 to 82.4 during 1980. This 9.8-point jump in the CPI translates into a 13.5 percent rate of inflation (9.8 ÷ 72.6 = 0.135). This inflation rate, represented by point A in Figure 7.3 , was the highest in a generation. Since then, prices have continued to increase, but at much slower rates.
As the accompanying World View documents, the low rates of inflation the United States has experienced are far below the pace in other nations. In 2006, for example, the inflation rate in the United States was lower than in Europe and incomprehensibly low to Zimbabwe- ans, who saw their prices rise 300 percent in one month (earlier World View, page 129) .
22 20 18 16 14 12 10 8 6 4 2 0 –2 –4 –6 –8 –10 –12
CHANGE IN CONSUMER PRICE INDEX (percent)
Inflation Deflation
B A
1910 1920 1930 1940 1950 1960
YEAR
1970 1980 1990 2000 2010
FIGURE 7.3
Annual Infl ation Rates
During the 1920s and 1930s, consumer prices fell significantly, causing a general deflation. Since the Great Depression, however, average prices have risen almost every year. But even during this inflationary period, the annual rate of price increase has varied
widely. In 1980, the rate of inflation was 13.5 percent (point A); in 1998, average prices rose only 1.6 percent (point B).
Source: U.S. Bureau of Labor Statistics.
Year CPI Year CPI Year CPI Year CPI
1800 17.0 1900 8.3 1940 14.0 1980 82.4
1825 11.3 1915 10.1 1950 24.1 1982–84 100.0
1850 8.3 1920 20.0 1960 29.6 1990 130.5
1875 11.0 1930 16.7 1970 38.8 2000 172.8
Note: Data from 1915 forward reflect the official all-items Consumer Price Index, which used the pre-1983 measure of shelter costs. Estimated indexes for 1800 through 1900 are drawn from several sources.
Source: U.S. Bureau of Labor Statistics.
TABLE 7.5
Two Centuries of Price Changes
Before World War II, the average level of prices rose in some years and fell in others. Since 1945, prices have risen continuously. The Con- sumer Price Index has more than doubled since 1980.
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C H A P T E R 7 : I N F L AT I O N 137