Teaching about inflation in my Principles of Macroeconomics classes is a somewhat delicate operation. Inflation is a charged topic; it’s typically one of the top two variables that my students say they worry about in an informal survey that I give at the start of each semester. The other variable they care most about is unemployment, which may illustrate the tension people understand between these two, sometimes competing, dragons to be slain with economic policy. Inflation is also poorly understood. However, it frightens many people, not just college students, and is currently being touted as another bad harbinger for Democrats’ chances in the midterm elections (2022) and Biden’s prospects of winning a second term. I have come, over time, to take extra care to emphasize what inflation is and isn’t, why it is a confusing topic that generates sensationalist rhetoric and political grandstanding, and how students might better understand the relationships and dynamics that contribute to inflation overall.
When I started teaching macroeconomics, these worries about inflation annoyed me. In the first ten years that I taught the subject, inflation rates were low, and routinely below 2%, the targeted rate the Federal Reserve aims for. While I used to minimize the importance of inflation as a worry – it’s so low, you don’t know what you’re talking about, people constantly overestimate inflation – I have shifted tactics over time. In hindsight, I wish it hadn’t taken the observed rise in inflation in the past two years at the time of writing for me to do so, but here we are! Inflation invokes scary images for many: the interwar period in Germany, hyperinflationary episodes in low and middle income economies in the 1980s and 90s, and the prospect of worsening living standards, especially for those living on fixed incomes. Dismissing fears of inflation as incorrect (which they may be) or irrelevant compared to unemployment (a value judgement that may require persuasion and subtlety) is more likely to alienate students, and to lose potential allies to work on changing their parents and grandparents’ minds.
At its most basic, inflation refers to a sustained increase in the aggregate price level. A common method for assessing inflation is to observe the change in a so-called market basket of commonly purchased goods and services, which varies from country to country. The consumer price index (CPI) in the US tracks inflation by the indexed measure of the price of this specific market basket. If a critical mass of components of the basket get more expensive, the CPI grows. The reverse occurs if more goods and services fall in price, or if their decrease in price is more dramatic than the parallel increases in price. The Bureau of Labor Statistics (BLS) constructs myriad CPIs. These indices focus on different parts of the economy (urban versus rural, regions of the US), and may include or exclude particular goods to account for particularly volatile prices for goods like food and fuel. The basic CPI includes the highly volatile components of food and fuel; the personal consumption expenditure (PCE) index does not. These indices are used to calculate how benefit payments should change, if they are indexed to inflation, and as official measures of inflation overall.
When I teach inflation, I emphasize thinking about inflation as an increase in the aggregate price level – a literal inflation. Effectively, an increase in the price level, all else equal, should lead to a decrease in real purchasing power. It’s common for people to think about inflation leading to a decrease in purchasing power, which they may describe as a ‘decrease in the value of the dollar’. While this is effectively the consequence of rising prices and diminished purchasing power, I find that it can turn people around if they extrapolate from inflation to changes in the exchange rate, which also considers the price of other currencies in terms of the dollar (or vice versa). This extension may complicate students’ understanding of the link between changes in the exchange rate and inflation as a whole. If the dollar appreciates relative to other currencies, it implies that imports are relatively less expensive to US consumers, though the reverse may be true for exports. Inflation can occur in tandem with appreciation or depreciation of a currency in foreign exchange markets, so I try to emphasize changing only one variable at a time.
What factors may contribute to inflation overall? Supply factors are most directly associated with inflation. If producers observe higher costs of production, whether due to labor costs, input costs, or service costs, these changes are most directly linked with changes in overall prices, if producers opt to pass them on. Do producers always pass on increased costs to consumers? Not necessarily. Producers care about consumers’ price elasticity of demand (propensity to change quantities they buy relative to changes in the price); changing the price of goods for sale may be costly in and of itself. Another factor to consider is why a producer might transfer costs to consumers. Does a business in a particular industry earn a profit margin? The prevalence of profit margins and rates varies industry to industry. Some high price services like childcare and restaurant service may have low profit margins, given the high costs of operating in those industries. Other goods and services may generate much higher profits, based on the willingness and ability of producers to mark up their output for sale.
How do demand factors affect inflation? It’s complicated! If demand induces firms to produce at rates associated with increased average costs of production, and if those firms want to maintain their profit margins, they may increase prices. These changes may be temporary or longer lasting. But the component of inflation that can be attributed to demand is tenuous and hard to verify. Similarly, the effects of government spending on inflation is ambiguous – if a government is spending to improve road infrastructure, the costs of transporting goods may fall as firms spend less on vehicle maintenance, for example. Will this spending translate into lower prices? It’s difficult to predict from outside. Key pillars of the ‘Build Back Better’ bill, which aimed to negotiate for lower prescription drug prices and to fund more childcare services, could have decreased the costs of two sources of rising costs for households in recent decades. These policies were clearly focused on depressing prices of a good, or fostering an increased supply of a service, rather than mitigating demand for those services, which is how anti-inflationary policy typically looks in practice.
Yet, despite the ambiguous links between changes in demand and inflation, the specter of inflation is invoked to oppose expansive welfare states and government spending. Centrist Democrats have asked President Biden to stop talking about welfare programs in favor of explaining how his administration will slow or reverse inflation rates. Republicans that have willfully increased structural deficits when they’ve held the presidency quickly pivot to arguments for austerity as a tool to curb inflation. Comparisons of fiscal responses to the Great Recession reveal an unprecedentedly muted government spending response to the largest recession since the Great Depression. In Europe, stronger economic members of the Eurozone argued that 4-5% inflation in Germany was just as bad an outcome as 20%+ unemployment rates in Southern European states. Political and economic discourse about inflation typically works to demonstrate the value judgements actors in these institutions have made about the relative desirability of decreasing unemployment or limiting the potential for prices to increase.
What’s also worth noting is that people have a notoriously bad track record at estimating inflation based on prices they encounter. Academics have been analyzing this phenomenon for decades – households in the US and abroad, across demographic groups, and over time consistently overestimate inflation rates. Part of the problem owes to how they may be surveyed on the topic. Evidence seems to indicate that how survey distributors frame questions about whether people perceive an increase in prices versus bouts of inflation have the potential to increase respondents’ estimation of inflation rates. As such, politicians willing to stoke fears of inflation – threatening that current welfare spending will lead to inflation that future generations will have to pay back, for instance, or that allowing governments of countries in crisis to delay repayment of debts paired with drastic tax increases and budget cuts while social costs proliferate – prey on popular misperceptions of actually observed inflation. When central bank employees invoke their duty to stabilize inflation in order to anchor expectations, they may not be quite honest about the degree to which perceptions of inflation match experience, or whether it would behoove the broader public to understand that actually, inflation is not that high.
Factors that may exacerbate the importance that people grant to inflation is how it’s written about and analyzed. How researchers phrase survey questions about the importance of inflation to households, and whether they believe that they observe inflation or not matters substantially for their responses. Economists have gone to elaborate lengths to reframe ‘inflation’ to survey respondents to see how important those respondents believe inflation is, which brings into question the relative importance of inflation to households overall. At the same time, when surveys ask people on the street about whether they believe prices are rising or if inflation is occurring, the relative neutrality of how those questions are worded contribute both to assessments of whether inflation is occurring, and if it is a problem. Persistent academic analyses of the importance of inflation and expectations of inflation for households’ behavior may shape media treatment of the topic, in ways likely to further stoke anxieties about inflation, and whether or not it is problematic for the average individual or household.
All of this worrying about inflation has the potential to shape economic views, assessments of elected officials, and voting behavior. However, the officials with the official purview to mitigate inflation are unelected, and the officials that may be better poised to shape those circumstances may be loath to regulate price-setting by firms, or to approve measures to increase spending on productive capacity that might lead to lower costs and prices by extension. Past experience during Biden’s time in office seems to indicate that Republican and Democratic officials that purport to oppose inflation may overestimate the potential for contractionary policies, fiscal or monetary, to curb inflation. How I approach this in my classes now is to emphasize the microstructures of these processes. How is the CPI constructed? How do aggressively pessimistic forecasts of future cost increases shape inflation expectations and forecasts? What are the mechanisms by which austerity measures or contractionary monetary policy actually throttle inflation? At what point must we leap from facts to value judgements, and meet those worried about inflation where they are? (There will be a moment!) Alienating people worried about inflation because they hear about it frequently risks turning them off to better solutions. This tendency is exacerbated by economists appearing to do all that they can to make survey respondents more anxious about inflation. If I succeed in getting students to re-evaluate their perceptions of inflation, and what the best responses to it are in practice, I have some hope that they may be able to convince their parents and others who may in turn reconsider some of their voting practices. Doing this requires compassion and changing up tactics, but it’s a key part of shifting the narrative starting in the classroom.
Nina Quinn Eichacker 