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The Elementary Basics of Inflation

Summary:
It is always surprising how even the financial press is confused about inflation. I am not speaking of complex conflicting theories on the causes of inflation but of the very basic distinction between inflation and changes in relative prices. For example, The Economist just wrote: America’s annual inflation rate stood at 5.3% in August, down slightly from the 13-year highs of the previous two months. There was some evidence that inflationary pressures may be levelling off, such as an easing of prices for used cars, which have driven some of this year’s inflation. [my emphasis] An increase in the price of used cars cannot generate or “drive” inflation for a simple reason: it works the other way around. Inflation, which is defined as a continuous and sustained

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It is always surprising how even the financial press is confused about inflation. I am not speaking of complex conflicting theories on the causes of inflation but of the very basic distinction between inflation and changes in relative prices.

For example, The Economist just wrote:

America’s annual inflation rate stood at 5.3% in August, down slightly from the 13-year highs of the previous two months. There was some evidence that inflationary pressures may be levelling off, such as an easing of prices for used cars, which have driven some of this year’s inflation. [my emphasis]

An increase in the price of used cars cannot generate or “drive” inflation for a simple reason: it works the other way around. Inflation, which is defined as a continuous and sustained increase in the general price level, causes all individual prices (including wages, interest rates, etc.) to rise more or less proportionately, over and above the change in relative prices caused by changes in demand or supply on specific markets. To the extent that used car prices were partially caused by both inflation and a relative price change, they could not be a cause of inflation.

Suppose that a decrease in the supply of new cars causes an increase in their prices. This in turn boosts the demand for used cars, a substitute, and causes an increase in their prices of, say, 27%. The consumers who continue to buy cars at the higher prices must spend less on other goods and services, whose relative prices would decrease. Assuming no independently generated inflation (no increase in the general price level), that would be the end of the story: fewer cars and more of other goods or services are produced. Prices of cars have increased relative to the prices of other goods; only a change in relative prices has occurred. If there is inflation, though, the increase of used car prices will be augmented by the general rate of inflation in the economy, say, 5%.

To illustrate, take the Bureau of Labor Statistics (BLS) data for August. The BLS report on the Consumer Price Index (CPI) reveals a 5.3% increase in the index compared to August of last year. In other words, the BLS estimates that the general level of consumer prices in the economy grew by 5.3%. It also calculates that the prices of used cars and trucks (the available statistical category) increased by 31.9%. If the 5.3% represents a good estimate of inflation (in the price level), this means that the relative price of used cars and trucks increased by (roughly) 26.6% (= 31.9% – 5.3%), that is, relative to other goods in the economy. (I say “roughly” because an exact calculation would require excluding the increased price of used cars and trucks from the total increase of the CPI, not a large correction as used cars and trucks account for only 3.5% of the goods and services in the CPI.) The remaining 5.3% in the increase of used car and truck prices is what is due to inflation. It is nonsensical to say that the 26.6% “has driven some of this year’s inflation” of 5.3%, because the latter gets added to the former.

Look at it in another way. If T=R+L, it is nonsensical to say that R contributed to, or “exerts pressure” on, L. If the Total price change of used cars and trucks (32%, rounded) is equal to the Relative price change (27%) plus the change in the general price Level (5%), it is nonsensical to say that the relative price change (R)  contributed to the change in the general level of prices (L).

The Economist is not the only media to be confused. For another example, see the Wall Street Journal’s related story, “Inflation Eased in August, Though Prices Stayed High,” September 14, 2021. God knows what the New York Times, the Washington Post, or Fox News must have said!

Steve Ambler, an economics professor at the University of Québec in Montréal, adds a point that may partly explain the confusion of non-economists (and perhaps some economists):

There’s a significant empirical correlation between the rate of inflation and relative price variability. … In an inflationary environment there’s likely going to be a few price increases that commentators will be able to point to that are in the right hand tail of the distribution. Then they conclude that those extreme price increases are “driving” inflation.

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