Learning Objectives

• Explain the relationship between indexing and inflation
• Identify three ways the government can control inflation through macroeconomic policy

Indexing in Private Markets

In the 1970s and 1980s, labor unions commonly negotiated wage contracts that had cost-of-living adjustments (COLAs), which guaranteed that their wages would keep up with inflation. These contracts were sometimes written as, for example, COLA plus three percent. Thus, if inflation was five percent, the wage increase would automatically be eight percent, but if inflation rose to nine percent, the wage increase would automatically be 12 percent. COLAs are a form of indexing applied to wages.

Loans often have built-in inflation adjustments, too, so that if the inflation rate rises by two percentage points, then the interest rate charged on the loan rises by two percentage points as well. An adjustable-rate mortgage (ARM) is a kind of loan used to purchase a home in which the interest rate varies with the rate of inflation. Often, a borrower will be able receive a lower interest rate if borrowing with an ARM, compared to a fixed-rate loan. The reason is that with an ARM, the lender is protected against the risk that higher inflation will reduce the real loan payments, and so the risk premium part of the interest rate can be correspondingly lower.

A number of ongoing or long-term business contracts also have provisions that prices will be adjusted automatically according to inflation. Sellers like such contracts because they are not locked into a low nominal selling price if inflation turns out higher than expected; buyers like such contracts because they are not locked into a high buying price if inflation turns out to be lower than expected. A contract with automatic adjustments for inflation in effect agrees on a real price to be paid, rather than a nominal price.

Indexing in Government Programs

Many government programs are indexed to inflation. The U.S. income tax code is designed so that as a person’s income rises above certain levels, the tax rate on the marginal income earned rises as well; this is what is meant by the expression “move into a higher tax bracket.” For example, according to the basic tax tables from the Internal Revenue Service, in 2014 a single person owed 10 percent of all taxable income from $0 to $9,075; 15 percent of all income from $9,076 to $36,900; 25 percent of all taxable income from $36,901 to $89,350; 28 percent of all taxable income from $89,351 to $186,350; 33 percent of all taxable income from $186,351 to $405,100; 35 percent of all taxable income from $405,101 to $406,750; and 39.6 percent of all income from $406,751 and above.

Because of the many complex provisions in the rest of the tax code, the taxes owed by any individual cannot be exactly determined based on these numbers, but the numbers illustrate the basic theme that tax rates rise as the marginal dollar of income rises. Until the late 1970s, if nominal wages increased along with inflation, people were moved into higher tax brackets and owed a higher proportion of their income in taxes, even though their real income had not risen. This bracket creep as it was called, was eliminated by law in 1981. Now, the income levels where higher tax rates kick in are indexed to rise automatically with inflation.

The Social Security program offers two examples of indexing. Since the passage of the Social Security Indexing Act of 1972, the level of Social Security benefits increases each year along with the CPI. Also, Social Security is funded by payroll taxes, which are imposed on the income earned up to a certain amount—$117,000 in 2014. This level of income is adjusted upward each year according to the rate of inflation, so that the indexed rise in the benefit level is accompanied by an indexed increase in the Social Security tax base.

As yet another example of a government program affected by indexing, in 1996 the U.S. government began offering indexed bonds. Bonds are means by which the U.S. government, and many private-sector companies as well, borrows money; that is, investors buy the bonds, and then the government repays the money with interest. Traditionally, government bonds have paid a fixed rate of interest. This policy gave a government that had borrowed an incentive to encourage inflation, because it could then repay its past borrowing in inflated dollars at a lower real interest rate. But indexed bonds promise to pay a certain real rate of interest above whatever inflation rate occurs. In the case of a retiree trying to plan for the long term and worried about the risk of inflation, for example, indexed bonds that guarantee a rate of return higher than inflation—no matter the level of inflation—can be a very comforting investment.

Might Indexing Reduce Concern Over Inflation?

Indexing may seem like an obviously useful step. After all, when individuals, firms, and government programs are indexed against inflation, then people can worry less about arbitrary redistributions and other effects of inflation.

However, some of the fiercest opponents of inflation express grave concern about indexing. They point out that indexing is always partial. Not every employer will provide COLAs for workers. Not all companies can assume that costs and revenues will rise in lockstep with the general rates of inflation. Not all interest rates for borrowers and savers will change to match inflation exactly. But as partial inflation indexing spreads, the political opposition to inflation may diminish. After all, older people whose Social Security benefits are protected against inflation, or banks that have loaned their money with adjustable-rate loans, no longer have as much reason to care whether inflation heats up. In a world where some people are indexed against inflation and some are not, financially savvy businesses and investors may seek out ways to be protected against inflation, while the financially unsophisticated and small businesses may suffer from it most.

A Preview of Policy Discussions of Inflation

This chapter has focused on how inflation is measured, historical experience with inflation, how to adjust nominal variables into real ones, how inflation affects the economy, and how indexing works. The causes of inflation have barely been hinted at, and government policies to deal with inflation have not been addressed at all. These issues will be taken up in depth in other chapters. However, it is useful to offer a preview here.

The cause of inflation can be summed up in one sentence: Too many dollars chasing too few goods. The great surges of inflation early in the twentieth century came after wars, which are a time when government spending is very high, but consumers have little to buy, because production is going to the war effort. Governments also commonly impose price controls during wartime. After the war, the price controls end and pent-up buying power surges forth, driving up inflation. On the other hand, if too few dollars are chasing too many goods, then inflation will decline or even turn into deflation. Therefore, slowdowns in economic activity, as in major recessions and the Great Depression, are typically associated with a reduction in inflation or even outright deflation.

The policy implications are clear. If inflation is to be avoided, the amount of purchasing power in the economy must grow at roughly the same rate as the production of goods. Macroeconomic policies that the government can use to affect the amount of purchasing power through taxes, spending, and regulation of interest rates and credit, can thus cause inflation to rise or reduce inflation to lower levels.