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Gail Makinent, Congressional Research Service
Updated May 20, 2003
Inflation: Causes, Costs and Current Status
Since the end of World War II, the
United States has experienced more or less continuous inflation. It would be
difficult to find a similar period in American history before that war. Indeed,
prior to World War II, the United States often experienced long periods of
deflation. It is worth noting that the Consumer Price Index in 1941 was
virtually at the same level as in 1807.
During the last economic expansion, March1991-March 2001, the inflation
rate remained low by historic standards. This is true regardless of which of the
indexes is used to calculate the rate at which the price of goods and services
rose. A low inflation rate is especially significant since the U.S. economy was
fully employed, if not over fully employed, according to many estimates for the
last 3 years of that expansion. Yet, contrary to expectations, the inflation
rate showed little tendency to accelerate. Keeping an economy moving along a
full employment path without igniting a burst of inflation is a difficult policy
task.
Because labor costs make up nearly two-thirds of total production costs,
the rate at which they rise is often regarded as an indication of future
inflation at the retail level. They tended to rise in the latter stage of the
1991-2001 expansion, but have moderated since then as the unemployment rate
rises and labor markets ease.
Rather than measure inflation by using the actual rate at which prices
are rising, some economists prefer a measure of inflation that reflects
primarily only the systematic factors that act to raise prices. This is the
so-called underlying or core rate of inflation. Three measures of this rate show
that inflation was in the 4% to 6% range during 1989-1990, with some tendency to
accelerate. Evidence for the end of the 1991-2001 expansion also shows little
tendency for the underlying rate to accelerate. It was then in the 2.5% to 3%
range. This rate has also moderated over 2002-2003 allowing an inference that
the U.S. has now achieved a stable price level.
Why should the United States be concerned about inflation? This study
reports the distilled knowledge of economists on the real cost to an economy
from inflation. These are remarkably more varied than the outlays for "shoe
leather," long reported to be the major cost of inflation.
The costs of inflation are related to its rate, the uncertainty it engenders, whether it is anticipated, and the degree to which contracts and the tax system are indexed. A possible major cost, that related to the inefficient utilization of resources because economic agents mistake changes in nominal variables for changes in real variables and act accordingly (the so-called "signal problem"), may not have been experienced in the United States during the post-World War II era ("shoe leather" being a shorthand term for the resources that have to be expended on less efficient methods of exchanges).
This document is not necessarily endorsed by the Almanac of Policy Issues. It is being preserved in the Policy Archive for historic reasons.