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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).

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