[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

INFLATION ADJUSTMENT
The first two fundamental ideas for understanding economic fluctuations—that
wages and prices do not adjust rapidly—set the stage for the model that is developed
over the next two chapters. They imply that changes in demand will cause fluctuations
in employment and production. But in macroeconomics, we are also
interested in the factors that determine inflation, and our other two fundamental
ideas will serve to link fluctuations in unemployment and inflation.
The adjustment of inflation turns out to be one of the keys to understanding how
economies return eventually to full employment. While many prices are slow to
adjust, they do not remain constant; the rate of inflation is the rate at which the
aggregate price level is changing.
To understand the behavior of inflation, it is important to avoid two common
confusions. The first potential problem involves a failure to distinguish between the
price level and the rate of inflation. The price level is an index number that measures
overall prices relative to a base year (the construction of price indexes is discussed
in Chapter 23). In 2004, the consumer price index (CPI) was equal to 188.9. The base
year for the CPI is an average of 1982–1984 prices. Because the CPI is by definition
equal to 100 in the base period, the index shows that by 2004 the prices of the goods
and services in its basket had risen 88.9 percent since that period. The price level in
2004 is higher than it was in 1982–1984.
The inflation rate tells us how fast the price level is rising. In 2004, the CPI
inflation rate was 2.7 percent. In other words, the price level in 2004 was 2.7 percent
higher than it had been in 2003. The higher the inflation rate, the faster the
rise in the price level. A negative inflation rate (deflation) would indicate that prices
were falling.
A higher price level does not mean that inflation is higher. For example, the price
level was much higher in 2004 than it was in 1982, but the inflation rate was lower.
Inflation in 1982 was 6.2 percent; in 2004, it was only 2.7 percent, and thus prices
were rising more slowly.
The second potential confusion arises if sticky is not distinguished from constant.
In calling wages and prices “sticky,” economists mean that they fail to adjust rapidly
in the face of shifts in supply and demand, not that they are constant—that
is, that they never change. Both wages and prices do adjust over time. The rate at
which the general level of prices changes, the inflation rate, will be one of the key
macroeconomic variables in our model of short-run fluctuations.
What Causes Inflation to Adjust? The law of supply and demand tells us
that whenever supply and demand are out of balance in a market, pressures will be
brought to bear on the price in that market to adjust. The same applies for the aggregate
economy. The balance between labor demand and supply, as reflected in cyclical
unemployment, is an important factor influencing how wages change. As
unemployment falls—that is, as labor markets become tight—firms must boost the
wages they pay to attract new workers and retain their existing workforce. In unionized
sectors, a tight labor market increases the bargaining power of unions, enabling
them to negotiate larger wage increases. Wages therefore rise more rapidly in tight
652 ∂ CHAPTER 29 INTRODUCTION TO MACROECONOMIC FLUCTUATIONS