Principles of Economics 3e - Indexing and Its Limitations

Learning Objectives

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

What is Indexing?

• When prices, wages, or interest rates are adjusted with inflation, it is known as indexing.
• Indexed payments rise with the inflation index, mitigating unexpected inflation effects.

Indexing in Private Markets

• COLAs (Cost-of-Living Adjustments): Used in wage contracts to adjust wages with inflation, e.g., a contract might include COLA + 3%.
• Loans and Mortgages: Adjustable-rate mortgages (ARMs) vary with inflation rates to protect lenders against inflation risk.
• Business Contracts: Include provisions for automatic price adjustments with inflation.

Indexing in Government Programs

• U.S. Income Tax: Tax brackets are indexed to inflation to prevent "bracket creep" where nominal income increases could lead to higher taxes without real income increase.
• Social Security: Benefits and payroll taxes are indexed to inflation as per the Social Security Indexing Act of 1972.
• Indexed Bonds: Introduced in 1996, these bonds offer returns above inflation, providing a real rate of return.

Limitations and Concerns about Indexing

• Partial Indexing: Not all wages, costs, or interest rates are fully indexed, leaving some exposed to inflation.
• Political Implications: Less opposition to inflation as indexing spreads, potentially diminishing concerns about inflationary policies.

Policy Discussions Related to Inflation

• Inflation can result from "too many dollars chasing too few goods," often seen post-war when government spending is high.
• Macroeconomic Policy: Must balance purchasing power with production growth to manage inflation.
• Tools include taxes, government spending, and regulation of interest rates and credit.

Case Study: Inflation during the COVID-19 Pandemic

• The pandemic caused price disruptions; stimulus checks and benefits injected cash, leading to inflation in 2021.
• There is debate about whether this inflation is temporary or indicative of long-term trends similar to the 1970s.
• Inflation must be matched by productivity and living standards improvements to avoid economic issues.

Key Takeaways

• Indexing helps manage inflation's arbitrary effects but is not a comprehensive solution.
• Understanding the balance of economic policy and inflation is crucial for long-term economic stability.
• The ongoing debate on inflation's transient or enduring nature impacts future economic policy-making.