# Inflation

## How to Measure Changes in the Cost of Living

The most commonly cited measure of inflation in the United States is the Consumer Price Index (CPI). Government statisticians at the U.S. Bureau of Labor Statistics calculate the CPI based on the prices in a fixed basket of goods and services that represents the purchases of the average family of four. In recent years, the statisticians have paid considerable attention to a subtle problem: that the change in the total cost of buying a fixed basket of goods and services over time is conceptually not quite the same as the change in the cost of living, because the cost of living represents how much it costs for a person to feel that their consumption provides an equal level of satisfaction or utility.
To understand the distinction, imagine that over the past 10 years, the cost of purchasing a fixed basket of goods increased by 25% and your salary also increased by 25%. Has your personal standard of living held constant? If you do not necessarily purchase an identical fixed basket of goods every year, then an inflation calculation based on the cost of a fixed basket of goods may be a misleading measure of how your cost of living has changed. Two problems arise here: substitution bias and quality/new goods bias.
When the price of a good rises, consumers tend to purchase less of it and to seek out substitutes instead. Conversely, as the price of a good falls, people will tend to purchase more of it. This pattern implies that goods with generally rising prices should tend over time to become less important in the overall basket of goods used to calculate inflation, while goods with falling prices should tend to become more important. Consider, as an example, a rise in the price of peaches by $100 per pound. If consumers were utterly inflexible in their demand for peaches, this would lead to a big rise in the price of food for consumers. Alternatively, imagine that people are utterly indifferent to whether they have peaches or other types of fruit. Now, if peach prices rise, people completely switch to other fruit choices and the average price of food does not change at all. A fixed and unchanging basket of goods assumes that consumers are locked into buying exactly the same goods, regardless of price changes—not a very likely assumption. Thus, substitution bias—the rise in the price of a fixed basket of goods over time—tends to overstate the rise in a consumer’s true cost of living, because it does not take into account that the person can substitute away from goods whose relative prices have risen.
The other major problem in using a fixed basket of goods as the basis for calculating inflation is how to deal with the arrival of improved versions of older goods or altogether new goods. Consider the problem that arises if a cereal is improved by adding 12 essential vitamins and minerals—and also if a box of the cereal costs 5% more. It would clearly be misleading to count the entire resulting higher price as inflation, because the new price reflects a higher quality (or at least different) product. Ideally, one would like to know how much of the higher price is due to the quality change, and how much of it is just a higher price. The Bureau of Labor Statistics, which is responsible for computing the Consumer Price Index, must deal with these difficulties in adjusting for quality changes.
We can think of a new product as an extreme improvement in quality—from something that did not exist to something that does. However, the basket of goods that was fixed in the past obviously does not include new goods created since then. The basket of goods and services in the Consumer Price Index (CPI) is revised and updated over time, and so new products are gradually included. However, the process takes some time. For example, room air conditioners were widely sold in the early 1950s, but were not introduced into the basket of goods behind the Consumer Price Index until 1964. The VCR and personal computer were available in the late 1970s and widely sold by the early 1980s, but did not enter the CPI basket of goods until 1987. By 1996, there were more than 40 million cellular phone subscribers in the United States—but cell phones were not yet part of the CPI basket of goods. The parade of inventions has continued, with the CPI inevitably lagging a few years behind.
The arrival of new goods creates problems with respect to the accuracy of measuring inflation. The reason people buy new goods, presumably, is that the new goods offer better value for money than existing goods. Thus, if the price index leaves out new goods, it overlooks one of the ways in which the cost of living is improving. In addition, the price of a new good is often higher when it is first introduced and then declines over time. If the new good is not included in the CPI for some years, until its price is already lower, the CPI may miss counting this price decline altogether. Taking these arguments together, the quality/new goods bias means that the rise in the price of a fixed basket of goods over time tends to overstate the rise in a consumer’s true cost of living, because it does not account for how improvements in the quality of existing goods or the invention of new goods improves the standard of living. The following Clear It Up feature is a must-read on how statisticians comprise and calculate the CPI.

### The CPI and Core Inflation Index

Imagine if you were driving a company truck across the country- you probably would care about things like the prices of available roadside food and motel rooms as well as the truck’s operating condition.  However, the manager of the firm might have different priorities. He would care mostly about the truck’s on-time performance and much less so about the food you were eating and the places you were staying. In other words, the company manager would be paying attention to the firm's production, while ignoring transitory elements that impacted you, but did not affect the company’s bottom line.

In a sense, a similar situation occurs with regard to measures of inflation. As we’ve learned, CPI measures prices as they affect everyday household spending. Economists typically calculate a core inflation index by taking the CPI and excluding volatile economic variables. In this way, economists have a better sense of the underlying trends in prices that affect the cost of living.
Examples of excluded variables include energy and food prices, which can jump around from month to month because of the weather. According to an article by Kent Bernhard, during Hurricane Katrina in 2005, a key supply point for the nation’s gasoline was nearly knocked out.  Gas prices quickly shot up across the nation, in some places by up to 40 cents a gallon in one day. This was not the cause of an economic policy but rather a short-lived event until the pumps were restored in the region. In this case, the CPI that month would register the change as a cost of living event to households, but the core inflation index would remain unchanged. As a result, the Federal Reserve’s decisions on interest rates would not be influenced.  Similarly, droughts can cause world-wide spikes in food prices that, if temporary, do not affect the nation’s economic capability.

As former Chairman of the Federal Reserve Ben Bernanke noted in 1999 about the core inflation index, “It provide(s) a better guide to monetary policy than the other indices, since it measures the more persistent underlying inflation rather than transitory influences on the price level.” Bernanke also noted that it helps communicate that the Federal Reserve does not need to respond to every inflationary shock since some price changes are transitory and not part of a structural change in the economy.
In sum, both the CPI and the core inflation index are important, but serve different audiences. The CPI helps households understand their overall cost of living from month to month, while the core inflation index is a preferred gauge from which to make important government policy changes.

### Practical Solutions for the Substitution and the Quality/New Goods Biases

By the early 2000s, the Bureau of Labor Statistics was using alternative mathematical methods for calculating the Consumer Price Index, more complicated than just adding up the cost of a fixed basket of goods, to allow for some substitution between goods. It was also updating the basket of goods behind the CPI more frequently, so that it could include new and improved goods more rapidly. For certain products, the BLS was carrying out studies to try to measure the quality improvement. For example, with computers, an economic study can try to adjust for changes in speed, memory, screen size, and other product characteristics, and then calculate the change in price after accounting for these product changes. However, these adjustments are inevitably imperfect, and exactly how to make these adjustments is often a source of controversy among professional economists.
By the early 2000s, the substitution bias and quality/new goods bias had been somewhat reduced, so that since then the rise in the CPI probably overstates the true rise in inflation by only about 0.5% per year. Over one or a few years, this is not much. Over a period of a decade or two, even half of a percent per year compounds to a more significant amount. In addition, the CPI tracks prices from physical locations, and not at online sites like Amazon, where prices can be lower.
When measuring inflation (and other economic statistics, too), a tradeoff arises between simplicity and interpretation. If we calculate the inflation rate with a basket of goods that is fixed and unchanging, then the calculation of an inflation rate is straightforward, but the problems of substitution bias and quality/new goods bias will arise. However, when the basket of goods is allowed to shift and evolve to reflect substitution toward lower relative prices, quality improvements, and new goods, the technical details of calculating the inflation rate grow more complex.

### Additional Price Indices: PPI, GDP Deflator, and More

The basket of goods behind the Consumer Price Index represents an average hypothetical U.S. household's consumption, which is to say that it does not exactly capture anyone’s personal experience. When the task is to calculate an average level of inflation, this approach works fine. What if, however, you are concerned about inflation experienced by a certain group, like the elderly, or the poor, or single-parent families with children, or Hispanic-Americans? In specific situations, a price index based on the buying power of the average consumer may not feel quite right.
This problem has a straightforward solution. If the Consumer Price Index does not serve the desired purpose, then invent another index, based on a basket of goods appropriate for the group of interest. The Bureau of Labor Statistics publishes a number of experimental price indices: some for particular groups like the elderly or the poor, some for different geographic areas, and some for certain broad categories of goods like food or housing.
The BLS also calculates several price indices that are not based on baskets of consumer goods. For example, the Producer Price Index (PPI) is based on prices paid for supplies and inputs by producers of goods and services. We can break it down into price indices for different industries, commodities, and stages of processing (like finished goods, intermediate goods, or crude materials for further processing). There is an International Price Index based on the prices of merchandise that is exported or imported. An Employment Cost Index measures wage inflation in the labor market. The GDP deflator, which the Bureau of Economic Analysis measures, is a price index that includes all the GDP components (that is, consumption plus investment plus government plus exports minus imports). Unlike the CPI, its baskets are not fixed but re-calculate what that year’s GDP would have been worth using the base-year’s prices. MIT's Billion Prices Project is a more recent alternative attempt to measure prices: economists collect data online from retailers and then put them into an index that they compare to the CPI (Source: http://bpp.mit.edu/usa/).
What’s the best measure of inflation? If one is concerned with the most accurate measure of inflation, one should use the GDP deflator as it picks up the prices of goods and services produced. However, it is not a good measure of the cost of living as it includes prices of many products not purchased by households (for example, aircraft, fire engines, factory buildings, office complexes, and bulldozers). If one wants the most accurate measure of inflation as it impacts households, one should use the CPI, as it only picks up prices of products purchased by households. That is why economists sometimes refer to the CPI as the cost-of-living index. As the Bureau of Labor Statistics states on its website: “The ‘best’ measure of inflation for a given application depends on the intended use of the data.”

### Key Concepts and Summary

Measuring price levels with a fixed basket of goods will always have two problems: the substitution bias, by which a fixed basket of goods does not allow for buying more of what becomes relatively less expensive and less of what becomes relatively more expensive; and the quality/new goods bias, by which a fixed basket cannot account for improvements in quality and the advent of new goods. These problems can be reduced in degree—for example, by allowing the basket of goods to evolve over time—but we cannot totally eliminate them. The most commonly cited measure of inflation is the Consumer Price Index (CPI), which is based on a basket of goods representing what the typical consumer buys. The Core Inflation Index further breaks down the CPI by excluding volatile economic commodities. Several price indices are not based on baskets of consumer goods. The GDP deflator is based on all GDP components. The Producer Price Index is based on prices of supplies and inputs bought by producers of goods and services. An Employment Cost Index measures wage inflation in the labor market. An International Price Index is based on the prices of merchandise that is exported or imported.

### Self-Check Questions

### Review Questions

### Critical Thinking Question

### References

Bernhard, Kent. “Pump Prices Jump Across U.S. after Katrina.” NBC News, September 1, 2005. http://www.nbcnews.com/id/9146363/ns/business-local_business/t/pump-prices-jump-across-us-after-katrina/#.U00kRfk7um4.

Wynne, Mark A. “Core Inflation, A Review of Some Conceptual Issues.” Federal Reserve Bank of St. Louis. p. 209.  Accessed April 14, 2014. http://research.stlouisfed.org/publications/review/08/05/part2/Wynne.pdf


# Inflation

## How the U.S. and Other Countries Experience Inflation

In the last three decades, inflation has been relatively low in the U.S. economy, with the Consumer Price Index typically rising 2% to 4% per year. Looking back over the twentieth century, there have been several periods where inflation caused the price level to rise at double-digit rates, but nothing has come close to hyperinflation.

### Historical Inflation in the U.S. Economy

 (a) shows the level of prices in the Consumer Price Index stretching back to 1913. In this case, the base years (when the CPI is defined as 100) are set for the average level of prices that existed from 1982 to 1984.  (b) shows the annual percentage changes in the CPI over time, which is the inflation rate.
Inflation as measured by the consumer price index reflects the annual percentage change in the cost to the average consumer of acquiring a basket of goods and services that may be fixed or changed at specified intervals, such as yearly.
The first two waves of inflation are easy to characterize in historical terms: they are right after World War I and World War II. However, there are also two periods of severe negative inflation—called deflation—in the early decades of the twentieth century: one following the deep 1920-21 recession and the other during the Great Depression of the 1930s. (Since inflation is a time when the buying power of money in terms of goods and services is reduced, deflation will be a time when the buying power of money in terms of goods and services increases.) For the period from 1900 to about 1960, the major inflations and deflations nearly balanced each other out, so the average annual rate of inflation over these years was only about 1% per year. A third wave of more severe inflation arrived in the 1970s and departed in the early 1980s.
Times of recession or depression often seem to be times when the inflation rate is lower, as in the recession of 1920–1921, the Great Depression, the recession of 1980–1982, and the Great Recession in 2008–2009. There were a few months in 2009 that were deflationary, but not at an annual rate. High levels of unemployment typically accompany recessions, and the total demand for goods falls, pulling the price level down. Conversely, the rate of inflation often, but not always, seems to start moving up when the economy is growing very strongly, like right after wartime or during the 1960s. The frameworks for macroeconomic analysis, that we developed in other chapters, will explain why recession often accompanies higher unemployment and lower inflation, while rapid economic growth often brings lower unemployment but higher inflation.

### Inflation around the World

Around the rest of the world, the pattern of inflation has been very mixed;  shows inflation rates over the last several decades. Many industrialized countries, not just the United States, had relatively high inflation rates in the 1970s. For example, in 1975, Japan’s inflation rate was over 8% and the inflation rate for the United Kingdom was almost 25%. In the 1980s, inflation rates came down in the United States and in Europe and have largely stayed down.
Countries with controlled economies in the 1970s, like the Soviet Union and China, historically had very low rates of measured inflation—because prices were forbidden to rise by law, except for the cases where the government deemed a price increase to be due to quality improvements. However, these countries also had perpetual shortages of goods, since forbidding prices to rise acts like a price ceiling and creates a situation where quantity demanded often exceeds quantity supplied. As Russia and China made a transition toward more market-oriented economies, they also experienced outbursts of inflation, although we should regard the statistics for these economies as somewhat shakier. Inflation in China averaged about 10% per year for much of the 1980s and early 1990s, although it has dropped off since then. Russia experienced hyperinflation—an outburst of high inflation—of 2,500% per year in the early 1990s, although by 2006 Russia’s consumer price inflation had dipped below 10% per year, as  shows. The closest the United States has ever reached hyperinflation was during the 1860–1865 Civil War, in the Confederate states.
Many countries in Latin America experienced raging inflation during the 1980s and early 1990s, with inflation rates often well above 100% per year. In 1990, for example, both Brazil and Argentina saw inflation climb above 2000%. Certain countries in Africa experienced extremely high rates of inflation, sometimes bordering on hyperinflation, in the 1990s. Nigeria, the most populous country in Africa, had an inflation rate of 75% in 1995.
In the early 2000s, the problem of inflation appears to have diminished for most countries, at least in comparison to the worst times of recent decades. As we noted in this earlier Bring it Home feature, in recent years, the world’s worst example of hyperinflation was in Zimbabwe, where at one point the government was issuing bills with a face value of $100 trillion (in Zimbabwean dollars)—that is, the bills had $100,000,000,000,000 written on the front, but were almost worthless. In many countries, the memory of double-digit, triple-digit, and even quadruple-digit inflation is not very far in the past.

### Key Concepts and Summary

In the U.S. economy, the annual inflation rate in the last two decades has typically been around 2% to 4%. The periods of highest inflation in the United States in the twentieth century occurred during the years after World Wars I and II, and in the 1970s. The period of lowest inflation—actually, with deflation—was the 1930s Great Depression.

### Self-Check Question

### Review Questions

### Critical Thinking Question

### Problems


# Inflation

## The Confusion Over Inflation

Economists usually oppose high inflation, but they oppose it in a milder way than many non-economists. Robert Shiller, one of 2013’s Nobel Prize winners in economics, carried out several surveys during the 1990s about attitudes toward inflation. One of his questions asked, “Do you agree that preventing high inflation is an important national priority, as important as preventing drug use or preventing deterioration in the quality of our schools?” Answers were on a scale of 1–5, where 1 meant “Fully agree” and 5 meant “Completely disagree.” For the U.S. population as a whole, 52% answered “Fully agree” that preventing high inflation was a highly important national priority and just 4% said “Completely disagree.” However, among professional economists, only 18% answered “Fully agree,” while the same percentage of 18% answered “Completely disagree.”

### The Land of Funny Money

What are the economic problems caused by inflation, and why do economists often regard them with less concern than the general public? Consider a very short story: “The Land of Funny Money.”
One morning, everyone in the Land of Funny Money awakened to find that everything denominated in money had increased by 20%. The change was completely unexpected. Every price in every store was 20% higher. Paychecks were 20% higher. Interest rates were 20 % higher. The amount of money, everywhere from wallets to savings accounts, was 20% larger. This overnight inflation of prices made newspaper headlines everywhere in the Land of Funny Money. However, the headlines quickly disappeared, as people realized that in terms of what they could actually buy with their incomes, this inflation had no economic impact. Everyone’s pay could still buy exactly the same set of goods as it did before. Everyone’s savings were still sufficient to buy exactly the same car, vacation, or retirement that they could have bought before. Equal levels of inflation in all wages and prices ended up not mattering much at all.
When the people in Robert Shiller’s surveys explained their concern about inflation, one typical reason was that they feared that as prices rose, they would not be able to afford to buy as much. In other words, people were worried because they did not live in a place like the Land of Funny Money, where all prices and wages rose simultaneously. Instead, people live here on Planet Earth, where prices might rise while wages do not rise at all, or where wages rise more slowly than prices.
Economists note that over most periods, the inflation level in prices is roughly similar to the inflation level in wages, and so they reason that, on average, over time, people’s economic status is not greatly changed by inflation. If all prices, wages, and interest rates adjusted automatically and immediately with inflation, as in the Land of Funny Money, then no one’s purchasing power, profits, or real loan payments would change. However, if other economic variables do not move exactly in sync with inflation, or if they adjust for inflation only after a time lag, then inflation can cause three types of problems: unintended redistributions of purchasing power, blurred price signals, and difficulties in long-term planning.

### Unintended Redistributions of Purchasing Power

Inflation can cause redistributions of purchasing power that hurt some and help others. People who are hurt by inflation include those who are holding considerable cash, whether it is in a safe deposit box or in a cardboard box under the bed. When inflation happens, the buying power of cash diminishes. However, cash is only an example of a more general problem: anyone who has financial assets invested in a way that the nominal return does not keep up with inflation will tend to be affected by inflation. For example, if a person has money in a bank account that pays 4% interest, but inflation rises to 5%, then the real rate of return for the money invested in that bank account is negative 1%.
The problem of a good-looking nominal interest rate transforming into an ugly-looking real interest rate can be worsened by taxes. The U.S. income tax is charged on the nominal interest received in dollar terms, without an adjustment for inflation. Thus, the government taxes a person who invests $10,000 and receives a 5% nominal rate of interest on the $500 received—no matter whether the inflation rate is 0%, 5%, or 10%. If inflation is 0%, then the real interest rate is 5% and all $500 is a gain in buying power. However, if inflation is 5%, then the real interest rate is zero and the person had no real gain—but owes income tax on the nominal gain anyway. If inflation is 10%, then the real interest rate is negative 5% and the person is actually falling behind in buying power, but would still owe taxes on the $500 in nominal gains.
Inflation can cause unintended redistributions for wage earners, too. Wages do typically creep up with inflation over time, eventually. The last row of  at the start of this chapter showed that the average hourly wage in manufacturing in the U.S. economy increased from $3.23 in 1970 to $30.11 in 2021, which is an increase by a factor of close to ten. Over that time period, the Consumer Price Index increased by about a factor of eight. However, increases in wages may lag behind inflation for a year or two, since wage adjustments are often somewhat sticky and occur only once or twice a year. Moreover, the extent to which wages keep up with inflation creates insecurity for workers and may involve painful, prolonged conflicts between employers and employees. If the government adjusts minimum wage for inflation only infrequently, minimum wage workers are losing purchasing power from their nominal wages, as  shows.
One sizable group of people has often received a large share of their income in a form that does not increase over time: retirees who receive a private company pension. Most pensions have traditionally been set as a fixed nominal dollar amount per year at retirement. For this reason, economists call pensions “defined benefits” plans. Even if inflation is low, the combination of inflation and a fixed income can create a substantial problem over time. A person who retires on a fixed income at age 65 will find that losing just 1% to 2% of buying power per year to inflation compounds to a considerable loss of buying power after a decade or two.
Fortunately, pensions and other defined benefits retirement plans are increasingly rare, replaced instead by “defined contribution” plans, such as 401(k)s and 403(b)s. In these plans, the employer contributes a fixed amount to the worker’s retirement account on a regular basis (usually every pay check). The employee often contributes as well. The worker invests these funds in a wide range of investment vehicles. These plans are tax deferred, and they are portable so that if the individual takes a job with a different employer, their 401(k) comes with them. To the extent that the investments made generate real rates of return, retirees are not burdened by the inflation costs of traditional pensioners.
However, ordinary people can sometimes benefit from the unintended redistributions of inflation. Consider someone who borrows $10,000 to buy a car at a fixed interest rate of 9%. If inflation is 3% at the time the loan is made, then the borrower must repay the loan at a real interest rate of 6%. However, if inflation rises to 9%, then the real interest rate on the loan is zero. In this case, the borrower’s benefit from inflation is the lender’s loss. A borrower paying a fixed interest rate, who benefits from inflation, is just the flip side of an investor receiving a fixed interest rate, who suffers from inflation. The lesson is that when interest rates are fixed, rises in the rate of inflation tend to penalize suppliers of financial capital, who receive repayment in dollars that are worth less because of inflation, while demanders of financial capital end up better off, because they can repay their loans in dollars that are worth less than originally expected.
The unintended redistributions of buying power that inflation causes may have a broader effect on society. America’s widespread acceptance of market forces rests on a perception that people’s actions have a reasonable connection to market outcomes. When inflation causes a retiree who built up a pension or invested at a fixed interest rate to suffer, however, while someone who borrowed at a fixed interest rate benefits from inflation, it is hard to believe that this outcome was deserved in any way. Similarly, when homeowners benefit from inflation because the price of their homes rises, while renters suffer because they are paying higher rent, it is hard to see any useful incentive effects. One of the reasons that the general public dislikes inflation is a sense that it makes economic rewards and penalties more arbitrary—and therefore likely to be perceived as unfair – even dangerous, as the next Clear It Up feature shows.

### Blurred Price Signals

Prices are the messengers in a market economy, conveying information about conditions of demand and supply. Inflation blurs those price messages. Inflation means that we perceive price signals more vaguely, like a radio program received with considerable static. If the static becomes severe, it is hard to tell what is happening.
In Israel, when inflation accelerated to an annual rate of 500% in 1985, some stores stopped posting prices directly on items, since they would have had to put new labels on the items or shelves every few days to reflect inflation. Instead, a shopper just took items from a shelf and went up to the checkout register to find out the price for that day. Obviously, this situation makes comparing prices and shopping for the best deal rather difficult. When the levels and changes of prices become uncertain, businesses and individuals find it harder to react to economic signals. In a world where inflation is at a high rate, but bouncing up and down to some extent, does a higher price of a good mean that inflation has risen, or that supply of that good has decreased, or that demand for that good has increased? Should a buyer of the good take the higher prices as an economic hint to start substituting other products—or have the prices of the substitutes risen by an equal amount? Should a seller of the good take a higher price as a reason to increase production—or is the higher price only a sign of a general inflation in which the prices of all inputs to production are rising as well? The true story will presumably become clear over time, but at a given moment, who can say?
High and variable inflation means that the incentives in the economy to adjust in response to changes in prices are weaker. Markets will adjust toward their equilibrium prices and quantities more erratically and slowly, and many individual markets will experience a greater chance of surpluses and shortages.

### Problems of Long-Term Planning

Inflation can make long-term planning difficult. In discussing unintended redistributions, we considered the case of someone trying to plan for retirement with a pension that is fixed in nominal terms and a high rate of inflation. Similar problems arise for all people trying to save for retirement, because they must consider what their money will really buy several decades in the future when we cannot know the rate of future inflation.
Inflation, especially at moderate or high levels, will pose substantial planning problems for businesses, too. A firm can make money from inflation—for example, by paying bills and wages as late as possible so that it can pay in inflated dollars, while collecting revenues as soon as possible. A firm can also suffer losses from inflation, as in the case of a retail business that gets stuck holding too much cash, only to see inflation eroding the value of that cash. However, when a business spends its time focusing on how to profit by inflation, or at least how to avoid suffering from it, an inevitable tradeoff strikes: less time is spent on improving products and services or on figuring out how to make existing products and services more cheaply. An economy with high inflation rewards businesses that have found clever ways of profiting from inflation, which are not necessarily the businesses that excel at productivity, innovation, or quality of service.
In the short term, low or moderate levels of inflation may not pose an overwhelming difficulty for business planning, because costs of doing business and sales revenues may rise at similar rates. If, however, inflation varies substantially over the short or medium term, then it may make sense for businesses to stick to shorter-term strategies. The evidence as to whether relatively low rates of inflation reduce productivity is controversial among economists. There is some evidence that if inflation can be held to moderate levels of less than 3% per year, it need not prevent a nation’s real economy from growing at a healthy pace. For some countries that have experienced hyperinflation of several thousand percent per year, an annual inflation rate of 20–30% may feel basically the same as zero. However, several economists have pointed to the suggestive fact that when U.S. inflation heated up in the early 1970s—to 10%—U.S. growth in productivity slowed down, and when inflation slowed down in the 1980s, productivity edged up again not long thereafter, as  shows.

### Any Benefits of Inflation?

Although the economic effects of inflation are primarily negative, two countervailing points are worth noting. First, the impact of inflation will differ considerably according to whether it is creeping up slowly at 0% to 2% per year, galloping along at 10% to 20% per year, or racing to the point of hyperinflation at, say, 40% per month. Hyperinflation can rip an economy and a society apart. An annual inflation rate of 2%, 3%, or 4%, however, is a long way from a national crisis. Low inflation is also better than deflation which occurs with severe recessions.
Second, economists sometimes argue that moderate inflation may help the economy by making wages in labor markets more flexible. The discussion in Unemployment pointed out that wages tend to be sticky in their downward movements and that unemployment can result. A little inflation could nibble away at real wages, and thus help real wages to decline if necessary. In this way, even if a moderate or high rate of inflation may act as sand in the gears of the economy, perhaps a low rate of inflation serves as oil for the gears of the labor market. This argument is controversial. A full analysis would have to account for all the effects of inflation. It does, however, offer another reason to believe that, all things considered, very low rates of inflation may not be especially harmful.

### Key Concepts and Summary

Unexpected inflation will tend to hurt those whose money received, in terms of wages and interest payments, does not rise with inflation. In contrast, inflation can help those who owe money that they can pay in less valuable, inflated dollars. Low rates of inflation have relatively little economic impact over the short term. Over the medium and the long term, even low rates of inflation can complicate future planning. High rates of inflation can muddle price signals in the short term and prevent market forces from operating efficiently, and can vastly complicate long-term savings and investment decisions.

### Self-Check Question

### Review Question

### Critical Thinking Questions

### References

Shiller, Robert. “Why Do People Dislike Inflation?” NBER Working Paper Series, National Bureau of Economic Research, p. 52. 1996.


# Inflation

## Indexing and Its Limitations

When a price, wage, or interest rate is adjusted automatically with inflation, economists use the term indexed. An indexed payment increases according to the index number that measures inflation. Those in private markets and government programs observe a wide range of indexing arrangements. Since the negative effects of inflation depend in large part on having inflation unexpectedly affect one part of the economy but not another—say, increasing the prices that people pay but not the wages that workers receive—indexing will take some of the sting out of inflation.

### 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 3%. Thus, if inflation was 5%, the wage increase would automatically be 8%, but if inflation rose to 9%, the wage increase would automatically be 12%. 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 that a financial institution charges on the loan rises by two percentage points as well. An adjustable-rate mortgage (ARM) is a type of loan that one can use to purchase a home in which the interest rate varies with the rate of inflation. Often, a borrower will be able to 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 adjust 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 for the borrower to pay, 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. That is what the expression “move into a higher tax bracket” means. For example, according to the basic tax tables from the Internal Revenue Service, in 2020, a married person filing jointly owed 10% of all taxable income from $0 to $19,750; 12% of all income from $19,751 to $80,250; 22% of all taxable income from $80,251 to $171,050; 24% of all taxable income from $171,051 to $326,600; 32% of all taxable income from $326,601 to $414,700; 35% of all taxable income from $414,701 to $622,050; and 37% of all income from $622,051 and above.
Because of the many complex provisions in the rest of the tax code, it is difficult to determine exactly the taxes an individual owes the government 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. In 1981, the government eliminated this “bracket creep”. 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 Consumer Price Index. Also, Social Security is funded by payroll taxes, which the government imposes on the income earned up to a certain amount—$137,700 in 2020. The government adjusts this level of income upward each year according to the rate of inflation, so that an indexed increase in the Social Security tax base accompanies the indexed rise in the benefit level.
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. However, 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. However, 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 feel it the most.

### A Preview of Policy Discussions of Inflation

This chapter has focused on how economists measure inflation, historical experience with inflation, how to adjust nominal variables into real ones, how inflation affects the economy, and how indexing works. We have barely hinted at the causes of inflation, and we have not addressed government policies to deal with inflation. We will examine these issues in depth in other chapters. However, it is useful to offer a preview here.
We can sum up the cause of inflation in one phrase: 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. Otherwise, if too few dollars are chasing too many goods, then inflation will decline or even turn into deflation. Therefore, we typically associate slowdowns in economic activity, as in major recessions and the Great Depression, with a reduction in inflation or even outright deflation.
The policy implications are clear. If we are to avoid inflation, 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.

### Key Concepts and Summary

A payment is indexed if it is automatically adjusted for inflation. Examples of indexing in the private sector include wage contracts with cost-of-living adjustments (COLAs) and loan agreements like adjustable-rate mortgages (ARMs). Examples of indexing in the public sector include tax brackets and Social Security payments.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### Problems

### References

Wines, Michael. “How Bad is Inflation in Zimbabwe?” The New York Times, May 2, 2006. http://www.nytimes.com/2006/05/02/world/africa/02zimbabwe.html?pagewanted=all&_r=0.
Hanke, Steve H. “R.I.P. Zimbabwe Dollar.” CATO Institute. Accessed December 31, 2013. http://www.cato.org/zimbabwe.
Massachusetts Institute of Technology. 2015. "Billion Prices Project." Accessed March 4, 2015. http://bpp.mit.edu/usa/.


# The International Trade and Capital Flows

## Introduction to the International Trade and Capital Flows

The balance of trade (or trade balance) is any gap between a nation’s dollar value of its exports, or what its producers sell abroad, and a nation’s dollar value of imports, or the foreign-made products and services that households and businesses purchase. Recall from The Macroeconomic Perspective that if exports exceed imports, the economy has a trade surplus. If imports exceed exports, the economy has a trade deficit. If exports and imports are equal, then trade is balanced, but what happens when trade is out of balance and large trade surpluses or deficits exist?
Germany, for example, has had substantial trade surpluses in recent decades, in which exports have greatly exceeded imports. According to the World Bank, in 2020, Germany ran a trade surplus of $242 billion. In contrast, the U.S. economy in recent decades has experienced large trade deficits, in which imports have considerably exceeded exports. In 2020, for example, U.S. imports exceeded exports by $651 billion.
A series of financial crises triggered by unbalanced trade can lead economies into deep recessions. These crises begin with large trade deficits. At some point, foreign investors become pessimistic about the economy and move their money to other countries. The economy then drops into deep recession, with real GDP often falling up to 10% or more in a single year. This happened to Mexico in 1995 when their GDP fell 8.1%. A number of countries in East Asia—Thailand, South Korea, Malaysia, and Indonesia—succumbed to the same economic illness in 1997–1998 (called the Asian Financial Crisis). In the late 1990s and into the early 2000s, Russia and Argentina had the identical experience. What are the connections between imbalances of trade in goods and services and the flows of international financial capital that set off these economic avalanches?
We will start by examining the balance of trade in more detail, by looking at some patterns of trade balances in the United States and around the world. Then we will examine the intimate connection between international flows of goods and services and international flows of financial capital, which to economists are really just two sides of the same coin. People often assume that trade surpluses like those in Germany must be a positive sign for an economy, while trade deficits like those in the United States must be harmful. As it turns out, both trade surpluses and deficits can be either good or bad. We will see why in this chapter.


# The International Trade and Capital Flows

## Measuring Trade Balances

A few decades ago, it was common to track the solid or physical items that planes, trains, and trucks transported between countries as a way of measuring the balance of trade. Economists call this measurement the merchandise trade balance. In most high-income economies, including the United States, goods comprise less than half of a country’s total production, while services comprise more than half. The last two decades have seen a surge in international trade in services, powered by technological advances in telecommunications and computers that have made it possible to export or import customer services, finance, law, advertising, management consulting, software, construction engineering, and product design. Most global trade still takes the form of goods rather than services, and the government announces and the media prominently report the merchandise trade balance. Old habits are hard to break. Economists, however, typically rely on broader measures such as the balance of trade or the current account balance which includes other international flows of income and foreign aid.

### Components of the U.S. Current Account Balance

 breaks down the four main components of the U.S. current account balance for the last quarter of 2015 (seasonally adjusted). The first line shows the merchandise trade balance; that is, exports and imports of goods. Because imports exceed exports, the trade balance in the final column is negative, showing a merchandise trade deficit. We can explain how the government collects this trade information in the following Clear It Up feature.
The second row of  provides data on trade in services. Here, the U.S. economy is running a surplus. Although the level of trade in services is still relatively small compared to trade in goods, the importance of services has expanded substantially over the last few decades. For example, U.S. exports of services were equal to about one-half of U.S. exports of goods in 2020, compared to one-fifth in 1980.
The third component of the current account balance, labeled “income payments,” refers to money that U.S. financial investors received on their foreign investments (money flowing into the United States) and payments to foreign investors who had invested their funds here (money flowing out of the United States). The reason for including this money on foreign investment in the overall measure of trade, along with goods and services, is that, from an economic perspective, income is just as much an economic transaction as car, wheat, or oil shipments: it is just trade that is happening in the financial capital market.
The final category of the current account balance is unilateral transfers, which are payments that government, private charities, or individuals make in which they send money abroad without receiving any direct good or service. Economic or military assistance from the U.S. government to other countries fits into this category, as does spending abroad by charities to address poverty or social inequalities. When an individual in the United States sends money overseas, as is the case with some immigrants, it is also counted in this category. The current account balance treats these unilateral payments like imports, because they also involve a stream of payments leaving the country. For the U.S. economy, unilateral transfers are almost always negative. This pattern, however, does not always hold. In 1991, for example, when the United States led an international coalition against Saddam Hussein’s Iraq in the Gulf War, many other nations agreed that they would make payments to the United States to offset the U.S. war expenses. These payments were large enough that, in 1991, the overall U.S. balance on unilateral transfers was a positive $10 billion.
The following Work It Out feature steps you through the process of using the values for goods, services, and income payments to calculate the merchandise balance and the current account balance.

### Key Concepts and Summary

The trade balance measures the gap between a country’s exports and its imports. In most high-income economies, goods comprise less than half of a country’s total production, while services comprise more than half. The last two decades have seen a surge in international trade in services; however, most global trade still takes the form of goods rather than services. The current account balance includes the trade in goods, services, and money flowing into and out of a country from investments and unilateral transfers.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### Problems

### References

Central Intelligence Agency. “The World Factbook.” Last modified October 31, 2013. https://www.cia.gov/library/publications/the-world-factbook/geos/gm.html.
U.S. Department of Commerce. “Bureau of Economic Analysis.” Last modified December 1, 2013. http://www.bea.gov/.
U.S. Department of Commerce. “United States Census Bureau.” http://www.census.gov/.


# The International Trade and Capital Flows

## Trade Balances in Historical and International Context

We present the history of the U.S. current account balance in recent decades in several different ways.  (a) shows the current account balance and the merchandise trade balance—the latter of which is simply the balance on goods exported versus imported—in dollar terms.  (b) shows the current account balance and merchandise account balance yet again, this time as a share of the GDP for that year. By dividing the trade deficit in each year by GDP in that year,  (b) factors out both inflation and growth in the real economy.
By either measure, the U.S. balance of trade pattern is clear. From the 1960s into the 1970s, the U.S. economy had mostly small trade surpluses—that is, the graphs in  show positive numbers. However, starting in the 1980s, the trade deficit increased rapidly, and after a tiny surplus in 1991, the current account trade deficit became even larger in the late 1990s and into the mid-2000s. However, the trade deficit declined in 2009 after the recession had taken hold, then rebounded partially in 2010 and remained stable up through 2019, before falling again in 2020.
Current Account Balance in Billions of Dollars.
 shows the U.S. trade picture in 2013 compared with some other economies from around the world. While the U.S. economy has consistently run trade deficits in recent years, Japan and many European nations, among them France and Germany, have consistently run trade surpluses. Some of the other countries listed include Brazil, the largest economy in Latin America; Nigeria, along with South Africa competing to be the largest economy in Africa; and China, India, and Korea. The first column offers one measure of an economy's globalization: exports of goods and services as a percentage of GDP. The second column shows the trade balance. Usually, most countries have trade surpluses or deficits that are less than 5% of GDP. As you can see, the U.S. current account balance is –2.6% of GDP, while Germany's is 8.4% of GDP.

### Key Concepts and Summary

The United States developed large trade surpluses in the early 1980s, swung back to a tiny trade surplus in 1991, and then had even larger trade deficits in the late 1990s and early 2000s. As we will see below, a trade deficit necessarily means a net inflow of financial capital from abroad, while a trade surplus necessarily means a net outflow of financial capital from an economy to other countries.

### Self-Check Questions

### Review Question

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# The International Trade and Capital Flows

## Trade Balances and Flows of Financial Capital

As economists see it, trade surpluses can be either good or bad, depending on circumstances, and trade deficits can be good or bad, too. The challenge is to understand how the international flows of goods and services are connected with international flows of financial capital. In this module we will illustrate the intimate connection between trade balances and flows of financial capital in two ways: a parable of trade between Robinson Crusoe and Friday, and a circular flow diagram representing flows of trade and payments.

### A Two-Person Economy: Robinson Crusoe and Friday

To understand how economists view trade deficits and surpluses, consider a parable based on the story of Robinson Crusoe. Crusoe, as you may remember from the classic novel by Daniel Defoe first published in 1719, was shipwrecked on a desert island. After living alone for some time, he is joined by a second person, whom he names Friday. Think about the balance of trade in a two-person economy like that of Robinson and Friday.
Robinson and Friday trade goods and services. Perhaps Robinson catches fish and trades them to Friday for coconuts, or Friday weaves a hat out of tree fronds and trades it to Robinson for help in carrying water. For a period of time, each individual trade is self-contained and complete. Because each trade is voluntary, both Robinson and Friday must feel that they are receiving fair value for what they are giving. As a result, each person’s exports are always equal to his imports, and trade is always in balance between the two. Neither person experiences either a trade deficit or a trade surplus.
However, one day Robinson approaches Friday with a proposition. Robinson wants to dig ditches for an irrigation system for his garden, but he knows that if he starts this project, he will not have much time left to fish and gather coconuts to feed himself each day. He proposes that Friday supply him with a certain number of fish and coconuts for several months, and then after that time, he promises to repay Friday out of the extra produce that he will be able to grow in his irrigated garden. If Friday accepts this offer, then a trade imbalance comes into being. For several months, Friday will have a trade surplus: that is, he is exporting to Robinson more than he is importing. More precisely, he is giving Robinson fish and coconuts, and at least for the moment, he is receiving nothing in return. Conversely, Robinson will have a trade deficit, because he is importing more from Friday than he is exporting.
This parable raises several useful issues in thinking about what a trade deficit and a trade surplus really mean in economic terms. The first issue that this story of Robinson and Friday raises is this: Is it better to have a trade surplus or a trade deficit? The answer, as in any voluntary market interaction, is that if both parties agree to the transaction, then they may both be better off. Over time, if Robinson’s irrigated garden is a success, it is certainly possible that both Robinson and Friday can benefit from this agreement.
The parable raises a second issue: What can go wrong? Robinson’s proposal to Friday introduces an element of uncertainty. Friday is, in effect, making a loan of fish and coconuts to Robinson, and Friday’s happiness with this arrangement will depend on whether Robinson repays that loan as planned, in full and on time. Perhaps Robinson spends several months loafing and never builds the irrigation system, or perhaps Robinson has been too optimistic about how much he will be able to grow with the new irrigation system, which turns out not to be very productive. Perhaps, after building the irrigation system, Robinson decides that he does not want to repay Friday as much as he previously agreed. Any of these developments will prompt a new round of negotiations between Friday and Robinson. Why the repayment failed is likely to shape Friday’s attitude toward these renegotiations. If Robinson worked very hard and the irrigation system just did not increase production as intended, Friday may have some sympathy. If Robinson loafed or if he just refuses to pay, Friday may become irritated.
A third issue that the parable raises is that an intimate relationship exists between a trade deficit and international borrowing, and between a trade surplus and international lending. The size of Friday’s trade surplus is exactly how much he is lending to Robinson. The size of Robinson’s trade deficit is exactly how much he is borrowing from Friday. To economists, a trade surplus literally means the same thing as an outflow of financial capital, and a trade deficit literally means the same thing as an inflow of financial capital. This last insight is worth exploring in greater detail, which we will do in the following section.
The story of Robinson and Friday also provides a good opportunity to consider the law of comparative advantage, which you learn more about in the International Trade chapter. The following Work It Out feature steps you through calculating comparative advantage for the wheat and cloth traded between the United States and Great Britain in the 1800s.

### The Balance of Trade as the Balance of Payments

The connection between trade balances and international flows of financial capital is so close that economists sometimes describe the balance of trade as the balance of payments. Each category of the current account balance involves a corresponding flow of payments between a given country and the rest of the world economy.
 shows the flow of goods and services and payments between one country—the United States in this example—and the rest of the world. The top line shows U.S. exports of goods and services, while the second line shows financial payments from purchasers in other countries back to the U.S. economy. The third line then shows U.S. imports of goods, services, and investment, and the fourth line shows payments from the home economy to the rest of the world. Flow of goods and services (lines one and three) show up in the current account, while we find flow of funds (lines two and four) in the financial account.
The bottom four lines in  show the flows of investment income. In the first of the bottom lines, we see investments made abroad with funds flowing from the home country to the rest of the world. Investment income stemming from an investment abroad then runs in the other direction from the rest of the world to the home country. Similarly, we see on the bottom third line, an investment from the rest of the world into the home country and investment income (bottom fourth line) flowing from the home country to the rest of the world. We find the investment income (bottom lines two and four) in the current account, while investment to the rest of the world or into the home country (lines one and three) is in the financial account. This figure does not show unilateral transfers, the fourth item in the current account.
A current account deficit means that, the country is a net borrower from abroad. Conversely, a positive current account balance means a country is a net lender to the rest of the world. Just like the parable of Robinson and Friday, the lesson is that a trade surplus means an overall outflow of financial investment capital, as domestic investors put their funds abroad, while a deficit in the current account balance is exactly equal to the overall or net inflow of foreign investment capital from abroad.
It is important to recognize that an inflow and outflow of foreign capital does not necessarily refer to a debt that governments owe to other governments, although government debt may be part of the picture. Instead, these international flows of financial capital refer to all of the ways in which private investors in one country may invest in another country—by buying real estate, companies, and financial investments like stocks and bonds.

### Key Concepts and Summary

International flows of goods and services are closely connected to the international flows of financial capital. A current account deficit means that, after taking all the flows of payments from goods, services, and income together, the country is a net borrower from the rest of the world. A current account surplus is the opposite and means the country is a net lender to the rest of the world.

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# The International Trade and Capital Flows

## The National Saving and Investment Identity

The close connection between trade balances and international flows of savings and investments leads to a macroeconomic analysis. This approach views trade balances—and their associated flows of financial capital—in the context of the overall levels of savings and financial investment in the economy.

### Understanding the Determinants of the Trade and Current Account Balance

The national saving and investment identity provides a useful way to understand the determinants of the trade and current account balance. In a nation’s financial capital market, the quantity of financial capital supplied at any given time must equal the quantity of financial capital demanded for purposes of making investments. What is on the supply and demand sides of financial capital? See the following Clear It Up feature for the answer to this question.
There are two main sources for the supply of financial capital in the U.S. economy: saving by individuals and firms, called S, and the inflow of financial capital from foreign investors, which is equal to the trade deficit (M – X), or imports minus exports. There are also two main sources of demand for financial capital in the U.S. economy: private sector investment, I, and government borrowing, where the government needs to borrow when government spending, G, is higher than the taxes collected, T. We can express this national savings and investment identity in algebraic terms:
Again, in this equation, S is private savings, T is taxes, G is government spending, M is imports, X is exports, and I is investment. This relationship is true as a matter of definition because, for the macro economy, the quantity supplied of financial capital must be equal to the quantity demanded.
However, certain components of the national savings and investment identity can switch between the supply side and the demand side. Some countries, like the United States in most years since the 1970s, have budget deficits, which mean the government is spending more than it collects in taxes, and so the government needs to borrow funds. In this case, the government term would be G – T > 0, showing that spending is larger than taxes, and the government would be a demander of financial capital on the right-hand side of the equation (that is, a borrower), not a supplier of financial capital on the left-hand side. However, if the government runs a budget surplus so that the taxes exceed spending, as the U.S. government did from 1998 to 2001, then the government in that year was contributing to the supply of financial capital (T – G > 0), and would appear on the left (supplier or saving) side of the national savings and investment identity.
Similarly, if a national economy runs a trade surplus, the trade sector will involve an outflow of financial capital to other countries. A trade surplus means that the domestic financial capital is in surplus within a country and can be invested in other countries.
The fundamental notion that total quantity of financial capital demanded equals total quantity of financial capital supplied must always remain true. Domestic savings will always appear as part of the supply of financial capital and domestic investment will always appear as part of the demand for financial capital. However, the government and trade balance elements of the equation can move back and forth as either suppliers or demanders of financial capital, depending on whether government budgets and the trade balance are in surplus or deficit.

### Domestic Saving and Investment Determine the Trade Balance

One insight from the national saving and investment identity is that a nation's own levels of domestic saving and investment determine a nation’s balance of trade. To understand this point, rearrange the identity to put the balance of trade all by itself on one side of the equation. Consider first the situation with a trade deficit, and then the situation with a trade surplus.
In the case of a trade deficit, the national saving and investment identity can be rewritten as:

In this case, domestic investment is higher than domestic saving, including both private and government saving. The only way that domestic investment can exceed domestic saving is if capital is flowing into a country from abroad. After all, that extra financial capital for investment has to come from someplace.
Now consider a trade surplus from the standpoint of the national saving and investment identity:

In this case, domestic savings (both private and public) is higher than domestic investment. That extra financial capital will be invested abroad.
This connection of domestic saving and investment to the trade balance explains why economists view the balance of trade as a fundamentally macroeconomic phenomenon. As the national saving and investment identity shows, the performance of certain sectors of an economy, like cars or steel, do not determine the trade balance. Further, whether the nation’s trade laws and regulations encourage free trade or protectionism also does not determine the trade balance (see Globalization and Protectionism).

### Exploring Trade Balances One Factor at a Time

The national saving and investment identity also provides a framework for thinking about what will cause trade deficits to rise or fall. Begin with the version of the identity that has domestic savings and investment on the left and the trade deficit on the right:

Now, consider the factors on the left-hand side of the equation one at a time, while holding the other factors constant.
As a first example, assume that the level of domestic investment in a country rises, while the level of private and public saving remains unchanged.  shows the result in the first row under the equation. Since the equality of the national savings and investment identity must continue to hold—it is, after all, an identity that must be true by definition—the rise in domestic investment will mean a higher trade deficit. This situation occurred in the U.S. economy in the late 1990s. Because of the surge of new information and communications technologies that became available, business investment increased substantially. A fall in private saving during this time and a rise in government saving more or less offset each other. As a result, the financial capital to fund that business investment came from abroad, which is one reason for the very high U.S. trade deficits of the late 1990s and early 2000s.
As a second scenario, assume that the level of domestic savings rises, while the level of domestic investment and public savings remain unchanged. In this case, the trade deficit would decline. As domestic savings rises, there would be less need for foreign financial capital to meet investment needs. For this reason, a policy proposal often made for reducing the U.S. trade deficit is to increase private saving—although exactly how to increase the overall rate of saving has proven controversial.
As a third scenario, imagine that the government budget deficit increased dramatically, while domestic investment and private savings remained unchanged. This scenario occurred in the U.S. economy in the mid-1980s. The federal budget deficit increased from $79 billion in 1981 to $221 billion in 1986—an increase in the demand for financial capital of $142 billion. The current account balance collapsed from a surplus of $5 billion in 1981 to a deficit of $147 billion in 1986—an increase in the supply of financial capital from abroad of $152 billion. The connection at that time is clear: a sharp increase in government borrowing increased the U.S. economy’s demand for financial capital, and foreign investors through the trade deficit primarily supplied that increase. The following Work It Out feature walks you through a scenario in which private domestic savings has to rise by a certain amount to reduce a trade deficit.

### Short-Term Movements in the Business Cycle and the Trade Balance

In the short run, whether an economy is in a recession or on the upswing can affect trade imbalances. A recession tends to make a trade deficit smaller, or a trade surplus larger, while a period of strong economic growth tends to make a trade deficit larger, or a trade surplus smaller. These are not hard-and-fast rules, however.
As an example, note in  that the U.S. trade deficit declined by almost half from 2006 to 2009. One primary reason for this change is that during the recession, as the U.S. economy slowed down, it purchased fewer of all goods, including fewer imports from abroad. However, buying power abroad fell less, and so U.S. exports did not fall by as much. On the other hand, during the 2020 pandemic-induced recession, the trade deficit expanded (current account balance plummeted) as the U.S. economy became more reliant on other countries for goods and services.
Conversely, in the mid-2000s, when the U.S. trade deficit became very large, a contributing short-term reason is that the U.S. economy was growing. As a result, there was considerable aggressive buying in the U.S. economy, including the buying of imports. Thus, a trade deficit (or a much lower trade surplus) often accompanies a rapidly growing domestic economy, while a trade surplus (or a much lower trade deficit) accompanies a slowing or recessionary domestic economy.
Regardless of whether the trade deficit falls or rises during expansions or downturns, when the trade deficit rises, it necessarily means a greater net inflow of foreign financial capital. The national saving and investment identity teaches that the rest of the economy can absorb this inflow of foreign financial capital in several different ways. For example, reduced private savings could offset the additional inflow of financial capital from abroad, leaving domestic investment and public saving unchanged. Alternatively, the inflow of foreign financial capital could result in higher domestic investment, leaving private and public saving unchanged. Yet another possibility is that greater government borrowing could absorb the inflow of foreign financial capital, leaving domestic saving and investment unchanged. The national saving and investment identity does not specify which of these scenarios, alone or in combination, will occur—only that one of them must occur.

### Key Concepts and Summary

The national saving and investment identity is based on the relationship that the total quantity of financial capital supplied from all sources must equal the total quantity of financial capital demanded from all sources. If S is private saving, T is taxes, G is government spending, M is imports, X is exports, and I is investment, then for an economy with a current account deficit and a budget deficit:

A recession tends to increase the trade balance (meaning a higher trade surplus or lower trade deficit), while economic boom will tend to decrease the trade balance (meaning a lower trade surplus or a larger trade deficit).

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# The International Trade and Capital Flows

## The Pros and Cons of Trade Deficits and Surpluses

Because flows of trade always involve flows of financial payments, flows of international trade are actually the same as flows of international financial capital. The question of whether trade deficits or surpluses are good or bad for an economy is, in economic terms, exactly the same question as whether it is a good idea for an economy to rely on net inflows of financial capital from abroad or to make net investments of financial capital abroad. Conventional wisdom often holds that borrowing money is foolhardy, and that a prudent country, like a prudent person, should always rely on its own resources. While it is certainly possible to borrow too much—as anyone with an overloaded credit card can testify—borrowing at certain times can also make sound economic sense. For both individuals and countries, there is no economic merit in a policy of abstaining from participation in financial capital markets.
It makes economic sense to borrow when you are buying something with a long-run payoff; that is, when you are making an investment. For this reason, it can make economic sense to borrow for a college education, because the education will typically allow you to earn higher wages, and so to repay the loan and still come out ahead. It can also make sense for a business to borrow in order to purchase a machine that will last 10 years, as long as the machine will increase output and profits by more than enough to repay the loan. Similarly, it can make economic sense for a national economy to borrow from abroad, as long as it wisely invests the money in ways that will tend to raise the nation’s economic growth over time. Then, it will be possible for the national economy to repay the borrowed money over time and still end up better off than before.
One vivid example of a country that borrowed heavily from abroad, invested wisely, and did perfectly well is the United States during the nineteenth century. The United States ran a trade deficit in 40 of the 45 years from 1831 to 1875, which meant that it was importing capital from abroad over that time. However, that financial capital was mostly invested in projects like railroads that brought a substantial economic payoff. (See the following Clear It Up feature for more on this.)
A more recent example along these lines is the experience of South Korea, which had trade deficits during much of the 1970s—and so was an importer of capital over that time. However, South Korea also had high rates of investment in physical plant and equipment, and its economy grew rapidly. From the mid-1980s into the mid-1990s, South Korea often had trade surpluses—that is, it was repaying its past borrowing by sending capital abroad.
In contrast, some countries have run large trade deficits, borrowed heavily in global capital markets, and ended up in all kinds of trouble. Two specific sorts of trouble are worth examining. First, a borrower nation can find itself in a bind if it does not invest the incoming funds from abroad in a way that leads to increased productivity. Several of Latin America's large economies, including Mexico and Brazil, ran large trade deficits and borrowed heavily from abroad in the 1970s, but the inflow of financial capital did not boost productivity sufficiently, which meant that these countries faced enormous troubles repaying the money borrowed when economic conditions shifted during the 1980s. Similarly, it appears that a number of African nations that borrowed foreign funds in the 1970s and 1980s did not invest in productive economic assets. As a result, several of those countries later faced large interest payments, with no economic growth to show for the borrowed funds.
A second “trouble” is: What happens if the foreign money flows in, and then suddenly flows out again? We raised this scenario at the start of the chapter. In the mid-1990s, a number of countries in East Asia—Thailand, Indonesia, Malaysia, and South Korea—ran large trade deficits and imported capital from abroad. However, in 1997 and 1998 many foreign investors became concerned about the health of these economies, and quickly pulled their money out of stock and bond markets, real estate, and banks. The extremely rapid departure of that foreign capital staggered the banking systems and economies of these countries, plunging them into deep recession. We investigate and discuss the links between international capital flows, banks, and recession in The Impacts of Government Borrowing.
While a trade deficit is not always harmful, there is no guarantee that running a trade surplus will bring robust economic health. For example, Germany and Japan ran substantial trade surpluses for most of the last three decades. Regardless of their persistent trade surpluses, both countries have experienced occasional recessions and neither country has had especially robust annual growth in recent years. Read more about Japan’s trade surplus in the next Clear It Up feature.
The sheer size and persistence of the U.S. trade deficits and inflows of foreign capital since the 1980s are a legitimate cause for concern. The huge U.S. economy will not be destabilized by an outflow of international capital as easily as, say, the comparatively tiny economies of Thailand and Indonesia were in 1997–1998. Even an economy that is not knocked down, however, can still be shaken. American policymakers should certainly be paying attention to those cases where a pattern of extensive and sustained current account deficits and foreign borrowing has gone badly—if only as a cautionary tale.

### Key Concepts and Summary

Trade surpluses are no guarantee of economic health, and trade deficits are no guarantee of economic weakness. Either trade deficits or trade surpluses can work out well or poorly, depending on whether a government wisely invests the corresponding flows of financial capital.

### Self-Check Questions

### Review Questions

### Critical Thinking Question

### References

Tabuchi, Hiroko. “Japan Reports a $78 Billion Trade Deficit for 2012.” The New York Times, January 23, 2013. http://www.nytimes.com/2013/01/24/business/global/japan-reports-a-78-billion-trade-deficit-for-2012.html?_r=0.
World Bank. 2014. "Exports of Goods and Services (% of GDP)." Accesed April 13, 2015. http://data.worldbank.org/indicator/NE.EXP.GNFS.ZS/countries.


# The International Trade and Capital Flows

## The Difference between Level of Trade and the Trade Balance

A nation’s level of trade may at first sound like much the same issue as the balance of trade, but these two are actually quite separate. It is perfectly possible for a country to have a very high level of trade—measured by its exports of goods and services as a share of its GDP—while it also has a near-balance between exports and imports. A high level of trade indicates that the nation exports a good portion of its production. It is also possible for a country’s trade to be a relatively low share of GDP, relative to global averages, but for the imbalance between its exports and its imports to be quite large. We emphasized this general theme earlier in Measuring Trade Balances, which offered some illustrative figures on trade levels and balances.
A country’s level of trade tells how much of its production it exports. We measure this by the percent of exports out of GDP. It indicates the degree of an economy's globalization. Some countries, such as Germany, have a high level of trade—they export almost 50% of their total production. The balance of trade tells us if the country is running a trade surplus or trade deficit. A country can have a low level of trade but a high trade deficit. (For example, the United States only exports around 10% of its GDP, but it has a trade deficit of over $600 billion.)
Three factors strongly influence a nation’s level of trade: the size of its economy, its geographic location, and its history of trade. Large economies like the United States can do much of their trading internally, while small economies like Sweden have less ability to provide what they want internally and tend to have higher ratios of exports and imports to GDP. Nations that are neighbors tend to trade more, since costs of transportation and communication are lower. Moreover, some nations have long and established patterns of international trade, while others do not.
Consequently, a relatively small economy like Sweden, with many nearby trading partners across Europe and a long history of foreign trade, has a high level of trade. Brazil and India, which are fairly large economies that have often sought to inhibit trade in recent decades, have lower levels of trade; whereas, the United States and Japan are extremely large economies that have comparatively few nearby trading partners. Both countries actually have quite low levels of trade by world standards. The ratio of exports to GDP in either the United States or in Japan is about half of the world average.
The balance of trade is a separate issue from the level of trade. The United States has a low level of trade, but had enormous trade deficits for most years from the mid-1980s into the 2000s. Japan has a low level of trade by world standards, but has typically shown large trade surpluses in recent decades. Nations like Germany and the United Kingdom have medium to high levels of trade by world standards, but Germany had a moderate trade surplus in 2020, while the United Kingdom had a moderate trade deficit. Their trade picture was roughly in balance in the late 1990s. Sweden had a high level of trade and a moderate trade surplus in 2020, while Canada had a high level of trade and a moderate trade deficit that same year.
In short, it is quite possible for nations with a relatively low level of trade, expressed as a percentage of GDP, to have relatively large trade deficits. It is also quite possible for nations with a near balance between exports and imports to worry about the consequences of high levels of trade for the economy. It is not inconsistent to believe that a high level of trade is potentially beneficial to an economy, because of the way it allows nations to play to their comparative advantages, and to also be concerned about any macroeconomic instability caused by a long-term pattern of large trade deficits. The following Clear It Up feature discusses how this sort of dynamic played out in Colonial India.

### Final Thoughts about Trade Balances

Trade deficits can be a good or a bad sign for an economy, and trade surpluses can be a good or a bad sign. Even a trade balance of zero—which just means that a nation is neither a net borrower nor lender in the international economy—can be either a good or bad sign. The fundamental economic question is not whether a nation’s economy is borrowing or lending at all, but whether the particular borrowing or lending in the particular economic conditions of that country makes sense.
It is interesting to reflect on how public attitudes toward trade deficits and surpluses might change if we could somehow change the labels that people and the news media affix to them. If we called a trade deficit “attracting foreign financial capital”—which accurately describes what a trade deficit means—then trade deficits might look more attractive. Conversely, if we called a trade surplus “shipping financial capital abroad”—which accurately captures what a trade surplus does—then trade surpluses might look less attractive. Either way, the key to understanding trade balances is to understand the relationships between flows of trade and flows of international payments, and what these relationships imply about the causes, benefits, and risks of different kinds of trade balances. The first step along this journey of understanding is to move beyond knee-jerk reactions to terms like “trade surplus,” “trade balance,” and “trade deficit.”

### Key Concepts and Summary

There is a difference between the level of a country’s trade and the balance of trade. The government measures its level of trade by the percentage of exports out of GDP, or the size of the economy. Small economies that have nearby trading partners and a history of international trade will tend to have higher levels of trade. Larger economies with few nearby trading partners and a limited history of international trade will tend to have lower levels of trade. The level of trade is different from the trade balance. The level of trade depends on a country’s history of trade, its geography, and the size of its economy. A country’s balance of trade is the dollar difference between its exports and imports.
Trade deficits and trade surpluses are not necessarily good or bad—it depends on the circumstances. Even if a country is borrowing, if it invests that money in productivity-boosting investments it can lead to an improvement in long-term economic growth.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions


# The Aggregate Demand/Aggregate Supply Model

## Introduction to the Aggregate Supply–Aggregate Demand Model

New One-Family Houses Sold in the United States.
A key part of macroeconomics is the use of models to analyze macro issues and problems. How is the rate of economic growth connected to changes in the unemployment rate? Is there a reason why unemployment and inflation seem to move in opposite directions: lower unemployment and higher inflation from 1997 to 2000, higher unemployment and lower inflation in the early 2000s, lower unemployment and higher inflation in the mid-2000s, and then higher unemployment and lower inflation in 2009? Why did the current account deficit rise so high, but then decline in 2009?
To analyze questions like these, we must move beyond discussing macroeconomic issues one at a time, and begin building economic models that will capture the relationships and interconnections between them. The next three chapters take up this task. This chapter introduces the macroeconomic model of aggregate supply and aggregate demand, how the two interact to reach a macroeconomic equilibrium, and how shifts in aggregate demand or aggregate supply will affect that equilibrium. This chapter also relates the model of aggregate supply and aggregate demand to the three goals of economic policy (growth, unemployment, and inflation), and provides a framework for thinking about many of the connections and tradeoffs between these goals. The chapter on The Keynesian Perspective focuses on the macroeconomy in the short run, where aggregate demand plays a crucial role. The chapter on The Neoclassical Perspective explores the macroeconomy in the long run, where aggregate supply plays a crucial role.


# The Aggregate Demand/Aggregate Supply Model

## Macroeconomic Perspectives on Demand and Supply

Macroeconomists over the last two centuries have often divided into two groups: those who argue that supply is the most important determinant of the size of the macroeconomy while demand just tags along, and those who argue that demand is the most important factor in the size of the macroeconomy while supply just tags along.

### Say’s Law and the Macroeconomics of Supply

Those economists who emphasize the role of supply in the macroeconomy often refer to the work of a famous early nineteenth century French economist named Jean-Baptiste Say (1767–1832). Say’s law is: “Supply creates its own demand.” As a matter of historical accuracy, it seems clear that Say never actually wrote down this law and that it oversimplifies his beliefs, but the law lives on as useful shorthand for summarizing a point of view.
The intuition behind Say’s law is that each time a good or service is produced and sold, it generates income that is earned for someone: a worker, a manager, an owner, or those who are workers, managers, and owners at firms that supply inputs along the chain of production. We alluded to this earlier in our discussion of the National Income approach to measuring GDP. The forces of supply and demand in individual markets will cause prices to rise and fall. The bottom line remains, however, that every sale represents income to someone, and so, Say’s law argues, a given value of supply must create an equivalent value of demand somewhere else in the economy. Because Jean-Baptiste Say, Adam Smith, and other economists writing around the turn of the nineteenth century who discussed this view were known as “classical” economists, modern economists who generally subscribe to the Say’s law view on the importance of supply for determining the size of the macroeconomy are called neoclassical economists.
If supply always creates exactly enough demand at the macroeconomic level, then (as Say himself recognized) it is hard to understand why periods of recession and high unemployment should ever occur. To be sure, even if total supply always creates an equal amount of total demand, the economy could still experience a situation of some firms earning profits while other firms suffer losses. Nevertheless, a recession is not a situation where all business failures are exactly counterbalanced by an offsetting number of successes. A recession is a situation in which the economy as a whole is shrinking in size, business failures outnumber the remaining success stories, and many firms end up suffering losses and laying off workers.
Say’s law that supply creates its own demand does seem a good approximation for the long run. Over periods of some years or decades, as the productive power of an economy to supply goods and services increases, total demand in the economy grows at roughly the same pace. However, over shorter time horizons of a few months or even years, recessions or even depressions occur in which firms, as a group, seem to face a lack of demand for their products.

### Keynes’ Law and the Macroeconomics of Demand

The alternative to Say’s law, with its emphasis on supply, is Keynes’ law: “Demand creates its own supply.” As a matter of historical accuracy, just as Jean-Baptiste Say never wrote down anything as simpleminded as Say’s law, John Maynard Keynes never wrote down Keynes’ law, but the law is a useful simplification that conveys a certain point of view.
When Keynes wrote his influential work The General Theory of Employment, Interest, and Money during the 1930s Great Depression, he pointed out that during the Depression, the economy's capacity to supply goods and services had not changed much. U.S. unemployment rates soared higher than 20% from 1933 to 1935, but the number of possible workers had not increased or decreased much. Factories closed, but machinery and equipment had not disappeared. Technologies that had been invented in the 1920s were not un-invented and forgotten in the 1930s. Thus, Keynes argued that the Great Depression—and many ordinary recessions as well—were not caused by a drop in the ability of the economy to supply goods as measured by labor, physical capital, or technology. He argued the economy often produced less than its full potential, not because it was technically impossible to produce more with the existing workers and machines, but because a lack of demand in the economy as a whole led to inadequate incentives for firms to produce. In such cases, he argued, the level of GDP in the economy was not primarily determined by the potential of what the economy could supply, but rather by the amount of total demand.
Keynes’ law seems to apply fairly well in the short run of a few months to a few years, when many firms experience either a drop in demand for their output during a recession or so much demand that they have trouble producing enough during an economic boom. However, demand cannot tell the whole macroeconomic story, either. After all, if demand was all that mattered at the macroeconomic level, then the government could make the economy as large as it wanted just by pumping up total demand through a large increase in the government spending component or by legislating large tax cuts to push up the consumption component. Economies do, however, face genuine limits to how much they can produce, limits determined by the quantity of labor, physical capital, technology, and the institutional and market structures that bring these factors of production together. These constraints on what an economy can supply at the macroeconomic level do not disappear just because of an increase in demand.

### Combining Supply and Demand in Macroeconomics

Two insights emerge from this overview of Say’s law with its emphasis on macroeconomic supply and Keynes’ law with its emphasis on macroeconomic demand. The first conclusion, which is not exactly a hot news flash, is that an economic approach focused only on the supply side or only on the demand side can be only a partial success. We need to take into account both supply and demand. The second conclusion is that since Keynes’ law applies more accurately in the short run and Say’s law applies more accurately in the long run, the tradeoffs and connections between the three goals of macroeconomics may be different in the short run and the long run.

### Key Concepts and Summary

Neoclassical economists emphasize Say’s law, which holds that supply creates its own demand. Keynesian economists emphasize Keynes’ law, which holds that demand creates its own supply. Many mainstream economists take a Keynesian perspective, emphasizing the importance of aggregate demand, for the short run, and a neoclassical perspective, emphasizing the importance of aggregate supply, for the long run.

### Self-Check Questions

### Review Questions

### Critical Thinking Question

### References

Keynes, John Maynard. The General Theory of Employment, Interest and Money. London: Palgrave Macmillan, 1936.
U.S. Department of Commerce: United States Census Bureau. “New Residential Sales: Historical Data.” http://www.census.gov/construction/nrs/historical_data/.