The Bad Economist

Increases in CPI: Good or bad? January 30, 2012

One of the nice things about WordPress is that I get a nice summary of the search engine terms that led people to my page. Bobby Bonilla is popular, as always – it’s nice to know that people are curious about him – but another common way people end up on my blog is by looking for pros and cons of the Consumer Price Index. One searcher this week asked:

Is an increase in CPI good or bad?

As with all economics, the answer is, “It depends,” but let’s start by asking a refining question: Good or bad for whom?

• The Government: Good.
  

An increase in the CPI represents an increasing cost of living, which is related to inflation. Inflation, as measured by an increase in the CPI, means that the government can sign contracts to pay employees or purchase materials in current dollars and then pay them back in inflated dollars; that is, if I sign a contract today, January 30, 2012, to pay you $100 on January 30, 2013, then the $100 I have now is worth more than the $100 I’ll pay you back with. (This is one reason for interest payments.) Of course, if everyone expects the inflation, they’ll take that into account when contracting with the government and demand higher payments. A government can, in fact, use large unexpected inflation to cut their costs this way – it’s called an inflation tax, and we’ll talk about it a little later on – but it’s not  a strategy that works well or often.

• Businesses: Good.

Businesses can take a beating if they’re contracting with governments, but consider wage contracts – when I worked at a factory, pay rates were set by position in January, so my only hope of getting a raise was to move to a higher position. If CPI rose over the course of the year, which it almost always did, I took what was effectively a pay cut until the next round of  cost-of-living adjustments in January. That means that the business could negotiate contracts throughout the year for supplies and sales, but its real wage expenses actually fell.

• Consumers: Bad (mostly).

And who takes the brunt of the drop in real wages? Households, or consumers. Since I lack the power to demand my wages rise throughout the course of the year, then my wages on January 1 are going to buy fewer goods than my wages on December 31, even though they’re nominally the same amount of money.

On the other hand, a small, predictable amount of inflation allows for a few things to happen. If it’s small, it means that prices more or less stay the same. (A large inflation rate would make it impossible for me to keep the same wage from January 1 to December 31 without built-in monthly or quarterly raises, for example.) If it’s predictable, we avoid a couple of ugly problems like the inflation tax or surprises when repaying loans. If it’s inflation, rather than deflation, people and businesses have a smaller incentive to hold on to their money to wait for prices to drop, so there’s an argument, weak though it is, to be made that inflation encourages spending.

All told, an increase in CPI means that a household has to spend more dollars to maintain the same standard of living; that’s mostly bad for the households, but it can be good for businesses and the government.