Just about everything we do as a nation lends to the annual inflation rate. In this article, though, I have chosen four of the most important variables that influence inflation the most. Inflation is the sustained increase in prices, or in other words, a steady decline in the buying power of the dollar. I have come up with an equation that includes the following variables: the unemployment rate, the federal funds interest rate, per capita income, and new home sales. These variables consistently have shown a relationship to the inflation rate and aggregately may help to explain the cause of inflation.
The first variable I chose was the unemployment rate. This is the annual average of persons 15 years of age or older, actively seeking and available for work, but unemployed. (BLS). The relationship between unemployment and inflation “provides evidence of a short-run trade-off between the two variables known as the short-run Phillips curve” (BLS). The relationship suggests that by accepting higher inflation levels, the Fed can use monetary policy to stimulate the economy and temporarily reduce unemployment. When prices go up, the wages are affected also. This occurs because if no adjustments are made, then the same wages will buy less goods and services, which affects consumer spending. Less spending means less profits, which ends in layoffs and higher unemployment. The flip side reveals the effect of unemployment on inflation. The hypothesis for this variable is that as the unemployment rate decreases, the annual inflation rate will increase. The reasoning here is that if more people are employed and have money, there is more spending, more demand, and therefore prices will rise.
The second variable I chose was the federal funds interest rate. Federal funds are the Fed’s channel of affecting the economy through the banks. The Fed aims to maintain a steady economy with steady growth and stable prices. Too much money results in price increases, or inflation. Too little money slows growth. To increase money, the Fed buys bank-owned government securities. It pays with deposits, which enable more loans, which enable more deposits, and so on. To reduce money, the Fed sells government securities, and banks pay from their Fed accounts. This reduces reserves, forcing banks to reduce loans. So they raise interest rates to consumers and businesses. “While reducing loans, a bank may find that its reserves are less than allowed under Fed regulations. To stay legal, it phones for a one-night loan from a bank with excess reserves. The borrowed funds move from one bank’s Fed account to another’s, thus the name federal funds” (Fedpoint15, p.2). The federal fund interest rate is a good indicator of what aims the Fed has for the economy and what state we are currently in. The hypothesis for this variable is that if the Fed raises interest rates, there must be too much money in the economy. The Fed is predicting a rise in inflation rates. So a rise in federal fund interest rates will reveal a rise in the inflation rate.
The next variable I chose to explain inflation was per capita income. When consumers have and are spending more money, prices will continue to climb. Income though, plays another role in inflation. A rise in per capita income is a good indicator of higher wages. Wage escalation is a direct result of low unemployment rates. The more people working the more money is being made and spent, more demand and thus higher prices. Take a look from a different angle. (Lonski, p.1). The hypothesis here is that as per capita income increases, inflation will also increase. More money means more spending and more demand, as stated previously. Thus, prices will inflate. Other factors may also play a role such as when interest rates are raised to combat inflation. Will we then see the opposite effect take place?
The fourth and final variable I chose to help explain inflation was new home sales. Construction spending is a good indicator of our nation’s economy, but the actual purchase of new homes is probably a better indicator of consumer spending. If the houses are built and no one is buying, it does not help the economy. “Volume of sales is a good indicator of the state housing demand” (New Home, p. 1). I chose this variable to represent consumer spending and demand coupled with construction spending; both of these are excellent economic indicators. The hypothesis for this variable is as new home sales increase, the inflation rate will also increase due to high demand and increased spending.
The strength of the variables I have chosen is that all of the leading economic indicators are covered in these few variables: employment, interest rates, income, construction spending, and consumer spending. These variables together should help to broaden the understanding of what causes inflation. (Not really). I do, however, feel that I have gained some much-needed experience in choosing variables that may contribute to substantially to a given problem.
Y(i) = Annual inflation rate (CPI base year 1982–1984 = 100)
X(3) = Per capita income (in current and 1998 CPI-U adjusted dollars)
Bureau of Labor Statistics. http://stats.bls.gov/opub/mlv/1998/08/art3exc.htm.
“Consumer Price Index”. http://stats.bls.gov/cpifact5.htm.
“Fedpoint 15: Federal Funds”. http://www.ny.frb.org/pihome/fedpoint/fed15.html.
Lonski, John. “Inflation is Back”. http://www.dismal.com/thoughts/th_jl_050900.asp.
“New Home Sales”. http://www.dismal.com/toolbox/print_definition.asp?r=usa_home_sales