FREE ESSAY ON THE ANNUAL INFLATION RATE

THE ANNUAL INFLATION RATE

The Annual Inflation Rate
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(1) = Unemployment rate
X(2) = Federal funds interest rate
X(3) = Per capita income (in current and 1998 CPI-U adjusted dollars)
X(4) = New Home Sales in 1000's.
Year Y(i) X(1) X(2) X(3) X(4)
1976 5.8 7.7 5.04 14464 646
1977 6.5 7.1 5.09 14920 819
1978 7.6 6.1 7.93 15588 817
1979 11.3 5.8 11.19 15789 709
1980 13.5 7.1 13.27 15423 545
1981 10.3 7.6 16.38 15334 436
1982 6.2 9.7 12.26 15311 412
1983 3.2 9.6 9.88 15537 623
1984 4.3 7.5 10.23 16203 639
1985 3.6 7.2 8.1 16683 688
1986 1.9 7.0 6.81 17356 750
1987 3.6 6.2 6.66 17779 671
1988 4.1 5.5 7.57 18082 676
1989 4.8 5.3 9.22 18477 650
1990 5.4 5.6 8.10 17942 534
1991 4.2 6.8 5.69 17493 509
1992 3.0 7.5 3.85 17249 610
1993 3.0 6.9 3.02 17797 666
1994 2.6 6.1 4.2 18208 670
1995 2.8 5.6 5.84 18425 667
1996 2.9 5.4 5.30 18841 757
1997 2.3 4.9 5.46 19541 804
1998 1.6 4.5 5.35 20120 886
Bibliography Cited
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