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“Sure, you™re raising my
tion, wages also rise. In fact, the average wage typically rises more or less in step allowance. But am I actually
with prices. Thus, contrary to popular myth, workers as a group are not usually vic- gaining any purchasing
timized by inflation. power?“
The purchasing power of wages”what is called the real wage rate”is not systematically
eroded by inflation. Sometimes wages rise faster than prices, and sometimes prices rise The real wage rate is the
faster than wages. In the long run, wages tend to outstrip prices as new capital equip- wage rate adjusted for infla-
ment and innovation increase output per worker. tion. Specifically, it is the
nominal wage divided by the
Figure 4 illustrates this simple fact. The brick-colored line shows the rate of increase of
price index. The real wage
prices in the United States for each year since 1948, and the black line shows the rate of in- thus indicates the volume of
crease of wages. The difference between the two, shaded in blue in the diagram, indicates goods and services that the
the rate of growth of real wages. Generally, wages rise faster than prices, reflecting the nominal wages will buy.

F I GU R E 4
Rates of Change of
10 Wages and Prices in
Wages the United States
9 since 1948
Percentage Change in Wages

Percentage Change in Prices

SOURCE: Bureau of Labor Statistics. Data pertain to nonfarm business sector.







1950 1960 1970 1980 1990 2000
1965 1975
1955 1985 1995 2005

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Part 2
118 The Macroeconomy: Aggregate Supply and Demand

Calculating the Real Wage: A Real Example
The real wage shows not how many dollars a worker is paid for an American workers. But over those same nine years, the Consumer
hour of work (that is called the nominal wage), but rather the pur- Price Index (CPI), the most commonly used index of the price level,
chasing power of that money. It indicates what an hour™s worth of rose by 27 percent, from 163.0 to 207.3. This means that the real
work can buy. As noted in the definition of the real wage in the wages in the two years were
margin on the previous page, we calculate the real wage by dividing
the nominal wage by the price level. The rule is Real wage in 1998 5 5 .0798
Nominal wage
Real wage 5
Real wage in 2007 5 5 .0840
Price level 207.3
Here™s a concrete example. Between 1998 and 2007, the aver-
for an increase of just 5.2 percent over the nine years, which is a
age hourly wage in the United States rose from $13.01 to $17.41,
small fraction of 34 percent.6
an increase of 34 percent over nine years. Sounds pretty good for

steady advance of labor productivity; therefore, real wages rise. But this is not always the
case; the graph shows several instances in which inflation outstripped wage increases.
The feature of Figure 4 that virtually jumps off the page is the way the two lines dance
together. Wages normally rise rapidly when prices rise rapidly, and they rise slowly when
prices rise slowly. But you should not draw any hasty conclusions from this association. It
does not, for example, imply that rising prices cause rising wages or that rising wages
cause rising prices. Remember the warnings given in Chapter 1 about trying to infer cau-
sation just by looking at data. But analyzing cause and effect is not our purpose right now.
We merely want to dispel the myth that inflation inevitably erodes real wages.
Why is this myth so widespread? Imagine a world without inflation in which wages
are rising 2 percent per year because of the increasing productivity of labor. Now imagine
that, all of a sudden, inflation sets in and prices start rising 3 percent per year but nothing
else changes. Figure 4 suggests that, with perhaps a small delay, wage increases will accel-
erate to 2 1 3 5 5 percent per year.
Will workers view this change with equanimity? Probably not. To each worker, the
5 percent wage increase will be seen as something he earned by the sweat of his brow. In
his view, he deserves every penny of his 5 percent raise. In a sense, he is right because “the
sweat of his brow” earned him a 2 percent increment in real wages that, when the infla-
tion rate is 3 percent, can be achieved only by increasing his money wages by 5 percent.
An economist would divide the wage increase in the following way:

Reason for Wages to Increase Amount
Higher productivity 2%
Compensation for higher prices 3%
Total 5%

But the worker will probably keep score differently. Feeling that he earned the entire
5 percent raise by his own merits, he will view inflation as having “robbed” him of three-
fifths of his just deserts. The higher the rate of inflation, the more of his raise the worker
will feel has been stolen from him.
Of course, nothing could be farther from the truth. Basically, the economic system re-
wards the worker with the same 2 percent real wage increment for higher productivity, regard-
less of the rate of inflation. The “evils of inflation” are often exaggerated because people fail
to understand this point.

As explained in the appendix, it is conventional to multiply index numbers by 100, which would make the two

real wage numbers 7.98 and 8.40, respectively. That does not alter the percentage change.

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Chapter 6 119
The Goals of Macroeconomic Policy

The Importance of Relative Prices
A related misperception results from failure to distinguish between a rise in the general
price level and a change in relative prices, which is a rise in one price relative to another. An item™s relative price is
its price in terms of some
To see the distinction most clearly, imagine first a pure inflation in which every price rises
other item rather than in
by 10 percent during the year, so that relative prices do not change. Table 3 gives an exam-
terms of dollars.
ple in which the price of movie tickets increases from $6.00 to $6.60, the price of candy
bars from 50 cents to 55 cents, and the price of automobiles from $9,000 to $9,900. After
the inflation, just as before, it will still take 12 candy bars to buy a movie ticket, 1,500
movie tickets to buy a car, and so on. A person who manufactures candy bars in order to
purchase movie tickets is neither helped nor harmed by the inflation. Neither is a car
dealer with a sweet tooth.

Pure Inflation

Last Year™s This Year™s
Item Price Price Increase
Candy bar $0.50 $0.55 10%
Movie ticket 6.00 6.60 10
Automobile 9,000 9,900 10

But real inflations are not like this. When there is 10 percent general inflation”meaning
that the “average price” rises by 10 percent”some prices may jump 20 percent or more
while others actually fall.7 Suppose that, instead of the price increases shown in Table 3,
prices rise as shown in Table 4. Movie prices go up by 25 percent, but candy prices do not
change. Surely, candy manufacturers who love movies will be disgruntled because it now
costs 15 candy bars instead of 12 to get into the theater. They will blame inflation for rais-
ing the price of movie tickets, even though their real problem stems from the increase in the
price of movies relative to candy. (They would have been hurt as much if movie tickets had
remained at $6 while the price of candy fell to 40 cents.) Because car prices have risen by
only 5 percent, theater owners in need of new cars will be delighted by the fact that an auto
now costs only 1,260 movie admissions”just as they would have cheered if car prices had
fallen to $7,560 while movie tickets remained at $6. However, they are unlikely to attribute
their good fortune to inflation. Indeed, they should not. What has actually happened is that
cars became cheaper relative to movies.

Real-World Inflation

Last Year™s This Year™s
Item Price Price Increase
Candy bar $0.50 $0.50 0%
Movie ticket 6.00 7.50 25
Automobile 9,000 9,450 5

Because real-world inflations proceed at uneven rates, relative prices are always chang-
ing. There are gainers and losers, just as some would gain and others lose if relative prices
were to change without any general inflation. Inflation, however, gets a bad name because
losers often blame inflation for their misfortune, whereas gainers rarely credit inflation for
their good luck.
Inflation is not usually to blame when some goods become more expensive relative to

How statisticians figure out “average” price increases is discussed in the appendix to this chapter.

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Part 2
120 The Macroeconomy: Aggregate Supply and Demand

These two kinds of misconceptions help explain why respondents to public opinion
polls often cite inflation as a major national issue, why higher inflation rates depress con-
sumers, and why voters express their ire at the polls when inflation is high. But not all of
the costs of inflation are mythical. Let us now turn to some of the real costs.

We have just seen that the average person is neither helped nor harmed by inflation. But
almost no one is exactly average! Some people gain from inflation and others lose. For ex-
ample, senior citizens trying to scrape by on pensions or other fixed incomes suffer badly
from inflation. Because they earn no wages, it is little solace to them that wages keep pace
with prices. Their pension incomes do not.8
This example illustrates a general problem. Think of pensioners as people who “lend”
money to an organization (the pension fund) when they are young, expecting to be paid
back with interest when they are old. Because of the rise in the price level during the in-
tervening years, the unfortunate pensioners get back dollars that are worth less in pur-
chasing power than those they originally loaned. In general:
Those who lend money are often victimized by inflation.
Although lenders may lose heavily, borrowers may do quite well. For example, home-
owners who borrowed money from banks in the form of mortgages back in the 1950s,
when interest rates were 3 or 4 percent, gained enormously from the surprisingly virulent
inflation of the 1970s. They paid back dollars of much lower purchasing power than those
that they borrowed. The same is true of other borrowers.
Borrowers often gain from inflation.
Because the redistribution caused by inflation generally benefits borrowers at the ex-
pense of lenders, and because both lenders and borrowers can be found at every income
level, we conclude that
Inflation does not systematically steal from the rich to aid the poor, nor does it always
do the reverse.
Why, then, is the redistribution caused by inflation so widely condemned? Because its
victims are selected capriciously. No one legislates the redistribution. No one enters into it
voluntarily. The gainers do not earn their spoils, and the losers do not deserve their fate.
Moreover, inflation robs particular classes of people of purchasing power year after
year”people living on private pensions, families who save money and “lend” it to banks,
and workers whose wages and salaries do not adjust to higher prices. Even if the average
person suffers no damage from inflation, that fact offers little consolation to those who are
its victims. This is one fundamental indictment of inflation.
Inflation redistributes income in an arbitrary way. Society™s income distribution should


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