Inflation can sneak up on us, eroding our purchasing power. That's where indexing comes in, adjusting wages, prices, and benefits to keep pace with rising costs. It's like a financial shield, protecting our wallets from inflation's sneaky attacks.

But there's a catch. While indexing helps in the short term, it can actually feed the inflation beast. It's a delicate balance – we want protection, but we don't want to accidentally make things worse. It's all about finding that sweet spot.

Indexing and Inflation

Indexing Impacts on Inflation

• Indexing adjusts economic variables to account for inflation's effects
  • Wages, prices, interest rates (indexed variables)
• Helps maintain purchasing power as prices rise
  • Indexed variables adjusted upward to compensate for increasing price levels
• Reduces inflation's negative impacts
  • Prevents erosion of real wages and savings
  • Cost-of-living adjustments (COLAs) protect against unexpected inflation
• Can perpetuate inflation
  • Automatic wage and price adjustments lead to wage-price spiral
  • Higher wages drive higher prices, leading to demands for even higher wages

Government Programs Using Indexing

• Social Security benefits
  • Adjusted annually based on Consumer Price Index (CPI) changes
  • Maintains purchasing power for retirees and beneficiaries
• Treasury Inflation-Protected Securities (TIPS)
  • Principal value adjusted based on CPI changes
  • Protects investors from purchasing power erosion due to inflation
• Federal income tax brackets
  • Adjusted annually for inflation using CPI
  • Prevents "bracket creep" (taxpayers pushed into higher brackets due to inflation, not real income increases)

Money Supply and Inflation

Excessive Money Supply Growth Fuels Inflation

• Inflation sustained increase in general price level over time
• Quantity theory of money states money supply has direct, proportional relationship with price level
  • Equation represented as $MV = PQ$
    • $M$ money supply
    • $V$ velocity of money (how quickly money changes hands)
    • $P$ price level
    • $Q$ quantity of goods and services produced (real GDP)
• Money supply growing faster than goods and services production means more money chasing same amount of goods
  • Leads to price level increase (inflation)
• Central banks (Federal Reserve) control money supply through monetary policy tools
  • Open market operations, reserve requirements, discount rate
• Central bank allowing money supply to grow too quickly leads to excessive inflation
  • "Too much money chasing too few goods"
• High inflation levels have negative economic consequences
  • Erodes money's purchasing power, discourages saving and investment, leads to economic instability