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By the end of this section, you will be able to:

  • Explain the relationship between indexing and inflation
  • Identify three ways the government can control inflation through macroeconomic policy

When a price, wage, or interest rate is adjusted automatically with inflation, it is said to be indexed    . An indexed payment increases according to the index number that measures inflation. A wide array of indexing arrangements is observed in private markets and government programs. Since the negative effects of inflation depend in large part on having inflation unexpectedly affect one part of the economy but not another—say, increasing the prices that people pay but not the wages that workers receive—indexing will take some of the sting out of inflation.

Indexing in private markets

In the 1970s and 1980s, labor unions commonly negotiated wage contracts that had cost-of-living adjustments (COLAs)    which guaranteed that their wages would keep up with inflation. These contracts were sometimes written as, for example, COLA plus 3%. Thus, if inflation was 5%, the wage increase would automatically be 8%, but if inflation rose to 9%, the wage increase would automatically be 12%. COLAs are a form of indexing applied to wages.

Loans often have built-in inflation adjustments, too, so that if the inflation rate rises by two percentage points, then the interest rate charged on the loan rises by two percentage points as well. An adjustable-rate mortgage (ARM)    is a kind of loan used to purchase a home in which the interest rate varies with the rate of inflation. Often, a borrower will be able receive a lower interest rate if borrowing with an ARM, compared to a fixed-rate loan. The reason is that with an ARM, the lender is protected against the risk that higher inflation will reduce the real loan payments, and so the risk premium part of the interest rate can be correspondingly lower.

A number of ongoing or long-term business contracts also have provisions that prices will be adjusted automatically according to inflation. Sellers like such contracts because they are not locked into a low nominal selling price if inflation turns out higher than expected; buyers like such contracts because they are not locked into a high buying price if inflation turns out to be lower than expected. A contract with automatic adjustments for inflation in effect agrees on a real price to be paid, rather than a nominal price.

Indexing in government programs

Many government programs are indexed to inflation. The U.S. income tax code is designed so that as a person’s income rises above certain levels, the tax rate on the marginal income earned rises as well; this is what is meant by the expression “move into a higher tax bracket.” For example, according to the basic tax tables from the Internal Revenue Service, in 2014 a single person owed 10% of all taxable income from $0 to $9,075; 15% of all income from $9,076 to $36,900; 25% of all taxable income from $36,901 to $89,350; 28% of all taxable income from $89,351 to $186,350; 33% of all taxable income from $186,351 to $405,100; 35% of all taxable income from $405,101 to $406,750; and 39.6% of all income from $406,751 and above.

Questions & Answers

what is competitive market?
Shantal Reply
a compataive market is when there are many producers competating to provide consumers with a goods and services needed
Tanveer
in a compitative market no single producer or consumer can dictate the market
Tanveer
types of demand elasticity
Farouq Reply
What is price elasticity of demand and its degrees. also explain factors determing price elasticity of demand?
Yutansh Reply
Price elasticity of demand (PED) is use to measure the degree of responsiveness of Quantity demanded for a given change on price of the good itself, certis paribus. The formula for PED = percentage change in quantity demanded/ percentage change in price of good A
GOH
its is necessarily negative due to the inverse relationship between price and Quantity demanded. since PED carries a negative sign most of the time, we will usually the absolute value of PED by dropping the negative sign.
GOH
PED > 1 means that the demand of the good is price elasticity and for a given increase in price there will be a more then proportionate decrease in quantity demanded.
GOH
PED < 1 means that the demand of the good is price inelasticity and for a given increase in price there will be a less then proportionate decrease in quantity demanded.
GOH
The factors that affects PES are: Avaliablilty of close substitutes, proportion of income spent on the good, Degree of necessity, Addiction and Time.
GOH
Calculate price elasticity of demand and comment on the shape of the demand curve of a good ,when its price rises by 20 percentage, quantity demanded falls from 150 units to 120 units.
Helen Reply
5 %fall in price of good x leads to a 10 % rise in its quantity demanded. A 20 % rise in price of good y leads to do a 10 % fall in its quantity demanded. calculate price elasticity of demand of good x and good y. Out of the two goods which one is more elastic.
Helen
what is labor
Grace Reply
labor is any physical or mental effort that helps in the production of goods and services
Kwabena
what is profit maximizing level of out put for above hypothetical firm TC = Q3 - 21Q2 + 600 + 1800 P = 600 MC = 3Q2 - 42Q + 600
Sosna Reply
consider two goods X and Y. When the price of Y changes from 10 to 20. The quantity demanded of X changes from 40 to 35. Calculate cross elasticity of demand for X.
Sosna
sorry it the mistake answer it is question
Sosna
consider two goods X and Y. When the price of Y changes from 10 to 20. The quantity demanded of X changes from 40 to 35. Calculate cross elasticity of demand for X.
Sosna
The formula for calculation income elasticity of demand is the percent change in quantity demanded divided by the percent change in income.
Sosna
what is labor productivity
Lizzy Reply
if the demand function is q=25-4p+p² 1.find elasticity of demand at the point p=5?
Puja Reply
what are some of the difference between monopoly and perfect competition market
Obeng Reply
n a perfectly competitive market, price equals marginal cost and firms earn an economic profit of zero. In a monopoly, the price is set above marginal cost and the firm earns a positive economic profit. Perfect competition produces an equilibrium in which the price and quantity of a good is economic
Naima
what are some characteristics of monopoly market
Obeng Reply
explicit cost is seen as a total experiences in the business or the salary (wages) that a firm pay to employee.
Idagu Reply
what is price elasticity
Fosua
...
krishna
it is the degree of responsiveness to a percentage change in the price of the commodity
Obeng
economics is known to be the field
John Reply
what is monopoly
Peter Reply
what is taxation
Peter
is the compulsory transfer of wealth from the private sector to the public sector
Jonna
why do monopoly make excess profit in both long run and short run
Adeola Reply
because monopoly have no competitor on the market and they are price makers,therefore,they can easily increase the princes and produce small quantity of goods but still consumers will still buy....
Kennedy
how to identify a perfect market graph
Adeola Reply
what is the investment
jimmy
investment is a money u used to the business
Mohamed
investment is the purchase of good that are not consumed today but are used in the future to create wealth.
Amina
investment is the good that are not consumed
Fosua
What is supply
Fosua
 Supply represents how much the market can offer.
Yusif
it is the quantity of commodity producers produces at the market
Obeng

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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