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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

price elasticity of demand is the degree of responsiveness of a quantity demanded to the change in price of the commodity in question.
Gladys Reply
what is the importance of learning economics?
Thelma Reply
it helps to make the correct choice
Gladys
it helps firm to produce products that will bring more profit
Gladys
the difference between needs and wants
londiwe Reply
needs are things that we basically can't live without wants are just luxury things
Thelma
needs are things without them we can't live but want are things without we can live
KP
what is education
KP
it's a process in which we give or receiving methodical instructions
Thelma
what is mixed economy
Amex
what is a deadweight loss? how monopoly creates a deadweight loss?
Ashraf Reply
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Lamine
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Cleaford
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nura
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Cleaford
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Dope
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Dope
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Dope
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Dope
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Dope
to learn from one another
Lamine
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Dope
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Creative
Yes
Lamine
what is type of economic
taiwo Reply
how to understand basics of economics
Aarif Reply
what is demand schedle
Princess Reply
When you make a Scedule of the demand you made
Rodeen
this is helpful for rbi grade b
Prema Reply
What is macroeconomics
Kauna Reply
It's one of the two branches of Economics that deal with the aggregate economy.
Mayen
it's about inflation, occupation, gdp and so on
alberto
What is differences between Microeconomics and Macroeconomic?
Bethrand
microeconomics focuses on the action of individual agents in the economy such as businesses, workers and household. while macroeconomics looks at the economy as a whole. it focuses on broad issues in the economy such as government deficit, economy growth, levels of exports and imports, and
Thelma
inflationary increase in prices
Thelma
a price floor of 24 imposed
Annie Reply
monopolistic competition
bintu Reply
yap
nura
any one there to answer my question
Richard Reply
Fixed Costs per week Variable Costs per bear Rent & Rates of Factory Hire & machines Heating & Lighting Repayment of Bank Loan K100.00 K45.00 K5.00 K50.00 Materials Foam Wages K6.00 K1.00 K1.00 Total K200.00 K8.00
Richard
one of the scarce resources that constrain our behaviour is time. each of us has only 24 hours in a day. how do you go about allocating your time in a given day among completing alternatives? once you choose a most important use of time. why do you not spend all your time to it. use the notion of op
naknak Reply
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Dipam Reply
mani Baba. First learn the spelling of Economics
Dipam Reply
Economics- The study of how people use their limited resources to tey and satisfy unlimited wants.
Kelly
hmmm
Mani
etar bangla apps hobe na?
Mohsina

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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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