The Level of Prices Doesn’t Matter . . .

The most common complaint about inflation, an increase in the price level, is that it makes everyone poorer—after all, a given amount of money buys less. But inflation does not make everyone poorer. To see why, it’s helpful to imagine what would happen if the United States did something other countries have done from time to time—replacing the dollar with a new currency.

An example of this kind of currency conversion happened in 2002, when France, like a number of other European countries, replaced its national currency, the franc, with the new pan-European currency, the euro. People turned in their franc coins and notes, and received euro coins and notes in exchange, at a rate of precisely 6.55957 francs per euro. At the same time, all contracts were restated in euros at the same rate of exchange. For example, if a French citizen had a home mortgage debt of 500,000 francs, this became a debt of 500,000/6.55957 = 76,224.51 euros. If a worker’s contract specified that he or she should be paid 100 francs per hour, it became a contract specifying a wage of 100/6.55957 = 15.2449 euros per hour, and so on.

Inflation can distort consumers’ incentives about what and when to buy.

You could imagine doing the same thing here, replacing the dollar with a “new dollar” at a rate of exchange of, say, 7 to 1. If you owed $140,000 on your home, that would become a debt of 20,000 new dollars. If you had a wage rate of $14 an hour, it would become 2 new dollars an hour, and so on. This would bring the overall U.S. price level back to about what it was in 1962, when John F. Kennedy was president.

The real wage is the wage rate divided by the price level.

So would everyone be richer as a result because prices would be only one-seventh as high? Of course not. Prices would be lower, but so would wages and incomes in general. If you cut a worker’s wage to one-seventh of its previous value, but also cut all prices to one-seventh of their previous level, the worker’s real wage—the wage rate divided by the price level—hasn’t changed. In fact, bringing the overall price level back to what it was during the Kennedy administration would have no effect on overall purchasing power because doing so would reduce income exactly as much as it reduced prices.

Real income is income divided by the price level.

Conversely, the rise in prices that has actually taken place since the early 1960s hasn’t made America poorer because it has also raised incomes by the same amount: real incomes—incomes divided by the price level—haven’t been affected by the rise in overall prices.

The moral of this story is that the level of prices doesn’t matter: the United States would be no richer than it is now if the overall level of prices was still as low as it was in 1961; conversely, the rise in prices over the past 50 years hasn’t made us poorer.