Full text of Review (Federal Reserve Bank of St. Louis) : June/July 1981

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June/July 1981
Vol. 63, No. 6

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Indexation of Social Security Benefits
A Reform in Need of Reform

The R e v i e w is published 10 times per year by the Research Department of the Federal Reserve
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2


Indexation of Social Security BenefitsA Reform in Need of Reform
NEIL A. STEVENS

c

I^ O C IA L security benefits for retired workers, their
dependents and their survivors are indexed or linked to
movements in the consumer price index (C P I).1 Price
indexing, a method of making adjustments to inflation,
is the linking of nominal (dollar) magnitudes, such as
wages, interest rates, government expenditures or
taxes, to movements in a price measure. The purpose
of indexing is to ensure that the purchasing power
over goods and services is not changed by movements
in the general level of prices.2 Under current law,
social security payments are automatically increased
in June “whenever the CPI in the first quarter of the
calendar year exceeds the CPI in the first quarter of
the previous calendar year by at least 3 percent.”3
iThe price index specified in legislation is the consumer price
index for urban wage earners and clerical workers rather than
the more recently constructed and more broadly based series
for all urban workers.
2For background information on indexing, see Thomas M.
Humphrey, “The Concept of Indexation in the History of Eco­
nomic Thought,” E conom ic R eview (Federal Reserve Bank of
Richmond, November/December 1974), pp. 3-16; Herbert
Giersch, Milton Friedman, et al., Essays on Inflation and
Indexation (Washington, D.C.: American Enterprise Institute
for Public Policy Research, 1972); and Jai-Hoon Yang, “The
Case For and Against Indexation: An Attempt at Perspective,”
this R eview (October 1974), pp. 2-11.
3An Analysis o f the E ffects o f Indexing for Inflation on F ed ­
eral Expenditures, Report to the Congress of the United States
by the Comptroller General (GAO, August 15, 1979), p. 18.
The current provision for the automatic indexing of social
security benefits was contained in social security legislation
enacted in 1973. Initially, however, automatic indexing of
benefits was included in die social security legislation enacted
in 1972. The first effective date was to have been January 1,
1975, based on increases in the CPI from the third quarter
of 1972 to the second quarter of 1974. In subsequent years,
possible benefit increases were to be based on second-quarterto-second-quarter changes in the CPI and made effective Jan­
uary 1. Legislation enacted in 1973 amended these provisions
by providing the first possible automatic increase in benefits
to be effective in June 1975, based on the change in CPI
from the second quarter of 1974 to the first quarter of 1975.



For example, effective June 1, 1981, social security
payments were increased 11.2 percent, reflecting the
increase in the consumer price index from the first
quarter of 1980 to the first quarter of 1981.4
Social security programs are funded by a tax on
wage and salary income.5 Currently, benefits for re­
tired workers, their dependents and survivors, are
rising faster than revenues into the Old Age and
Survivors Insurance (OASI) trust fund from which
these benefits are paid. According to estimates by the
trustees of the social security system6 and the Con­
gressional Budget Office (CBO), the OASI trust fund
will face a financing problem beginning in late 1981
or early 1982 that will continue through the decade.7
CBO estimates show that outlays from the OASI trust
fund in fiscal year 1981 will exceed income into the
fund by $4.8 billion. Furthermore, estimates are that
the trust fund balance will be depleted by the end of
fiscal year 1983, and that the fund will be approxi­
mately $64 billion in deficit by the end of 1986
(table 1).
4Increases are effective June 1 and are payable July 1.
5Social security benefits are provided under three separate
programs. The Old Age and Survivors Insurance program,
the largest, with expenditures of $87.6 billion in 1979, pays
benefits to retired workers, their dependents and survivors.
The Disability Insurance program pays benefits to disabled
workers and their dependents, and the Hospital Insurance
program pays benefits to workers covered by the previous
two programs and the railroad retirement program.
6The trustees include the Secretary of the Treasury, the Secre­
tary of Labor, and the Secretary of Health and Human
Services.
11980 Annual R eport of the Board of Trustees of the Federal
Old-Age and Survivors Insurance and Disability Insurance
Trust Funds, H. Doc. 96-332, 96th Congress, 2nd session
(GPO, 1980), p. 50; and Paying fo r Social Security: Funding
Options fo r the N ear Term , Congressional Budget Office of
the Congress of the United States (February 1981), p. 13.

3

JUNE/JULY

F E D E R A L R E S E R V E BAN K O F ST. L OUI S

1981

Table 1

Outlays, Income and Balances for the Old Age and Survivors Insurance Trust Fund
(billions of dollars)
Projections2

A ctual1
1970

1975

1980

1981

1982

1983

1984

1985

1986

Outlays

$27.3

$56.7

$103.2

$122.6

$141.4

$158.7

$178.0

$199.3

$222.6

Income

31.7

58.8

100.1

117.8

129.0

143.0

159.1

181.9

203.7

Year-end balance (fiscal ye a r)

32.6

39.9

24.6

19.7

7.4

-8 .2

-27.1

-4 4 .5

-6 3 .5

iSocial Security Bulletin (April 1981), p. 43.
2Paying for Social Security: Funding Options for the Near Term , (Congressional Budget Office of the Congress of the United
States, February 1981).

This short-term financing problem will begin to
dissipate in the next decade but only because of
sizable increases in payroll taxes scheduled as a re­
sult of the 1977 amendments to the Social Security
Act. In the next century, however, an imbalance again
will emerge between promised social security bene­
fits and projected revenues. The solution to this prob­
lem will require either larger increases in taxes than
those already scheduled or a reduction in promised
benefits.
This article examines the role that the price index­
ing of benefits has played in creating these financing
problems, particularly in the short term. The article
shows that the use of the CPI for indexing probably
has overstated the benefit increases necessary to keep
the purchasing power of benefits constant, and that
price indexing is inconsistent with the way benefits
are funded. In addition, it discusses modifications of
indexing formulas that would help eliminate the cur­
rent imbalance or avert the development of future
financial imbalances.

Table 2

Increases in Social Security Benefits
and the Consumer Price Index

Effective date of increase

Increase in
benefit
level

Increase in CPI
from last
effective date
of benefit
increase1

13%

0.5% 2

Before automatic indexing
Septem ber 1954
January 1954

7

January 1965

7

7.8

February 1968

13

9.3

January 1970

15

10.8

January 1971

10

5.2

Septem ber 1972

20

5.9

June 1974

113

Over time, the price level varies as the stock of
money changes relative to the available amount of
goods and services. Price indexing first came about to
rectify the fact that prices or incomes administered
by government agencies or fixed by private contractual
agreements, such as wage contracts or fixed payment
mortgage contracts, do not adjust rapidly to changes
in the price level. Market-determined prices of goods
and services eventually will adjust to changes in the
price level. However, social security benefits and pay­
ments under other government programs, which are

4


16.4

After autom atic indexing
June 1975

The Rationale for Price Indexing

8.0

8.0%

June 1976

6.4

June 1977

5.9

June 1978

6.5

June 1979

9.9

June 1980

14.3

June 1981

11.2

’ Computed from not seasonally adjusted data for urban wage
earners and clerical workers.
2Increase in CPI from September 1952, the previous date
benefits were increased.
3Effective in two steps — a 7 percent increase in March 1974
and a 4 percent increase in June 1974.

FEDE RAL . R E S E R V E BANK O F ST. L OUI S

JUNE/JULY

1981

Table 3
Alternative Measures of Changes in the Price Level1
Consumer price index

Period

Official
series2

Experimental
rental
equivalence
series

Official
series minus
experim ental
series

Personal
consumption
expenditures
deflator

Official CPI
minus PCE
deflator

1947-77

3.4%

n.a.

n.a.

3.3%

0.1%

1977

6.6

6.2%

0.4%

5.9

0.7

1978

9.0

7.8

1.2

7.5

1.5

1979

12.7

10.6

2.1

9.5

3.2

1980

12.5

10.8

1.7

10.1

2.4

1Changes are from fourth quarter to fourth quarter, except the 1947-77 period which was
computed from yearly average data.
2AU urban worker series.

not directly determined by market forces, must some­
how be adjusted to changes in the price level if
Congress desires to offset the impact of these changes
on the payments’ purchasing power.
On a practical level, an advantage of price indexing
is that it is automatic, so it relieves Congress from
having to devote considerable attention to frequent
increases in benefits in an inflationary environment.
Also, given the tendency of Congress in the late 1960s
and early 1970s to increase benefits faster than the
price level (table 2), indexing may have acted to
put a cap on benefit increases, and thus may have
averted an even larger financing crisis. Nevertheless,
there are problems with the price indexing of benefits
that should be discussed.

The Vexing Problem of Measuring Changes
in the Price Level
Price indexation requires a statistical measure of the
price level, which in practice, is measured by price
indexes. Typically, a price index is designed to answer
the question, “How much does the cost of a basket
of goods and services change over time?” Unfortu­
nately, there are numerous technical problems in pro­
viding an answer.8
8For a more thorough discussion of the problems in measuring
the price level, see William H. Wallace and William E.
Cullison, Measuring Price Changes: A Study o f the Price
Indexes, 4th ed. (Federal Reserve Bank of Richmond, 1979);
and R.G.D. Allen, “Index Numbers in Theory and Practice”
(Chicago: Aldine Publishing Co., 1975).




Two widely used price indexes — the consumer
price index and the personal consumption expendi­
tures (PCE) deflator — demonstrate the differences
that can arise between price measures. Though these
indexes have followed similar patterns in the past,
their movements diverged substantially in 1979 and
1980 (see table 3). For example, the CPI increased
3.2 percentage points more than the PCE deflator in
1979 and 1.7 percentage points more in 1980. While
there are several differences in the way these two
price indexes are computed, two of the more signifi­
cant differences are the choice of period in which to
define the market basket — either current or past —
and the methods used to measure housing costs.
Fixed Versus Variable Weights — The CPI-W,
which is used to index social security benefits, is
a “fixed-weight” index. The procedure for calculat­
ing this index is to regularly survey prices of a
large number of items consumers typically purchase
(the so-called market basket) and compare the aggre­
gate cost of these items with the cost of the same
market basket in a selected base period. The weights
given to various expenditure categories in the mar­
ket basket are kept constant or fixed from period to
period. Currently, the CPI market basket is based on
a survey taken in the 1972-73 period. In the past
these weights have revised approximately every 10
years. The PCE deflator, on the other hand, is essen­
tially a variable or current-weight index. This index,
unlike the CPI, takes into account the prices of per­
sonal consumption items in the current period and, in
effect, weighs them by the quantities currently pur­
5

F E D E R A L R E S E R V E BAN K O F ST. L OUI S

chased. Since expenditure patterns can change, the
weights can vary from period to period.
Economists have recognized that both fixed- and
variable-weight indexes present problems. One prob­
lem is that consumption patterns change over time
as people alter their preferences or respond to changes
in relative prices. For example, in the 1970s the
price of oil rose sharply relative to other prices. As
a result, consumers curtailed their consumption of
gasoline and other oil-based products and purchased
substitutes for these products. Yet, in calculating the
CPI, the 1972-73 consumption pattern for oil-based
products continues to be used. As a result, the CPI
overstates changes in the price level. On the other
hand, the PCE deflator, which uses the current ex­
penditures for oil-based products in its calculation,
understates the price level, since substitutions and
curtailed energy consumption lowered the living
standard of consumers.
While over past periods changing expenditure pat­
terns have been a rather insignificant problem, as
evidenced by the small difference between the CPI
and PCE deflator from 1947 to 1977, the problem has
been somewhat more pronounced in recent years. For
example, in 1979 it is estimated that about half of
the 2.9 percentage-point difference between the CPI
and the PCE deflator can be attributed to changing
weights or differences in weights on gasoline pur­
chases.9 Also important was the approximately 1.8
percentage-point difference caused by the different
treatment of homeownership costs in the two indexes.
Homeownership Costs — Much recent criticism of
the CPI has focused on the measurement of housing
costs. Durable goods, such as houses, are consumed
over an extended period of time. Thus, the purchase
of a durable good represents an act of saving (future
consumption) with relatively minor effects on cur­
rent consumption.
The cost of owner-occupied housing, like other
items in the CPI, are calculated by using weights
derived by surveys in the early 1970s. In this period,
about 6 percent of households purchased homes. As
currently measured, the CPI assumes that 6 percent of
households will purchase and consume the total
value of the house and one-half of the mortgage that
usually goes along with it in the current period, while
those living in previously purchased houses will
spend nothing for housing services except for mainte9Alan S. Blinder, “The Consumer Price Index and The Meas­
urement of Recent Inflation,” Brookings Papers on Econom ic
Activity (2 :1 9 8 0 ), pp. 539-65.

6




JU NE/JULY

1981

nance, taxes and insurance. Aside from numerous
technical problems, this view of housing costs gives
a misleading estimate of the cost to the “average”
consumer.10 A sharp rise in mortgage interest rates,
for example, raises the cost of housing, though few
homeowners may actually bear the cost.
While there is no “right” way to measure housing
costs, economists generally accept a procedure called
the “rental equivalence” approach. This method in­
volves the sampling of rents from rented houses. If
homeowners charge rents that cover all the costs of
maintaining a home, then the price of a house, the
cost of credit, etc., are included in the rent charged by
the owner to the renter.
The Bureau of Labor Statistics, which computes
the CPI, has experimented with several methods to
calculate homeownership costs, including rental equiv­
alence.11 A comparison of the experimental rental
equivalence series and the official CPI measure shows
considerable differences in recent years (table 3). In
1980, for example, the official CPI measure grew at a
12.5 percent annual rate compared with only a 10.8
percent increase in the experimental series.

Price Indexing and Real W age Declines
The Financial Implications

—

In essence, the price indexing of social security
payments is a promise by the government to keep
benefits unchanged in terms of their purchasing
power. As just seen, this may be hard to attain be­
cause of problems in measuring the price level. In
addition, the promise of fixed real benefits is some­
times inconsistent with the methods used to finance
social security benefits.
If Congress wants to maintain the purchasing power
of benefits received by current social security recip­
ients, it must levy an appropriate level of taxes to
pay for these benefits. Social security benefits are
currently funded on a pay-as-you-go basis; that is,
benefits for currently retired workers are funded by
payroll taxes on the wages and salaries of those cur­
rently working.12 A problem crops up whenever wages
10Ibid, p. 546.
n As a proxy for rents on rented houses, this experimental
series uses the CPI rent index, which includes rents on apart­
ments as well as rented houses.
12One-half of the payroll tax is levied directly on an employee’s
earnings and the other half is paid by employers. Studies,
however, indicate that the portion of the tax paid by em­
ployers is, for the most part, borne by employees. For a
discussion of this point, see John A. Brittain, T h e Payroll
Tax for Social Security (Washington, D.C.: The Brookings
Institution, 1975), Chapters I and II.

FEDE RAL . R E S E R V E BAN K O F ST. L OUI S

and salaries rise more slowly than the price level.
When this occurs, the benefits of current social security
recipients, which rise with increases in the price level,
increase more rapidly than revenues, which rise with
increases in wages and salaries.
Historically, wages have generally advanced more
rapidly than prices; that is, real wages have generally
risen (table 4). These increases reflect advances in
labor productivity (output per manhour worked). In
recent years, however, real wages have declined with
the decline in labor productivity.13 The adjusted hourly
earnings of workers,14 after allowances for increases
in the CPI, have declined or remained unchanged in
five of the past eight years and, on average, have de­
clined at about a 1 percent annual rate since 1972.15

JUNE/JULY

1981

Table 4

Changes in Consumer Price index and
Hourly Earnings (year-over-year
changes)

Y ear

Consumer
price
index1

Adjusted hourly earnings2
______________ _______ ___
Current
1967
dollars
dollars3

The CPI’s overstatement of the cost-of-living in­
crease in recent years magnifies the income transfer.
This overstatement results in benefit increases above
those necessary to maintain the same level of real
benefits, and implies an even greater increase in taxes
and a further reduction in the real after-tax wages of

13Several explanations have been offered by economists for
the recent decline in productivity and, hence, the decline
in real wages. One explanation points to the sharp rises in the
relative price of energy in 1973-74, and again in 197980. According to some studies, these sharp increases in the
relative price of energy made part of the capital stock eco­
nomically obsolete, thereby reducing workers’ productivity.
For details of this and other explanations, see John A. Tatom,
“The Productivity Problem,” this Review (September 1979),
pp. 3-16.
14Average hourly earnings are reported before deductions for
taxes, social insurance, fringe benefits, etc. The adjusted
hourly earnings index takes into account such factors as
variation in the amounts of overtime pay or shifts of workers
into higher or lower paying industries.
15As discussed earlier in this paper, to the extent the CPI has
overstated the rate of price increases in recent years, this
decline in real wages is also overstated.



2.2%

4.5%

2.2%

1972

3.3

6.4

3.0

1973

6.2

6.2

0.0

1974

11.0

7.9

-2 .7

1975

9.1

8.3

-0 .7

1976

The decline in real wages has contributed substan­
tially to the financing problem the social security sys­
tem now faces. Moreover, if this financing problem is
resolved by increasing payroll taxes rather than re­
ducing benefits, the price indexing of benefits will
further redistribute the ability to consume the nation’s
output from those working to those receiving social
security benefits. When nominal wages rise more
slowly than the price level, a tax increase imposes a
further decline in real wages. In effect, this decline
imposes an additional reduction in living standards
for workers in order to leave the purchasing power of
social security benefits unchanged.

1952-72*

5.7

7.3

-1 .3

1977

6.5

7.5

1.0

1978

7.6

8.2

0.6

1979

11.3

7.9

-3.1

1980

13.3

9.3

-3 .6

1972-804

8.8

7.8

-0 .9

1952-804

4.1

5.5

1.3

'Data are for all urban consumers.
2Total private nonagricultural earnings for production or
nonsupervisory workers adjusted for overtime and for in­
dustry employment shifts.
3Current dollar index divided by consumer price index.
4Annualized rates of change.

workers than would otherwise have been necessary.16

Alternative Indexing Rules
Modifying the indexing rules to tie benefits to nomi­
nal wage movements rather than price index move­
ments appears to be a way to alleviate some of these
problems. With benefits linked to nominal wage rates,
real benefits would change commensurately with real
wages; that is, when nominal wages rise faster than
the price level, indicating rising productivity and a
rising standard of living for workers, real social secu­
rity benefits would also increase. Conversely, when
wages increase more slowly than the price level, indi16Another potential problem is the difference in expenditure
patterns of social security beneficiaries, and urban wage
earners and clerical workers. To the extent there are differ­
ences in expenditure patterns, relative price changes would
affect the purchasing power of social security benefits differ­
ently than earnings of urban wage earners. A study by the
Bureau of Labor Statistics, however, indicated that a con­
sumer price index based on purchasing patterns of retired
workers would not be substantially different from the official
CPI measure. See Janet L. Norwood, “Cost-of-Living Escala­
tion of Pensions,’ Monthly L ab or Review (June 1972),
pp. 21-24.

7

F E D E R A L R E S E R V E BA N K O F ST. L OUI S

JUNE/JULY

1981

Table 5

Outlays, Income and Balances for the Old Age and Survivors Insurance Fund,
Assuming the Minimum Rule in Effect (billions of dollars)1
1979

1980

1981

1982

1983

1984

1985

1986

Outlays

$ 89.8

$100.3

$114.7

$131.6

$149.0

$168.3

$189.6

$212.9

Income

86.9

100.1

117.8

129.0

143.0

159.1

181.9

203.7

Year-end balance

28.1

27.9

31.0

28.4

22.4

13.2

5.5

-3 .7

iEstimates are based on actual OASI trust fund data for
income under current indexing procedures for 1981-86,
puted by assuming that the minimum rule had been in
rose less rapidly man the CPI. For subsequent years, it

1979-80 and Congressional Budget Office projections of outlays and
as shown in table 1. Modifications of these outlay data were com­
effect in 1979, 1980, 1981, all years in which average hourly earnings
is assumed that the hourly earnings rose more rapidly than the CPI.

eating lower productivity and a declining standard of
living for workers, real benefits would decline.
Had social security benefits been indexed to aver­
age hourly earnings during the recent period of real
wage declines, much of the current short-term finan­
cial problem would have been averted. Benefits in­
dexed to adjusted average hourly earnings during 1979,
1980, and 1981 would have resulted in social security
benefit increases of 8.2 percent in June 1979, 8.4 per­
cent in June 1980 and 9.8 percent in June 1981, instead
of the respective 9.9, 14.3 and 11.2 percent increases
actually granted. In total, during these three years,
benefits of retired workers rose 35 percent as average
hourly earnings of current workers rose only 26
percent.
To initiate the indexing of social security benefits
to nominal wages at this point, however, would prob­
ably still increase future deficits in the OASI trust
fund. Since, historically, nominal wages have risen
faster than the price level, the continuation of this
trend would result in greater increases in benefits
than under a price-indexed scheme and hence greater
deficits in the OASI trust fund than those currently
projected.
A variant of a wage indexing scheme is the “minimum-rule” scheme, which indexes benefits to the lower
increase of the wage or price index. This rule implies
that real social security benefits will decline when
real wages decline, but remain unchanged when real
wages rise.17 This rule would largely remove the fi17One objection to this rule is that real wages often decline
and rise in business cycles. For instance, if real wages fell
in year one but recovered that loss in year two, under the
minimum rule real social security benefits would be re­
duced in the first year but kept at that same lower real
level in the second year. However, Congress could easily
monitor this kind of problem and remedy it by ad hoc in­
creases in benefits.

8




nancial problem that occurs when real wages decline.
For example, if the minimum rule had been in effect
in the past three years so that benefits would have
increased with hourly earnings rather than the CPI,
the estimated year-end balance in fiscal year 1986
would be $3.7 billion in deficit rather than the CBO
estimates of $63.5 billion (see tables 1 and 5). Un­
fortunately, to introduce the minimum rule at this
point would not solve the financing problem of the
OASI trust fund, since this rule would not reduce
benefits from their present level.18 Thus, the minimum
rule will not cure the present budget problems, but
will prevent larger deficits in a future period of de­
clining real wages.
New measures will have to be taken to solve the
current short-term financing problem. The CBO for
example, has investigated a number of possible op­
tions, including a “partial” indexing to the CPI. It
estimated that if benefits were increased by only twothirds of the actual increase in the CPI over the next
several years, the financing problem over this decade
would be eliminated.19 Several other proposals have
also been suggested to eliminate the short-term financ­
ing problem. These include the reapportionment of
18The CBO has considered the effect of this rule on the im­
pending deficit of the OASI trust fund. According to their
estimates, the minimum rule would reduce outlays of the
trust fund over the next five years by $26 billion, or cut
about 40 percent of the projected deficit over the next five
years. Their estimate, however, is based on the assumption
that the indexing rule goes into effect in 1981 when the
CBO projects the nominal wages to rise about 3 percent
slower than the official CPI measure. In fact, if this rule
were instigated at a later date when the CBO projects wage
increases to again exceed price increases, the minimum rule
would do nothing to eliminate the short-run financing prob­
lem of the OASI trust fund. See Paying fo r Social Security:
Funding Options fo r the Near Term, (Congressional Budget
Office of the Congress of the United States, February 1981).
19Ibid, pp. 29-31.

F E D E R A L R E S E R V E BAN K O F ST. LO UI S

funds in other social security trust funds into the
OASI trust fund, the taxation of social security bene­
fits and the reduction or elimination of certain bene­
fits. The administration recently has proposed a plan
that would cut back the benefits of future early re­
tiring workers, while only marginally reducing the
benefits of current recipients. While these various
proposals would eliminate, to varying degrees, the
estimated deficit over the next several years, they
would not remove the basic inconsistency between
price indexing and the pay-as-you-go financing of the
social security benefits. In other words, none of these
proposals would preclude additional deficits from de­
veloping in the OASI trust fund should future declines
in real wages occur.

JU NE/JULY

1981

Table 6

Social Security Taxes on Payrolls Before
and After the 1977 Amendments
Tax rates (p e rc e n t)1
Before

Taxable base2

After

Before
$16,500

After
$16,500

Analysts also project a long-term financial imbal­
ance in the social security trust funds for the next
century, when outlays again are projected to exceed
inflows into the social security system. One of the
major factors underlying this imbalance is the in­
creasing ratio of retirees to workers.
Since benefits are now funded on a pay-as-you-go
basis, the benefits of current workers will be funded
by payroll taxes paid by the next generation of work­
ers. This funding scheme is subject to changes in
demographic patterns. Past increases in benefits were
granted on the assumption that birth rates would be
higher than current projections now indicate. With
declining birth rates, there will be fewer workers to
pay into the social security trust funds when the postWorld War II baby-boom generation begins to retire.
In addition, the increased life expectancy has in­
creased the ratio of retirees to workers.
This problem is potentially quite serious, despite the
substantial increases in social security taxes that have
already been scheduled as a result of the 1977 amend­
ments to the Social Security Act (see table 6). If the
current law is left intact until 2025, taxes on payrolls
would have to rise, according to estimates of the chief
actuary of the social security system, by at least 8
percentage points in order to fund benefits at that
point, implying nearly a 24 percent tax on taxable
payrolls.20 To compensate for these scheduled in20A. Haeworth Robertson, “Financial Status of Social Security
Program After the Social Security Amendments of 1977,”
Social Security Bulletin (March 1978), pp. 21-30. The 24
percent rate includes the tax on both the employer and the
employee.



5.85%

5.85%

6.05

6.05

17,700

17,700

1979

6.05

6.13

18,900

22,900

1980

6.05

6.13

20,400

25,900

1981

6.30

6.65

21,900

29,700

1982-84

6.30

6.70

1985

6.30

7.05

1986-89

INDEXING AND THE LONG-TERM
FINANCIAL IMBALANCE

1977
1978

6.45

7.15

1990-2010

6.45

7.65

2011 and after

7.45

7.65

includes taxes for old age, survivors, disability insurance
and hospital insurance.
beginning in 1982, the amounts will be determined auto­
matically under the new law on the basis of the annual
increase in average earnings on covered employment.

creases in social security taxes, alternatives to reduce
benefits have been suggested. One proposal is to in­
crease the retirement age from 65 to 68, thereby reduc­
ing the average period that benefits are paid out;
another is to tax social security benefits, which would
generate additional general revenues that could then be
used to fund social security benefits.21
The modification of current indexing procedures is
another alternative. Under current law, the benefits
of retired workers increase with the price level, but
the benefits of future retirees are tied to average wage
movements.22 Wage indexing is essentially a promise
21An argument for the taxation of social security benefits can
also be made on the basis of equity considerations. Taxation
of social benefits, or some portion of benefits, would treat
such income more equally with that of other pension in­
comes. Also, it would tax social security income according to
the ability-to-pay criteria applied to other income.
--Benefits of future retirees are indexed in two ways. First, the
wage history of retiring workers is indexed to the average
wages of U.S. workers so that earnings in past years are
brought up to current average wage levels. For example, if
the average earnings doubled from 1970 to 1980, the wage
that a retiring worker actually earned in 1970, say, $10,000,
would be doubled to $20,000. After a certain number of years
are dropped out, the worker’s indexed earning history is
averaged to obtain the average indexed monthly earnings
(A IM E). A formula to compute benefits, prescribed by Conress, is then applied which in 1979 was 90 percent of the
rst $180 plus 32 percent of the next $905 plus 15 percent
of the excess over $1,085. This formula is indexed to average
U.S. wage movements. The “breakpoints,” namely $180 and
$1,085, are adjusted automatically each year to reflect changes
in average U.S. wages.

9

F E D E R A L R E S E R V E BANK O F ST. L OUI S

to keep the benefits of retiring workers at a certain
proportion of their real income during their lifetime.
Thus, as discussed earlier, when wages rise faster than
prices, the initial benefits of future retiring workers
will increase in real terms in step with increases in
wages over their working years.
This procedure itself is consistent with the current
financing scheme that taxes payroll income, in the
sense that future benefits and taxes will rise or fall
together. However, large benefit increases were
granted in the late 1960s and early 1970s based on
what now appears to have been incorrect assumptions
about birth and death rates. As a result, a long-term
financing problem is expected to emerge if current
demographic trends persist.
An indexing procedure that would insure that bene­
fits grow at a lower rate than revenue is a “partiallyindexed” wage rule. This rule would specify that
benefits be indexed to wage movements, but by a
smaller percentage than the wage increase. When
real wages are growing, benefits would rise over time,
but not as rapidly as wages or revenues. While the
purchasing power of promised benefits to future re­
tirees would be reduced from where they are now,
they would normally be at a substantially higher level
than those of current retirees.

CONCLUSION
Congress has indexed social security benefits to
movements in the consumer price index, a reform in­
tended to protect the purchasing power of these bene­
fits. Recent U.S. experience, however, has shown that
there are problems with this procedure. One problem
is that the CPI has seriously overstated the rise in
prices in recent years; thus, it has contributed to


10


JUNE/JULY

1981

higher benefits than were necessary to keep the pur­
chasing power of benefits unchanged. The Bureau of
Labor Statistics is currently contemplating certain
technical changes in the official CPI calculations, such
as the measurement of home ownership costs by the
rental equivalence method. These changes, if imple­
mented, may result in a better measure of changes in
the price level.
In addition, price indexing of benefits can be in­
consistent with the method currently used to finance
the social security system. The system is essentially
financed on a pay-as-you-go basis by taxes on wages
and salaries, so when prices rise faster than wages,
benefits rise faster than revenues into the OASI trust
fund. To remedy such a situation, once the small
trust fund balances are depleted, requires that the
government either levy additional taxes on workers
or reduce the growth of benefits.
One reform of the indexing procedure that would
greatly diminish the likelihood of such financial im­
balances in the OASI trust fund in a future period
of declining real wages; is the so-called minimum
rule. This rule would limit benefit increases to either
average wage movements or the price level, whichever
is smaller, and implies that benefits would decline in
real terms when real wages of workers decline and
remain constant when real wages rise, as the current
law provides. Such a rule does not reduce benefits
from those promised under current law except when
real wages of workers are declining. Thus, at this
point, it would neither solve the short-term financing
problem faced in the 1980s nor the long-term problem
that is expected to develop in the next century. It
would, however, preclude them from becoming worse
should prices rise faster than wages in the future. To
solve these financing problems, other measures must
be taken to either increase taxes or reduce benefits.

Why the Median-Priced Home
Costs So Much
SCOTT E. HEIN and JAMES C. LAMB, JR.

I n FLATION has caused many distortions that af­
fect the affordability of housing, especially for first­
time buyers. Since 1965, the price of the medianpriced house in the United States has more than
tripled.1 More important, however, the annual mort­
gage payment for a standard financing arrangement
is almost seven times as large as before for the
median-priced house. As a result, the median-income
family is unlikely to qualify for and presumably would
be reluctant to obtain conventional financing to buy
the median-priced house today.
In 1965, the median before-tax family income was
$7,610, the new home mortgage rate averaged 5.81
percent, and the median sale price of a new onefamily house was $20,150. With a 20 percent down
payment and a 30-year mortgage to secure the bal­
ance, a homeowner would owe $1,136 in annual in­
terest and principal payment on the debt, approxi­
mately 14.9 percent of his income.
In 1980, by comparison, median before-tax income
was approximately $21,500, the new home mortgage
rate for the year averaged 13.73 percent, and the
median sale price of a new one-family house vaulted
to $64,900. The annual interest and principal charges
on a 30-year mortgage for this home, again assuming
a 20 percent down payment, would be $7,249, or 33.7
percent of the median income (see table 1).
As evidenced by these numbers, the change in the
cost of homeownership has been drastic. This article
explains why this cost has risen so sharply: why the
1965 median-income family had to pay less than
15 percent of its annual income in mortgage pay­
ments on a median-priced house, while the 1980
median-income family must pay more than 33 per'The median of a set of data is the number below and above
which there are an equal number of observations.



Table 1

Comparison of Income and Mortgage
Payments for 1965 and 1980
(current dollars)
1965

1980

Median before-tax income

$ 7,610

$21,500

M edian sale price of a new home

$20,150

$64,900

5.81%

13.73%

$ 1,136

$ 7,249

14.9%

33.7%

Average mortgage rate
Annual interest and principal1
Payment as a percentage of income

1Assuming 20 percent down payment.

cent. Two separate issues are considered: the increase
in housing prices and the increase in the cost of
financing a home purchase.

THE RISE IN HOUSING PRICES
From 1965 to 1980, the prices of personal consump­
tion goods more than doubled, rising 131.8 percent.
Since inflation is a sustained increase in the general
level of prices, one would expect similar increases in
housing prices. However, the prices of new housing
for the same period rose an even higher 223.2 per­
cent.2 Table 2 shows the annual rate of increase in
new housing prices and personal consumption goods.
2This indicates that individuals who owned homes over this
period have experienced sizable capital gains. On this matter,
see Patric H. Hendershott and Sheng Cheng Hu, “Inflation
and the Benefits from Owner-Occupied Housing” (National
Bureau of Economic Research, Working Paper No. 383, Au­
gust 1979) for a discussion of the capital gains experienced
by households. The present paper does not analyze the ramifi­
cations of these capital gains on the demand for housing.

F E D E R A L R E S E R V E BA N K O F ST. L OUI S

JUNE/JULY

1981

Demographic and Lifestyle Factors
Table 2

Annual Change in Housing Prices and
the Personal Consumption Deflator1
Change in
personal
consumption
deflator

Year

Change in
housing prices

1965

2.9%

1.7%

1966

3.5

2.9

1967

3.6

2.4

1968

5.6

4.1

1969

8.0

4.5

1970

3.0

4.7

1971

5.2

4.2
3.7

1972

6.4

1973

9.5

5.6

1974

9.3

10.1

1975

9.5
8.6

5.2

1977

12.8

6.0

In addition, lifestyle changes apparently have in­
creased the demand for shelter, at least partially af­
fecting the demand for owner-occupied housing. For
example, the proportion of unmarried adults has in­
creased with the rise in the divorce rate and the post­
ponement of marriage. These lifestyle changes have
resulted in more and more single-person households.
Today there often are two people demanding hous­
ing, where before there was one.

7.6

1976

Additional factors that help explain the relative
increase in housing prices are demographic changes
since 1965. First, the adult population — the pur­
chasers of homes — has grown rapidly in recent
years.4 There appear to be two sources of this growth.
One, individuals born in the post-World War II baby
boom have moved into the homebuying age group.
Two, the U.S. population now enjoys an increased
longevity.

1978

13.7

6.8

1979

14.2

8.9

1980

10.1

10.2

1Data on housing prices are for new sales only.

Only in 1970, 1974 and 1980 was the annual rate of
increase in housing prices less than that of personal
consumption goods. Thus, while general inflation ex­
plains most of the increase in housing prices, it leaves
unanswered the question why housing prices have
risen faster than the general price level.

Inflation and the Favorable Tax
Treatment of Homeotvnership
A third factor causing the relative rise of housing
prices is the favorable treatment of homeownership
by the U.S. tax structure. As inflation has accelerated,
this treatment has become even more favorable.5 For
example, an individual can deduct mortgage interest
expenses from taxable income in determining his in­
come tax. Thus, as nominal interest rates and mort­
gage rates rise with inflation, borrowers can deduct
larger interest expenses, even if the real (inflation
adjusted) cost of borrowing remains unchanged. In
other words, the higher the anticipated future infla­
tion, the cheaper it is to borrow under our tax
system.6 Since most people borrow to purchase a

Quality Changes
One possible explanation for this phenomenon is
that the quality of housing has risen over the past 15
years; thus, we are comparing the price of two dis­
similar goods. Though this problem plagues all price
index measures, it appears to be particularly impor­
tant in the case of housing. The average new home is
larger and has more amenities, such as central air
conditioning and insulation. Still, economists generally
believe that these quality increases are not substantial
enough to fully explain the rapid relative price rise.3
®For example, Randall J. Pozdena, “Inflation Expectations and
the Housing Market,” Federal Reserve Bank of San Francisco
E conom ic Review (Fall 1980), pp, 29-47, estimates that 15
percent of the increase in the average home sales price be­
tween 1970 and 1979 is explained by quality considerations.
Digitized for 12
FRASER


4For a more detailed discussion, see Dan M. Bechter, “How
Much For a New House in the Years Ahead? Some Insights
From 1975-80” (Federal Reserve Bank of Kansas City, Re­
search Working Paper 81-104),
5Anthony Downs, “The Low (Real) Cost of Housing,” Across
the Board (February 1981), pp. 51-55; James M. Poterba,
“Inflation, Income Taxes and Owner-Occupied Housing” (Na­
tional Bureau of Economic Research, Working Paper No. 553,
September 1980).
6There is an important distinction between nominal and real
interest rates. Nominal interest rates are market interest rates
which state how many dollars the borrower will pay and the
lender will receive on a loan. Since inflation depreciates the
value of a dollar in terms of its command over resources,
nominal rates are bid up by anticipated inflation. Real interest
rates are rates that have been adjusted for inflation. The
expected real interest rate can be measured by subtracting
the expected annual rate of inflation from the nominal interest
rate.
The favorable treatment given to borrowers comes from the
fact that individuals can deduct nominal interest expenses

F E D E R A L R E S E R V E BAN K O F ST. L OUI S

house, this increasingly favorable treatment has in­
creased the demand for the single-family dwelling.
This benefit becomes even more important as infla­
tion pushes individuals into higher marginal income
tax brackets (bracket creep). Bracket creep has in­
creased the marginal tax rate for the median-income
family from 17 percent in 1965 to 24 percent in 1980.
As individuals are pushed into higher marginal tax
brackets, the value of deducting interest expenses in­
creases. Thus, even if the interest expense on a loan
or mortgage were unaffected by inflation, individuals
would pay less after-tax dollars to borrow in 1980
than they did in 1965. Since we have a progressive
income tax structure, the increase in marginal tax
rates has been even larger for family incomes greater
than the median. In 1965, a family whose income was
in the 80th percentile (who earned more dollars than
80 percent of all other families) was in the 19 percent
marginal tax bracket. In comparison, by 1980 this
family was in the 37 percent marginal tax bracket.
Thus, high-income families have experienced even
greater reductions in the after-tax cost of borrowing
as inflation has moved them into higher marginal
tax brackets.7
In another benefit of our tax structure, capital gains
realized from the sale of a home are not taxed if
they are reinvested in another home. In addition,
people over the age of 55 can now realize a tax-free,
one-time capital gain of $100,000 or less from the sale
of their home. Consequently, some homeowners effec­
tively pay no tax on capital gains from home owner­
ship, substantially less than they would pay in taxes
on capital gains from stocks or bonds.
An additional favorable tax consideration concerns
housing as a form of investment. Consider an investor
from their incomes in determining taxable income. Compare
two individuals — one in an inflationary environment with 10
percent inflation and the other in an environment with no in­
flation. Suppose the interest rates are 13 percent and 3 per­
cent, respectively, so that the real rate is 3 percent in both
cases. Although the real cost of borrowing is the same for
each individual, the after-tax real cost is lower for the person
in the inflationary environment since that individual’s nominal
interest expense is much larger.

JUNE/JULY

1981

who is contemplating two alternative purchases: a
purchase either of $70,000 in securities or a $70,000
house. In the first case, the investor earns taxable
interest income from the investment. In the latter, he
receives no direct monetary remuneration, but he
does obtain certain housing services referred to as “im­
puted rent”— the value of these services if the investor
were renting the house.8 If the expected annual interest
income equals the imputed rent (and if neither in­
vestment is appreciating in value), tax considerations
would induce the investor to purchase the house
rather than the securities, because the income earned
from the house is untaxed.
Furthermore, inflation drives nominal interest rates
up so that the interest income from securities increases
(relative to interest income in noninflationary situa­
tions). This raises the tax burden on securities, mak­
ing the investor worse off. Thus, a rise in the inflation
rate increases the relative attractiveness of imputed
income versus income from securities.
Finally, the U.S. tax structure is such that, during
periods of high inflation, corporations are penalized
with higher tax bills, while no such effect occurs on
housing investments. Thus, individuals become wary
of investing in corporate stocks. Corporations are
affected because the depreciation of their assets is
based on historic cost, and their inventories are valued
by first-in - first-out (FIFO ) inventory accounting.
With respect to depreciation, present tax accounting
practices do not write off capital expenses rapidly
enough. In an inflationary environment, the dollar
value of depreciation for a machine should represent
both the physical deterioration of the machine, and the
fact that it will take more dollars in the future to re­
place the machine or any of its parts. Present depre­
ciation practices fail to recognize this latter element of
depreciation and, as such, overstate corporate profits.
With corporations paying more in taxes, the return to
equity holders is reduced accordingly. A similar over­
statement of profits results when corporations use
FIFO inventory accounting. A number of studies have
suggested that these factors have induced investors
to divert money from the stock market into the hous­
ing market, where as noted above, more favorable tax
treatment is available.9

The point that the present tax structure favors borrowing
has also been made in Lawrence H. Summers, “Inflation, the
Stock Market and Owner Occupied Housing” (National Bu­
reau of Economic Research, Working Paper No. 606, Decem­
ber 1980).

8See Anthony M. Rufolo, “What’s Ahead for Housing Prices?”
Federal Reserve Bank of Philadelphia Business R eview (July/
August 1980), pp. 9-15.

7See Patric H. Hendershott, “Estimates of Investment Functions
and Some Implications for Productivity Growth,” in Laurence
H. Meyer, eel., T he Supply-Side E ffects o f Econom ic Policy
(St. Louis: Center for the Study of American Business and
Federal Reserve Bank of St. Louis), pp. 149-65.

9Patric H. Hendershott, “The Decline in Aggregate Share
Values: Inflation and Taxation of the Returns From Equities
and Owner-Occupied Housing” ( National Bureau of Economic
Research, Working Paper No. 370, July 1979) and Summers,
“Inflation, the Stock Market and Owner Occupied Housing.”




13

F E D E R A L R E S E R V E BAN K O F ST. LOUIS

Many factors have increased the demand for resi­
dential housing over the last 15 years.10 It is important
to recognize that part of this stimulus to demand
comes from the favorable tax treatment of housing
which has worked to increase the after-tax afford­
ability of housing from an economic perspective; that
is, the relative after-tax price of housing is being re­
duced by the interaction of inflation and the present
tax structure.11 Looking at the ratio of mortgage pay­
ments to before-tax income, as many homebuyers and
lending institutions do, fails to recognize this point.

THE COST OF BORROWING
As we have seen, housing prices have risen faster
than other prices over the last 15 years. However,
family incomes have also risen faster than inflation
over this same period. In fact, family incomes nearly
have kept up with housing prices. In 1965, the ratio
of the median-priced house to the median family
income was 2.6; in 1980 the ratio had risen only to
3.0. Thus, ignoring tax considerations, the 1980 house
would not appear to be substantially more expensive
relative to income than it was in 1965.
To make this point another way, consider what
would result if the 1980 median-income family could
purchase the 1980 median-priced house, at the 1965
mortgage rate. If this family bought a 1980 medianpriced home, but borrowed 80 percent of the purchase
price at a mortgage rate equal to the 1965 average
of 5.81 percent, its principal and interest payments
would have been only 17.0 percent of the median
family income. Thus, the 1980 median-income family
could well afford the 1980 median-priced house, if
only they could obtain a 5.81 percent mortgage rate.
This hypothetical case is clearly unrealistic, but it
does suggest that a major culprit in the 1980 afforda­
bility problem is today’s high level of mortgage rates.
At a mortgage rate of 13.73 percent, today’s homebuyer would be paying more than 33 percent of his
current income in terms of interest and principal
alone.
10In addition, other factors have retarded the supply of hous­
ing. Bechter, “How Much For a New House? ’ p. 13, sees
government regulations “as being directly or indirectly re­
sponsible for holding back the rate of increase in the pace of
homebuilding during the rising portion of the last housing
cycle.” In this light government policies have also increased
the relative price of housing by imposing stringent zoning
codes and subdivision regulations.
1:lThis point has led Downs, “The Low (Real) Cost of Hous­
ing,” to suggest that the United States is overinvesting in
housing. Also, see Hendershott, “Estimates of Investment
Functions.”

14



JUNE/JULY

1981

But today’s high level of mortgage rates, in and of
itself, is not the problem. Though the mortgage rate
was quite high in 1980, it is unlikely that this rate
has substantially reduced the long-run economic in­
centive to own a home. Quoted mortgage rates are
nominal rates. Nominal rates alone, however, have
little influence on an individual’s purchasing or invest­
ment decisions. Both tax considerations and antici­
pated future inflation influence these decisions.
When the anticipated inflation rate and the favor­
able tax treatment given to housing are taken into
account, homebuying is not nearly as adversely af­
fected by high nominal mortgage rates as might first
be thought. As we have seen, the ability to write off
interest expenses reduces the true interest costs asso­
ciated with purchasing a home. Last year, for example,
a median-income family of four was in the 24 per­
cent marginal tax bracket for U.S. income tax pur­
poses. After deducting interest expenses from the pur­
chase of a new home, the family’s after-tax mortgage
rate was reduced (at the margin) from the market
rate of 13.73 percent to the net rate of 10.43 percent
[13.73 X (1-0.24)]. The 1965 median-income family,
on the other hand, paid a 4.71 percent [5.81 X (1 0.19)] marginal after-tax mortgage rate.
Further, when inflation expectations are considered,
this after-tax rate of 10.43 percent in 1980 may not be
all that high. Nominal interest rates are high today,
when compared to those in 1965, because investors
anticipate a higher future inflation rate than they
anticipated in 1965. As such, they recognize that
the dollars which will be paid back in the future will
buy fewer goods, and they demand compensation
accordingly. Borrowers, also anticipating inflation, rec­
ognize they will be paying back the loan with a
depreciated currency and thus do not find high nomi­
nal interest rates prohibitive.
For example, take the 1965 median-income family
who must pay 4.71 percent after taxes to borrow at
the 1965 mortgage rate. Suppose this family antici­
pates that future inflation will be 2 percent per year.
If this family borrows $100 for a year, they would
pay back, after tax deductibility is allowed, $104.71
at the end of one year. Since they expect 2 percent
inflation, however, they see the foregone $104.71 as
equivalent to giving up $102.66 ($104.71/1.02) in
present dollars. Thus, the real after-tax interest rate
is only 2.66 percent — this 1965 homebuyer expects
to give up only $2.66 worth of goods and services to
borrow $100.
How much inflation must today’s homebuyer antici­

FE DE RAL . R E S E R V E BA N K O F ST. L O U IS

pate to make them indifferent between the present
arrangement and that of 1965? The after-tax mortgage
rate for the 1980 median-income family is 10.43 per­
cent. Thus, after tax deductions, the family will pay
$110.43 to borrow $100 for one year at the 1980 mort­
gage rate. If the family anticipates inflation at 8 per­
cent over the next year, they see the $110.43 given up
at the end of one year as equivalent to $102.25
($110.43/1.08) in 1980 dollars. The real after-tax rate
is 2.25 percent. Thus, the 1980 median-income family
expecting the future inflation rate to be 8 percent or
more anticipates lower after-tax real borrowing costs
than the 1965 median-income family that expected a
future inflation rate of 2 percent.
If individuals expect inflation to continue at recent
levels, the 10.43 percent after-tax rate the medianincome family must pay for a 13.73 percent mortgage
represents a relatively small cost in terms of the real
goods and services that must be given up. It is un­
likely then that the recent high nominal mortgage
rates alone have significantly discouraged home pur­
chases. Thus, when both taxes and anticipated future
inflation are taken into account, the after-tax real cost
of the mortgage is apparently not unduly prohibitive.

THE CONVENTIONAL MORTGAGE
If, as has been argued, neither 1980 housing prices
nor 1980 mortgage rates are too great a burden for
prospective homeowners, what has caused the signifi­
cant increase in the ratio of mortgage payments to
income? The answer lies in restrictions resulting from
conventional mortgage agreements.
Conventionally, mortgage debt is amortized over
the repayment period, usually 25 to 30 years, so that
the periodic payment is fixed, and both the principal
and interest are paid off by the end of the loan. One
of the main features of the conventional mortgage is
that it fixes the periodic payments in dollar terms for
the duration of the loan. This feature was useful in
a noninflationary environment, but is it when future
inflation is expected?
Consider two hypothetical cases in which a family
with the median income in 1980 borrows $51,920 to
purchase the median-priced house.12 In the first case,
suppose the family (and the rest of the public) antici­
pates no inflation in the future, expecting the prices of
goods and services to remain essentially unchanged.
The family realistically expects its income to rise, but
this expectation is based on anticipated productivity
gains, not inflation. As such, the increase in expected
12We will ignore all tax considerations in the following analysis.



JUNE/JULY

1981

future income implies an increased future command
over goods and services. Assume the family expects
their income to rise at an annual rate of 3 percent.
Similarly, assume the family can borrow at a 3 per­
cent rate.
In the second case, suppose the family (and the
rest of the public) anticipates a steady 8 percent rate
of inflation for 30 years. We assume that in every other
way this family is similar to the first. Specifically, we
assume that the family expects its income to grow in
real (inflation-adjusted) terms at a 3 percent rate. This
implies that the family expects their dollar income to
increase at about an 11 percent rate — 8 percent due
to inflation, 3 percent due to real productivity gains.
Table 3 lists the two respective dollar income streams
that are anticipated in these two situations. While the
expected income streams are quite different, each fam­
ily expects its command over goods and services to be
the same under each scenario. In addition, we will as­
sume in this second case that the family expecting 8
percent inflation can borrow at an 11 percent rate, so
that in real terms the cost of borrowing is 3 percent
as it was in case one.
Thus, we are comparing a family in two different
situations that are essentially identical when infla­
tion is accounted for. Each family starts with the
same dollar income and buys the same dollar-priced
house. With the passing of every year, each family
can buy 3 percent more goods and services than it
could the previous year. In addition, the real cost of
borrowing is the same in each case: to borrow a dol­
lar today, each family promises to pay back enough
money in one year to buy what $1.03 buys today.
The two families should be equally happy. In real
terms their situations are identical. But let us con­
sider what would happen if each family were to obtain
a conventional mortgage. In the first case, with the
family expecting zero inflation and borrowing at a 3
percent rate, the annual mortgage payment turns out
to be $2,627. In the second case, the family expecting
8 percent inflation and borrowing at an 11 percent
rate faces a $5,933 annual mortgage payment. Over
the full term of the mortgage, the two situations are
identical. The significantly higher nominal payment
in the second case is due to expected inflation. If, as
we assume, inflation turns out to equal the 8 percent
rate expected, the interest paid on the second debt
over the full 30-year period will buy exactly the same
amount of goods and services as in the no inflation
case. Thus, in such a case the family is simply com­
pensating the lender for the eroding value of money
and is no worse off in a real sense.
15

JUNE/JULY

F E D E R A L R E S E R V E BAN K O F ST. LO UI S

1981

Table 3

Percent of Principal and Interest to Income With and Without Inflation
8 % Inflation

No Inflation

Y ear

Payment

M edian
Income

1980

$2,627

$21,500

1981

2,627

22,145

Paym ent as
a percent
of median
income
12.2%
11.9

Payment

Payment
adjusted
for
inflation

Payment as
a percent
of median
income

M edian
income

$5,933

$5,933

$ 21,500

5,933

5,494

23,917

24.8

27.6%

1982

2,627

22,809

11.5

5,933

5,087

26,604

22.3

1983

2,627

23,494

11.2

5,933

4,710

29,596

20.0

1984

2,627

24,198

10.9

5,933

4,361

32,921

18.0

1985

2,627

24,924

10.5

5,933

4,038

36,622

16.2

1986

2,627

25,672

10.2

5,933

3,739

40,738

14.6

1987

2,627

26,442

9.9

5,933

3,462

45,317

13.1

1988

2,627

27,235

9.6

5,933

3,205

50,410

11.8

1989

2,627

28,052

9.4

5,933

2,968

56,076

10.6

1990

2,627

28,894

9.1

5,933

2,748

62,380

9.5

1991

2,627

29,761

8.8

5,933

2,545

69,392

8.5

1992

2,627

30,654

8.6

5,933

2,356

77,192

7.7

1993

2,627

31,573

8.3

5,933

2,182

85,867

6.9

1994

2,267

32,520

8.1

5,933

2,020

95,518

6.2

1995

2,627

33,496

7.8

5,933

1,870

106,255

5.6

1996

2,627

34,501

7.6

5,933

1,732

118,198

5.0

1997

2,627

35,536

7.4

5,933

1,604

131,484

4.5

1998

2,627

36,602

7.1

5,933

1,485

142,262

4.1

1999

2,627

37,700

7.0

5,933

1,375

162,702

3.7

2000

2,627

38,831

6.8

5,933

1,273

180,990

3.3

2001

2,627

39,996

6.6

5,933

1,179

201,333

3.0

2002

2,627

41,196

6.4

5,933

1,091

223,969

2.7

2003

2,627

42,431

6.2

5,933

1,010

249,132

2.4

2004

2,627

43,704

6.0

5,933

936

277,135

2.1

2005

2,627

45,015

5.8

5,933

866

308,289

1.9

2006

2,627

46,366

5.7

5,933

802

342,939

1.7

2007

2,627

47,757

5.5

5,933

743

381,486

1.6

2008

2,627

49,189

5.3

5,933

688

424,359

1.4

2009

2,627

50,665

5.2

5,933

637

472,060

1.3

This, however, is a long-run perspective. In the
short run (less than the full term of the mortgage),
as table 3 indicates, the two families are treated
very differently. Specifically, the proportion of income
spent on the mortgage when inflation is expected to
be 8 percent is much larger in the early years of the
mortgage. For example, in the first year the mortgage
payment is 27.6 percent of the family income with 8
16




percent expected inflation, as opposed to 12.2 percent
of the family income in the zero anticipated inflation
case.
The explanation for this is simple enough. When
everyone anticipates inflation, the borrower must not
only repay the principal and interest, but must also
compensate the lender for the eroding value of money.

F E D E R A L R E S E R V E B AN K O F ST. L OUI S

Since, under the conventional mortgage, the periodic
payment is fixed in nominal terms, the borrower must
compensate the lender early in the repayment period
for inflation expected to occur many years down the
road. However, the ratio of mortgage payment to
family income falls quite rapidly as the second fam­
ily’s income increases because of productivity gains
and inflation, so that the very high ratio early in the
mortgage is counter-balanced by a lower ratio later on.
The conventional mortgage thus treats the homebuyer very differently depending on anticipated infla­
tion. In a noninflationary environment, the family in­
come is expected to be relatively stable in dollar
terms, and the mortgage payment plan is in complete
agreement with such an expectation. However, in an
inflationary environment the family expects its income
to rise with inflation; the fixed dollar mortgage pay­
ment fails to take such an expectation into account.
Thus, while nominal interest rates clearly reflect ex­
pectations of future inflation and require compensa­
tion accordingly, the payment schedule for a conven­
tional mortgage does not reflect such expectations.

THE MORTGAGE PAYMENT-INCOME
RATIO: LOAN CRITERION
This example indicates quite pointedly how allow­
ing for a maximum ratio on the mortgage payment to
family income is a dubious rule for the lender to fol­
low in determining whether or not to make a loan
under conventional arrangements. The two families
are in exactly the same situation in real terms. The
current house prices are the same. The expected real
income streams are the same. And the expected real
interest rates are the same. Therefore, if the family
in the noninflationary environment can buy the house,
then the family in the inflationary environment should
also be able to buy the same house.
Solely considering the ratio of the nominal mort­
gage payment to income in the first year of the mort­
gage would suggest that the family expecting 8 percent
inflation is less able to afford the house than the
family expecting no inflation. However, this problem
is a function of the interaction of anticipated inflation
and the conventional mortgage; it is unrelated to
whether or not the family can ultimately pay off the
loan. Surely if the family could “afford” the home in
the case of zero inflation, they could “afford” it in
the case of 8 percent inflation. In this light, recent
increases in the acceptable mortgage payment to fam­
ily income ratio are not seen as a major problem for
the long-run solvency of mortgage lenders, and in fact



JUNE/JULY

1981

is a natural response to the interaction of inflation
and the conventional mortgage.

The Real Mortgage Expenses
Table 3 further shows that the family in the infla­
tionary situation pays a substantially larger inflationadjusted mortgage payment in the early years of the
mortgage than the family in the non-inflationary case.
In our example, the real payments ( in terms of actual
command over goods and services) are higher for the
family in the inflationary environment for the first
11 years and lower thereafter. Thus, the early pay­
ments are high, not only relative to the family in­
come, but in real terms also.
In real terms, the family in the inflationary environ­
ment is saving more in the early part of the mortgage
than the family expecting no inflation. Relative to the
family expecting no inflation, the family anticipating
8 percent inflation is postponing consumption in the
early years of the mortgage so it can make the high
nominal payments. This postponed consumption early
in the life of the mortgage is, of course, offset by
lower real payments later on.
It is important to recognize that this savings de­
cision was dictated by the interaction of inflation and
the conventional mortgage. It may not be a choice that
the family would prefer. For example, our family ex­
pecting 8 percent inflation may not like the idea of
spending 27.6 percent of their 1980 income on mort­
gage payments. But, to the extent that only fixed
nominal payment plans are being offered, their choice
becomes either to accept this savings schedule or to
forego buying the home. In this light, it is entirely
likely that we could see a reduced demand for hous­
ing in periods of high anticipated inflation, as a result
of the pattern of real costs imposed by the conven­
tional mortgage. Families and individuals may forego
buying homes in inflationary periods, not because
housing is no longer a worthwhile long-term invest­
ment, but because of the disproportionate real mort­
gage payments forced on them in early years by the
conventional fixed-payment mortgage.

THE CONVENTIONAL MORTGAGE AND
EXPECTED INFLATION
Our example has shown that in the face of expected
inflation the conventional mortgage acts to frontend load the mortgage payments both in real terms
and relative to a family’s current income. Moreover,
as expected inflation accelerates, the front-end load­
ing problem becomes more severe. The larger the
17

JUNE/JULY

F E D E R A L R E S E R V E BAN K O F ST. L OUI S

1981

Table 4

Percent of Principal and Interest to Income Under Different Rates of Inflation
13% Inflation

8% Inflation
Paym ent as
a percent
of median
income
27.6%

Payment

Payment
adjusted
for inflation

Median
income

Paym ent as
a percent
of median
income
32.1%

Y ear

Payment

Payment
adjusted
for inflation

1980

$5,933

$5,933

$ 21,500

$6,892

$6,892

$ 21,500

1981

5,933

5,494

23,917

24.8

6,892

6,099

25,024

27.5

1982

5,933

5,087

26,604

22.3

6,892

5,397

29,125

23.7

Median
income

1983

5,933

4,710

29,596

20.0

6,892

4,777

33,899

20.3

1984

5,933

4,361

32,921

18.0

6,892

4,227

39,454

17.5

1985

5,933

4,038

36,622

16.2

6,892

3,741

45,921

15.0

1986

5,933

3,739

40,738

14.6

6,892

3,310

53,448

12.9

1987

5,933

3,462

45,317

13.1

6,892

2,930

62,208

11.1

1988

5,933

3,205

50,410

11.8

6,892

2,592

72,403

9.5

1989

5,933

2,968

56,076

10.6

6,892

2,294

84,269

8.2

1990

5,933

2,748

62,380

9.5

6,892

2,030

98,082

7.0

1991

5,933

2,545

69,392

8.5

6,892

1,797

114,159

6.0

1992

5,933

2,356

77,192

7.7

6,892

1,590

131,570

5.2

1993

5,933

2,182

85,867

6.9

6,892

1,407

154,645

4.5

1994

5,933

2,020

95,518

6.2

6,892

1,245

179,990

3.8

1995

5,933

1,870

106,255

5.6

6,892

1,102

209,493

3.3

1996

5,933

1,732

118,198

5.0

6,892

975

243,830

2.8

1997

5,933

1,604

131,484

4.5

6,892

863

283,793

2.4

1998

5,933

1,485

142,262

4.1

6,892

764

330,306

2.1

1999

5,933

1,375

162,702

3.7

6,892

676

384,443

1.8

2000

5,933

1,273

180,990

3.3

6,892

598

447,453

1.5

2001

5,933

1,179

201,333

3.0

6,892

529

520,791

1.3

2002

5,933

1,091

223,969

2.7

6,892

468

606,151

1.1

249,132

2.4

6,892

415

705,484

1.0
0.8

2003

5,933

1,010

2004

5,933

936

277,135

2.1

6,892

367

821,115

2005

5,933

866

308,289

1.9

6,892

325

955,693

0.7

2006

5,933

802

342,939

1.7

6,892

287

1,112,344

0.6

2007

5,933

743

381,486

1.6

6,892

254

1,294,657

0.5

2008

5,933

688

424,359

1.4

6,892

225

1,506,831

0.5

2009

5,933

637

472,060

1.3

6,892

199

1,753,812

0.4

expected rate of inflation, the higher the nominal
mortgage rate and the higher the first-year conven­
tional mortgage payment — both in real terms and
relative to family income. Table 4 shows this for a
case in which inflation accelerates from 8 percent to
13 percent.13
13At 13 percent inflation, the family’s mortgage payment in
1980 is 32.1 percent of their 1980 income. If inflation was
expected to be 40 percent or more, the family’s mortgage
payment would have exceeded their income.



This feature explains in large part why we had no
“affordability” problem from 1976 through 1978.14
14There is cursory evidence that the front-end loading problem
was evident in 1974. That year saw a sharp acceleration in
both inflation and nominal interest rates. The FHA mortgage
rate averaged 9.55 percent that year. As such, conditions
were conducive for the imposition of significant real mort­
gage payments early in the loan. Along these lines it is
appropriate to note that 1974 was one of only two years
from 1965 to 1980 in which housing prices did not rise as
rapidly as consumption goods.

F E D E R A L R E S E R V E BAN K O F ST. L OUI S

Over this period, both inflation and nominal interest
rates were fairly low — suggesting relatively low ex­
pected inflation. For example, the FHA mortgage rate
was below 10 percent from 1976 through 1978. Be­
ginning in 1979, however, inflation and nominal inter­
est rates rose sharply. Since the early part of 1979,
the front-end loading problem has likely become an
important one for homebuyers, especially first-time
buyers.15 For previous homeowners, this problem is
not as severe since they have realized significant capi­
tal gains from homeownership which can offset the
front-end loading problem.

SUMMARY AND CONCLUSION
A family with the 1980 median income must pay
over 33 percent of their income to buy the 1980
median-priced house. In comparison, the 1965 medianincome family paid less than 15 percent of their in­
come to buy the 1965 median-priced house. To some
15There is an alternative mortgage arrangement that can be
implemented to avoid this problem. For a discussion of such
a mortgage, see Donald Lessard and Franco Modigliani, “In­
flation and the Housing Market: Problems and Potential
Solutions,” in Donald Lessard and Franco Modigliani, eds.,
New M ortgage Designs for Stable Housing in an Inflationary
Environment ( Proceedings of a Conference Sponsored by the
Federal Reserve Bank of Boston), pp. 13-45; and Henry J.
Cassidy, “Price-Level Adjusted Mortgages ( PLAMs): A
Comparison with other Home Mortgage Instruments” (Fed­
eral Home Loan Bank Board, Working Paper No. 90, Janu­
ary 1981).
Note, however, that the variable or renegotiable mortgage
rate arrangements will not resolve the current cash-flow prob­
lems for first-time buyers.




JUNE/JULY

1981

extent, this drastic change is due to the fact that
housing prices have risen faster than inflation, spurred
on by demographic factors and the preferential tax
treatment of housing which has accelerated with infla­
tion. Family incomes, however, have to a large extent
kept up with housing prices, so this phenomenon is
not as crucial as may first appear.
The main culprit in causing the significant increase
in the proportion of income a new buyer must pay
to purchase a house is the combination of the expec­
tation of higher future inflation and the conventional
mortgage. Expected inflation requires that lenders be
compensated for the expected deterioration in the
purchasing power of money. Moreover, the conven­
tional mortgage requires that payments, including
those due to future inflationary effects on the value
of money, be spread evenly over the duration of the
mortgage so that dollar payments are constant. As
such, today’s conventional mortgage imposes a signifi­
cant cash-flow problem for the homebuyer, especially
the first-time buyer.
It is thus likely that many prospective new home­
buyers recently have postponed home purchases or
have bought a lower-priced home than they originally
desired, either because of the significant real costs of
the mortgage in the early years, or because of the
limitation on mortgage debt to income imposed by
credit institutions. In this regard, any actions taken
to reduce inflation will benefit the long-term future
of the housing industry.

19

Inflation: The Cost-Push Myth
DALLAS S. BATTEN

I NFLATION continues to be our greatest economic
problem. This is not a particularly new revelation —
policymakers have called it “public enemy No. 1” at
least four times in the past decade. What is puzzling
is that inflation has persisted (and worsened) even
though its reduction has been a primary goal of both
Federal Reserve and administration policy for over
10 years.
The explanations for persistent inflation are many:
uncontrollably rising wages; OPEC oil-price increases;
droughts or poor harvests; large government budget
deficits. The list of “causes” of inflation changes with
the circumstances. If we were to take them seriously,
we would conclude that inflation may be caused by
nearly everything. None of these causes, however, can
explain inflation consistently over time or across
countries.1
This article analyzes a frequently given cause of
inflation — cost-push — within a monetary framework.
The cost-push view of inflation is based on the notion
that prices are set by the costs of production and
that prices rise only when costs rise, regardless of
demand. Inflation, in this framework, is the result of
the sellers of productive inputs (including labor)
persistently and unilaterally raising their selling prices,
causing producers’ costs, and subsequently prices, to
rise.

definition must be distinguished from an increase in
relative prices (e.g., a rise in the price of wheat or
oil) which, as argued below, is not inflation. Some
advocates of the cost-push view confuse relative price
changes with changes in the overall price level. Conse­
quently, they view the increase in a particular price as
a contributor to inflation when in reality it is not.2 For
example, in a study of CBS Evening News broadcasts,
61.5 percent of the reports that dealt with the topic of
inflation either explicitly or implicitly identified the
rising prices of individual goods as the cause of infla­
tion. A typical report: “Inflation continued to steam
along at a double-digit annual rate. . . . The major
factor in the surge continues to be food.”3 In other
words, food price increases cause the overall price
level to rise. Changes in the prices of individual goods
do not cause inflation, although they do affect its
measurement.4 Individual price increases accompany
increases in the measure of inflation, but tell us little
about the cause of inflation.
There are an infinite number of individual prices
consistent with any given overall price level. At any
time, some prices are increasing, some are decreasing,
while others remain unchanged. Inflation — a persist­
-For a more thorough discussion of this point, see Hans H.
Helbling and James E. Turley, “A Primer on Inflation: Its
Conception, Its Costs, Its Consequences,” this R eview (Janu­
ary 1975), pp. 2-8.

WHAT IS INFLATION?

3Tom Bethell, “TV, Inflation and Government Handouts,” The
W all Street Journal, July 8, 1980.

Inflation is a persistent rise in the overall ( or aver­
age) level of prices of all goods and services. This

4Since there are many prices in an economy and since these
prices do not necessarily move together, some type of price
index must be constructed in order to capture changes in the
general level of prices (the overall price level). Two of the
most popular price indices are the consumer price index and
the implicit GNP deflator. For a discussion of the problems
associated with measuring the overall price level, see Denis S.
Karnosky, “A Primer on the Consumer Price Index,” this
R eview (July 1974), pp. 2-7.

iSee, for example, Scott E. Hein, “Deficits and Inflation,” this
R eview (March 1981), pp. 3-10; and Michael Parkin, “Oil
Push Inflation?” Banca Nazionale del Lavoro Quarterly R e­
view (June 1980), pp. 163-86.

20


F E D E R A L R E S E R V E BAN K O F ST. LOUIS

ent rise in the overall price level — can be detected
only by observing changes in an aggregate measure of
prices, not by changes in individual prices.
Since inflation is a continuous rise in the average
price level, a one-time increase caused by some ran­
dom shock (e.g., a drought or a reduction in the
quantity of oil supplied by OPEC) is not considered
inflation. Of course, this one-time increase will result
in a higher overall price level, but the rate of increase
of the overall price level (i.e., the rate of inflation)
will be unaffected if the economy adjusts to this
shock immediately. Consider the example in figure
1. Over time, the overall price level is rising at a
rate equal to the slope of line AB. (This rate of price
increase is usually called the trend or underlying rate
of inflation.) At point t0, the trend is interrupted by
the occurrence of a random shock (e.g., OPEC na­
tions reduce their rate of supplying oil). It the econ­
omy adjusted to this shock instantaneously, the over­
all price level would increase (from B to C ), but
the trend rate of inflation would be unaffected. (The
slopes of AB and CE are identical.) However, such
adjustments are not instantaneous. During the adjust­
ment period (t0 to tj), the overall price level will
rise at a rate (the slope of BD) that is greater than
the trend rate, giving the appearance that the shock
has actually increased the rate of inflation. This higher
rate of price change during the adjustment period is
not a continuing phenomenon, however, but simply a
transitory deviation of the rate of inflation from its
trend. Since these deviations do not persist, they are
not considered inflation.5

JUNE/JULY

1981

F ig u r e 1

E ffe c t of Tra nsito ry N o n m o n e ta ry Shock on the
T r e n d R a te o f Inflation

PA N E L B

WHAT CAUSES INFLATION?
As noted above, considerable confusion exists about
the relationships among changes in individual prices,
random shocks and the cause of inflation. Political
leaders attempt to persuade us that inflation is caused
primarily by either random shocks or greedy busi­
nesses and labor unions raising their prices and wages
unilaterally. As we have seen, the random shock argu­
ment is fallacious. Placing the blame for inflation on
business and labor is the central tenet of the cost-push
5Of course, these random shocks do cause the prices of some
commodities and consequently the overall price level to rise.
Other things equal, individuals will experience a decline in
their purchasing power. However, these shocks are typically a
temporary phenomenon and, by definition, uncontrollable. To
place the blame for persistent price level increases (i.e., infla­
tion) on continually occurring random shocks is, in essence,
contending that inflation is uncontrollable. This is an undesir­
able approach, for if inflation is ever to be eliminated, it must
be considered a result of controllable events.



argument. This argument typically holds that busi­
nesses continually raise their prices in an effort to earn
higher profits. Presumably, their ability to do this
successfully stems from monopoly power.
A similar argument can be made for labor unions.
Specifically, unions are alleged to exercise some mo­
nopoly power in labor markets to procure wage in­
creases for their members greater than those dictated
by market conditions. Then, the firms that employ
these workers must raise their prices in order to cover
these labor costs. Once this occurs, union members
realize that their increased wages do not buy as many
goods and services as they did before. As a result,
they ask for another raise. This continuing scenario is
the familiar “wage-price spiral.”
21

FEDER AL. R E S E R V E BAN K O F ST. L OUI S

These explanations of inflation conveniently ab­
solve government from having any role in creating
inflation. The “culprits” are identified by observing
which components of the overall price level rise the
most at any particular time. Needless to say, the list
of those contributing to inflation quickly becomes
quite large: farmers (rising food prices), participants
in financial markets (rising interest rates), foreigners
(rising oil prices), etc. The public then believes that
almost everyone is responsible for inflation, and a
myriad of government agencies are formed to regu­
late prices in various markets, protecting some people
from the presumed excesses of others. The Council on
Wage and Price Stability is one such example.

Money and Inflation
To understand the fallacy of the cost-push argu­
ment, the actual cause of inflation must be identified.
The ultimate source of inflation is persistent excessive
growth in aggregate demand resulting from persistent
excessive growth in the supply of money. This isn’t
a particularly novel idea — eighteenth century econ­
omists aptly described inflation as the result of “too
much money chasing too few goods;” that is, the
overall price level in any economy is determined by
the relationship between the demand for and the
supply of money. In particular, it depends on the
supply of money relative to the amount that individ­
uals desire to hold.
The quantity of money supplied is essentially a
policy variable controlled by the monetary authority,
the Federal Reserve System in the United States.
The Fed can affect the stock of money either by
changing the fraction of commercial bank and thrift
institution deposits that must be held in reserve ac­
counts with the Fed or by directly changing the level
of reserves in these accounts. The Fed most frequently
employs the latter method, participating in the gov­
ernment securities markets. Specifically, when it wants
to inject reserves, it buys government securities; when
it wants to drain reserves, it sells government
securities.
The demand for money is the individual’s desire
to hold a portion of his wealth in the form of money.
In the aggregate, it is determined by permanent in­
come (the expected flow of income over one’s life­
time), interest rates, prices and price expectations.
An increase in permanent income motivates individ­
uals to demand a larger stock of money. An increase
Digitized for22
FRASER


JUNE/JULY

1981

in permanent income results in an increase in wealth,
other things equal. Since individuals want to hold a
certain percentage of their wealth in the form of
money, they will add to their money balances (i.e.,
demand more money) as their permanent income
rises in order to maintain the desired relationship
between money and wealth. The interest rate is the
opportunity cost of holding money, the income fore­
gone by holding money instead of an interest-earning
asset. As interest rates rise, holding money becomes
relatively more costly; consequently individuals hold
smaller money balances. The demand for money is
positively and proportionately related to the overall
price level. For example, if prices double, individuals
will hold twice as much money since it will take twice
as many dollars to conduct any real transaction.
Finally, rising prices erode the purchasing power of
the money held by individuals. If expectations of
future inflation rise, individuals will attempt to hold
less of their wealth in the form of money and more
in some asset that will maintain its value in terms
of other goods as prices rise (e.g., land or gold).
The equilibrium overall price level is the one ( given
the level of permanent income, interest rates and price
expectations) that induces individuals to hold the
exact quantity of money that the monetary authority
supplies. Any other price level will motivate individ­
uals to demand more or less money than is being
supplied. If individuals are satisfied with the amount
of money that they are holding, they will have no
desire to increase or decrease their spending on goods
and services; in other words, they are in equilibrium
and the existing price level is the equilibrium one. If
the money supply changes, other things equal, in­
dividuals will alter their spending in order to reach
equilibrium again and, consequently, the price level
will change. For example, if the amount of money
supplied is greater than the amount that individuals
desire to hold, an excess supply of money exists. In­
dividuals will attempt to rid themselves of the excess
money by increasing their purchases of goods and
services. Thus, the existence of an excess supply of
money necessarily implies a corresponding excess de­
mand for goods and services. As individuals increase
their spending, they bid up the prices of goods and
services. This rise in the price level continues until
individuals are motivated to hold the existing stock
of money supplied by the monetary authority, that is,
until equilibrium is regained. If the monetary authority
continues to supply more money than is demanded,
excess aggregate demand will persist and prices will
continue to rise. Thus, inflation is the result of a
persistent excess supply of money.

F E D E R A L R E S E R V E B AN K O F ST. LO UI S

The link between money and inflation is not con­
fined to the United States. In fact, it is the “tie that
binds” the inflationary experience of the industrialized
world during the past decade.6 Table 1 provides a
cross-country comparison of the rate of money
growth and inflation over the 20-quarter period from
IV/1975 to IV/1980 for the major industrial nations.7
The countries are ranked in descending order accord­
ing to the rate of money growth experienced during
the period. If the demand for money is relatively
stable across countries, the analysis above predicts
a positive relationship between money growth and
inflation. This relationship can be clearly identified
in the table. In particular, Italy had the highest rate
of money growth and the highest rate of inflation;
the United Kingdom experienced the second highest
growth rates of money and prices, and so forth.8 In
fact, if this comparison is continued, only West Ger­
many violates the ordering of inflation with the rate
of money growth. These results are extremely robust
when one considers the heterogeneity of this group
of countries.

The Cost-Push Myth
Though the cost-push argument is appealing on
the surface, neither economic theory nor empirical
evidence indicates that businesses and labor can cause
continually rising prices. All firms, regardless of the
degree of competition in their industry, produce a
quantity and charge a price that they expect will
yield the highest profit. This price is higher in a more
monopolistic market than in a more competitive one.
If a firm with some monopoly power chooses to raise
its price arbitrarily, the quantity that it can sell will
decrease — since a monopolist faces a downward-sloping demand curve — and its profits will fall. Conse­
quently, since profits would actually fall as prices are
arbitrarily increased, a monopolist has no incentive to
raise its price continually.9 A monopolist may charge
•
’For additional support, see “Inflation and money — the tie
that binds,” Citibank Monthly Econom ic L etter (December
1980), pp. 8-11.
7The choice of a 20-quarter period is supported by evidence
presented by Denis S. Kamosky, “The Link Between Money
and Prices — 1971-76,” this Review (June 1976), pp. 17-23;
and Albert E. Burger, “Is Inflation All Due to Money?” this
R eview (December 1978), pp. 8-12.
8The Spearman rank correlation coefficient with Germany in­
cluded is .829; the calculated value when Germany is excluded
is .997. The critical values are .700 and .738, respectively;
that is, the hypothesis that money growth and inflation are
unrelated is rejected for both cases.
9In fact, one study has demonstrated that prices in highly con­
centrated industries increased less rapidly during the period
1954-73 than did other prices. See Steven Lustgarten, lndus


JUNE/JULY

1981

Table 1

Money Growth and Inflation in the Major
Industrial Nations (IV/1975-IV/1980)
Annual rates
of money growth1

Annual rates
of inflation2

Italy

20.5%

17.1%

United Kingdom

12.3

13.7

France

10.0

10.7

7.8

4.1

United States

7.5

9.1

Canada

7.5

9.0

Japan

7.2

6.3

Netherlands

6.8

5.8

Switzerland

5.3

2.5

Country

West Germany

X
M1 for all countries except the United States for which
M1B is used.
2Consumer price index used as a measure of inflation.

higher prices than a competitive firm, but this does
not imply constantly rising prices.
Unfortunately, realizing that monopolies (which
wish to maximize their profits) cannot unilaterally
contribute to inflation is insufficient to lay this argu­
ment to rest. A similar argument has been developed
based on changes in the degree of competition within
markets. Since monopolies do charge higher prices
than competitive firms, prices will continue to rise
if the economy becomes less and less competitive.
In other words, it is often argued that inflation is the
result of the acquisition of additional market power
by the firms within the economy. If the economy is
becoming less and less competitive, then the con­
tinually declining rate of growth of real output that
results will cause prices to rise; that is, inflation
caused by the acquisition of more and more monopoly
power must be accompanied by less and less output
being produced and sold. Chart 1 contains a com­
parison of a trend rate of inflation (as measured by
the consumer price index) with a trend rate of growth
of real output (real gross national product). Since
the trend rate of growth of real output does not show
a continuously decreasing pattern, the hypothesis that
increased monopolization has caused the rising in­
flation during the past decade can be rejected.
trial Concentration and Inflation ( American Enterprise Insti­
tute for Public Policy Research, 1975), pp. 25-29.

23

F E D E R A L R E S E R V E B AN K O F ST. LO UI S

JU NE/JULY

1981

C h a rt 1

Trend Rates of Inflation a n d O u tp u t G ro w th
Percent

--- 110

1
1965

1966

1967

19 68

19 69

1970

1971

19 72

1973

1974

1975

1976

19 77

19 78

1979

1980

1981

Sources: U.S. D e p a rtm e n t o f L a b o r a n d U.S. D e p a r tm e n t o f C o m m e rc e
Q T r e n d s a r e 2 0 - q u a r t e r m o v in g a v e r a g e s . In fla tio n is m e a s u r e d b y th e C o n s u m e r P ric e In d e x .

The cost-push argument is even less credible when
analyzed in a macroeconomic framework. In particu­
lar, other non-monopolized sectors of the economy
adapt to the exercising of monopoly power in one
sector. As a result, they tend to neutralize the monop­
oly’s impact on the entire economy. To understand
this more clearly, assume that the union in industry
A succeeds in obtaining a wage increase for its mem­
bers that is higher than that dictated by market con­
ditions (i.e., the demand for A’s product and the
productivity of the workers in A). As a result, the
firms in A raise their prices in an attempt to cover
the increased labor costs.10 Other things equal, these
higher prices cause the overall price level to rise. Be­
cause of this price increase, individuals in the aggre­
gate demand larger money balances. If the money
supply remains unchanged, however, there is no ad­
10It should be noted that an increase in wages need not be the
motivation for higher prices; higher prices could have re­
sulted from the firms in A exercising their monopoly power.
The crucial point is that prices in A have risen unilaterally,
independent of market conditions.

24




ditional money for them to hold. Consequently, in
order to increase their balances to the new desired
level, they must decrease their spending on goods
and services.
This decreased aggregate demand will ultimately
cause prices in other industries to fall until the over­
all price level returns to what it was prior to the
wage increase. The price level must return to its
original value because, other things equal (especially
the money supply), it is the only price level at which
the quantity of money supplied equals the quantity
demanded. The wage increase in A has induced
higher prices in A, but lower prices in other industries.
The union s action has caused relative prices to change,
but has not affected the overall price level.11
u The inability of a labor union (that doesn’t represent the
entire labor force) to affect the overall price level can be
seen through the quantity equation:
MV = PQ,
where M is the money stock; V is the velocity of money
(i.e., the average number of times that the money stock

F E D E R A L R E S E R V E B AN K O F ST. L O U IS

Critics of the above scenario state that “nowadays,
. . . compensatory price declines tend not to occur.”12
As a result, they conclude that “the rules of economics
don’t seem to be working any more.”13 The rules of
economics, however, always work despite attempts
to frustrate them. The point missed by these critics
is that the monetary accommodation of a price shock
prevents the occurrence of a compensatory price de­
crease. In the scenario above, prices in other industries
fell because the money stock was held constant.
This price adjustment does not occur immediately.
During the adjustment period, the cost of adjusting
is reflected by reduced output. If the monetary au­
thority confuses this loss of output (and the cor­
responding decline in employment) with a permanent
decline in aggregate demand, he may increase the
money supply. This then precludes the compensatory
price declines that one expects to observe in other
industries. The price level does not return to its
original level and the success of the labor union in
industry A in obtaining a higher than warranted wage
increase for its members is termed a cause of inflacirculates within the economy during a year); P is the over­
all price level; and Q is real gross national product (GNP).
Using the quantity equation, the overall price level can be
determined as follows:
p

= -MX_

Q '

Suppose that there are only two industries (A and B) in
this economy. Labor in A is unionized; labor in B is not.
In this simple world, the overall price level and real GNP
can be rewritten as:
P =

W

aP a

+ wB Pb

Q = Qa + Qb,
where PA and PB are the prices in industries A and B, re­
spectively; W a and w b are the percentages of the average
consumer’s consumption bundle composed of A’s output and
B’s output, respectively; and Q and Q are the output of
A and B, respectively. If the action of the union in A causes
wages and prices in A to rise, then the overall price level
must also rise, other things equal. Since nothing has occurred
that causes M or V to change, the new, higher P is consis­
tent with the quantity equation only if Q declines. Total out­
put (Q ) must decline because Qa decreases as consumers
react to the higher Pa by moving up their demand curves for
A. This new situation, however, cannot be one of equilibrium
because there are unemployed workers that are willing to
work at the current market wage. The union’s action has
precluded their employment in A; consequently, these workers
must search for work in B. As they search for employment
in B, wages in B decline, causing PB to fall and Qb to rise
until there are no unemployed workers at the current wage.
Since none of these occurrences change the equilibrium num­
ber of employed workers ( economy-wide) or the relationship
between the number of workers and the quantity of output
produced economy-wide, this equilibrating process must con­
tinue until Pb has decreased (and Qb has increased) suffi­
ciently for the overall price level ( P ) and real output ( Q ) to
return to their original levels.
a

b

12“Needed: A New Perspective on Inflation,” The Morgan
Guaranty Survey (November 1980), p. 2.

13Ibid.



JU NE/JULY

1981

tion. In fact, the actual cause of inflation has been
the accommodation on the part of the monetary
authority, not the monopolist, labor union, or an in­
herent price rigidity built into the economy.
It is difficult to support the cost-push hypothesis.
Gordon, in a study of inflation in the United States,
Canada, France, West Germany, Italy, Japan, Sweden
and the United Kingdom for the period 1958-76,
could find no support for the wage-push hypothesis;
“The wage-push hypothesis appears to be alive and
well as an explanation of wage rates, but not as a
theory of inflation or of monetary growth.”14 In an
analysis of post-World War II inflation in the United
States, Barth and Bennett concluded that “there is
evidence of unidirectional causality that runs from
consumer prices to wages.”15 In other words, higher
wages do not lead to higher prices as the cost-push
hypothesis predicts; instead, higher prices lead to
higher wages.

The Cost-Push Illusion
If cost-push inflation is really a myth, why do
consumers hear businessmen rationalize their price
increases with: “I have to raise my price because
my costs have risen.” Are businessmen simply trying
to pass the buck? No, most businessmen (especially
those operating relatively small businesses) believe
that higher costs of production are the motivation for
their raising prices. They seldom identify the real
cause — increased aggregate demand resulting from
increased money growth. The translation of increased
aggregate demand into higher prices is frequently
concealed in the marketplace by the existence of
inventories. As a result, a “cost-push illusion” is
created.16
No merchant sells his product at a constant rate;
sales in some time periods are larger than normal,
while sales in other time periods are smaller. In order
to hedge against running out of their product dur­
ing periods of larger than normal sales, merchants
14Robert J. Gordon, “World Inflation and Monetary Accommo­
dation in Eight Countries,” Brookings Papers on Econom ic
Activity (2 : 1977), p. 433. Since changes in wages are the
predominant causes of changes in costs of production, test­
ing the wage-push hypothesis is tantamount to testing the
cost-push hypothesis.
15James R. Barth and James T. Bennett, “Cost-push versus
Demand-pull Inflation: Some Empirical Evidence,” Journal
o f Money, C redit and Banking (August 1975), p. 397.
16This phrase was coined by Armen A. Alchian and William R.
Allen in University Econom ics, 3rd. ed. ( Wadsworth Publish­
ing Company, Inc., 1972), p. 95. This discussion follows
theirs.

25

F E D E R A L R E S E R V E B AN K O F ST. L OUI S

typically hold inventories (or buffer stocks). If ag­
gregate demand increases, merchants cannot immedi­
ately distinguish this phenomenon from a period in
which sales are temporarily above normal; that is,
they do not realize immediately that they could raise
their price and still make the normal amount of sales.
Consequently, they will not raise their price im­
mediately, but instead, will draw down their in­
ventories held for such an occasion as this. If these
higher than normal sales persist, merchants will
increase their purchase rate from suppliers in order
to maintain their inventories at the desired level.
The firms that supply these merchants thus will ex­
perience higher than normal rates of sales, and
their inventories will be depleted more rapidly than
desired, motivating them to increase the rates at
which they purchase from their suppliers.
This process continues filtering down the network
of markets until it finally reaches the market of raw
materials (the primary inputs used to produce this
commodity). In the raw materials markets, the
amount available is insufficient to meet the increased
amount demanded at the old price.17 Since aggregate
demand has increased (not just the demand of one
or a few manufacturers), all manufacturers want
additional raw materials. As a result, all offer higher
prices to suppliers until the price of raw materials is
bid up enough to clear the market. Because the higher
price for raw materials increases their cost of produc­
tion, manufacturers will charge wholesalers a higher
price for their product, citing increased raw material
costs as the reason. Wholesalers will say that the in­
creased manufacturers’ price makes it necessary to
charge retailers a higher price. And finally, the re­
tailer (merchant), being completely truthful, will tell
the consumer that he must charge a higher price
because his costs have risen.
17That is, existing inventories of raw materials are insufficient
to meet the increased demand.

26



JUNE/JULY

1981

Though it appears that increased raw material costs
have caused a higher final product price, the actual
cause of the higher prices at every level of the
manufacturing and distribution network is the initial
increase in aggregate demand for the final product.
The price increase is delayed until the impact of the
increased demand reaches the raw materials market
by the existence of inventories at each level that are
sufficient to buffer transitory, but not permanent,
changes in demand at each level.

SUMMARY AND CONCLUSION
The focus of this paper has been to separate the
cost-push myth from the reality of inflation. The costpush argument views inflation as the result of con­
tinually rising costs of production — costs that rise
unilaterally, independent of market forces. Such an
hypothesis (1) confuses changes in relative prices
with inflation, a continuously rising overall level of
prices, and (2) neglects the role that the money
supply plays in the determination of the overall price
level. The idea that greedy businesses and/or labor
unions can cause a continual rise in prices cannot be
supported by either the conceptual development or
the empirical evidence provided. Alternatively, the hy­
pothesis that inflation is caused by excessive money
growth is well supported. In the major industrial
countries, those with the highest rates of inflation
have the highest rates of money growth, and vice
versa. Consequently, inflation cannot be eliminated
by attacking those sectors of the economy that have
experienced the most rapid increase in prices, by
imposing wage and price controls, or even by em­
ploying some type of tax-based incomes policy.
Inflation will be eliminated only when the long-term
rate of money growth is approximately the same as
the long-term rate of real output growth.

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

JU NE/JULY

1981

“The Supply-Side Effects of Econom ic Policy 3
9
Single copies of this publication, the proceedings of a conference co-sponsored
by the Federal Reserve Bank of St. Louis and the Center for the Study of
American Business, Washington University, are available in limited supply to
our readers.
If you are interested in obtaining a copy, please address your request to Editor,
Review, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, Missouri
63166.




27