Grade Inflation: An Analogy

I remember taking economics last year, when some of my peers had trouble grasping the concept of inflation. What was inflation? How did it work? The whole concept of money itself was so confusing and new that few people could intuitively understand the basic principles underlying inflation. To try to make understanding inflation (arguably the most important concept in Macroeconomics) a bit easier, I provide you the following analogy:

Instead of money, consider the points system that many teachers use. The system works something like this: different assignments (homework and tests) are worth different amounts of points. At the end of the semester, the teacher adds up all of your points and divides by the total number of points possible to get your percentage and thus your grade.

Let's take a look at an example. Let's assume that Mr. Devine assigns 5 pieces of homework that are worth 10 points each and a test that is worth 50 points. You turn in all your homework, but get a 40/50 on your test. Your grade is 90/100 = 90%.

Now, let's introduce some inflation. Suppose that Mr. Devine now changes the system so that homework is worth 100 points and tests are worth 500 points. Your still turn in all of your homework, but this time, your test score is 400/500. Your final grade is 900/1000 = 90%.

If we think about the total number of points as equivalent to the money supply, the connection to inflation becomes clear. The value of a single point, in our example, went from 1/100 = 1% to 1/1000 = .1%. The reason for this decrease in value was an increase in the supply of points. In monetary policy, an increase in the supply of money in the economy decreases the value of a single dollar. See the connection?

Our analogy also shows us an interesting fact about inflation. If all prices are flexible and increase by the same amount, inflation has no effect on output. As you saw, the only thing that changed was the number of points in the system; your grade was the same. In other words, with price flexibility, nominal prices can change, but relative prices remain the same.

Now, let's consider a slightly different case. Suppose Mr. Devine kept the value of tests to be 50 points, but changed the value of homework to 100 points. You, doing the same amount of work, get 500 points for homework and 40/50 points on the test. When we calculate your grade, the calculation is 540/550 = 98%.

So what happened? Your grade jumped by 8%! The key here is that relative prices changed. This is very similar to the mechanism by which inflation actually promotes growth in economy. Keynesian theory states that prices are fixed in the short run, but in actuality, different prices have varying degrees of flexibility. For example, food and oil prices can change and fluctuate rather quickly, but housing prices cannot change very fast. As a result, the level and composition of your economy's output changes. "Oh, but that's not a bad thing," you say, "after all, my grade went up 8%!" However, the changes in relative prices causes some inefficiencies.

Let's consider for a moment the incentive structure this creates. Homework is worth 100 points, yet the test is only worth 50 points. Will you spend more time doing your homework or studying for the test? Any rational student would choose to spend his time doing his homework (he could get a 0 on his test and still keep an A). However, if we take a step back, we conclude that it is probably just as important that the student studies for his test as it is for him to do his homework, for the sake of learning. This, in econ-speak, is what we call a misallocation of resources. You should be spending your time studying, but instead you spend more time on homework.

This, when applied to US macroeconomic policy, can have debilitating effects. If prices in one sector grow disproportionately to the rest of the economy, *coughhousingcough* more economic resources will go toward that sector, depriving other markets of economic activity. This creates what we call a bubble, a rise in prices that outstrips the market's fundamentals. And as we all know, bubbles pop.

So while it may seem good at first glance that our economy has inflation, it is actually something that needs to be heavily moderated in the interest of efficiency. I suppose that's why we have the Federal Reserve, right?