McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Inflation Chapter 7.
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2 Chapter Overview 1. What is Inflation? 2. Redistributive Effects of Inflation. 3. Macro Consequences. 4. Measuring Inflation. 5. The Goal: Price Stability. 6. The Historical Record. 7. Causes of Inflation. 8. Protective Mechanisms.
Transcript of McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Inflation Chapter 7.
2
Chapter Overview
1. What is Inflation?
2. Redistributive Effects of Inflation.
3. Macro Consequences.
4. Measuring Inflation.
5. The Goal: Price Stability.
6. The Historical Record.
7. Causes of Inflation.
8. Protective Mechanisms.
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1. What is inflation?
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What Is Inflation?
Inflation:
an increase in the average level of prices,
not a change in any specific price.
Deflation:
a drop in the average price level.
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Relative Prices vs. the Price Level
Relative price:the price of one good in comparison with the price of other goods.
Changes in relative prices are key signals in the market mechanism:
They direct producers on how to allocate resources…
…and also direct consumer buying decisions.
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Relative Prices vs. the Price Level
However…
general inflation:
obscures and confuses relative price relationships;
inhibits the efficient reallocation of resources in the economy.
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2. Redistributive Effects of Inflation:
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Redistributive Effects of Inflation
Not all prices rise at the same rate during inflation:
People are hurt or helped by three redistributive effects of inflation:
Price effects.
Income effects.
Wealth effects.
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Price Effects
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Nominal vs. real income
Redistribution from price effects: rooted in nominal vs. real income:
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Nominal vs. real income
Nominal income:
income received in a given time period, measured in current dollars.
Real income:
income in constant dollars;
(nominal income adjusted for inflation).
Nominal income can rise even as real income is falling.
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Price Effects
Not all prices rise at the same rate during inflation.
Those who consume goods & services that are rising fastest in price are hurt the worst:
Their real income falls faster.
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Price Changes in 2006
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Income Effects
Rising prices = rising incomes,
…but ...
… like prices, incomes do not all rise at the same rate.
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Income Effects
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Income Effects
Income sufferers of inflation include fixed-income groups:
retirees.
workers locked into long-term contracts.
lenders.
Income winners: nominal income rises faster than average prices.
(Inflation = weaker dollars)
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Nominal Wages and Prices
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Productivity increases = Wages up faster than prices.
Fringe benefits & payroll taxes increases = Wages up more slowly than prices.
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Wealth Effects
Winners and losers from inflation depend on the form of wealth they own.
You lose when inflation reduces the real value of wealth, and vice versa.
Example: your savings account pays 2% interest…
inflation is running at 5%.
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The Real Story of Wealth
Asset Percentage change in value: 1991-2001
Asset Percentage change in value: 1991-2001
Stocks +250 U.S. farmland +49
Diamonds +71 Silver +22
Oil +66 Bonds +20
Housing +56 Stamps -9
The average price level increased 32%
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In Summary: Redistributions
The redistributive mechanics of inflation include:
price effects,
income effects,
and wealth effects.
Inflation acts like a tax, taking income or wealth from one group and giving it to another.
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Other Effects of Inflation:
Social Tensions:
labor and management,
government and the people, and …
among consumers.
The societal tensions of extreme and persistent inflation can overwhelm a society and its institutions.
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Effects: Money Illusion
Money illusion:The use of nominal dollars rather than real dollars to gauge changes in one’s income or wealth.
Money illusion distorts one’s perception of the current state of prices and the market.
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Review
1. What is inflation (& deflation).
1a. How does inflation/deflation affect the “power of money.”
2. What are the 3 redistributive effects of inflation?
3. What are the societal effects of inflation?
3a. What is money illusion?
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3. Macro Consequences:
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Uncertainty
Economic decisions, especially long-term planning, become more difficult.
“Time horizons” are shortened:people spend money before it loses more value.
Businesses hold off on investment.
This uncertainty can hinder economic activity and growth.
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Speculation
Few people will engage in actual production if it is easy to make speculative profits.
Such speculation may fuel hyperinflation.
Hyperinflation:
an inflation rate in excess of 200 percent, lasting at least one year.
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Bracket Creep
Bracket creep is the movement of taxpayers into higher tax brackets (rates) as nominal incomes grow.
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Deflation Dangers
Deflation occurs when the price level falls.
Deflation reverses the redistributions caused by inflation:
fixed income recipients gain.
lenders win and creditors lose.
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4. Measuring Inflation:- The CPI – Consumer Price Index
- Using the CPI.
- Construction of the CPI.
- Other measures of inflation.
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Consumer Price Index (CPI)
The consumer price index (CPI):a measure (index) of changes in the average price of consumer goods and services.
It is used to calculate the inflation rate.
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45,952
Consumer Price Index (CPI)
Nominal Income
Real Income
Year
GDP Deflator
1997 1998 1999 2000 2001 2002 2003 2004 2005
89 92 96 100 101 104 111 118 126
48,000 49,200 49,900 51,000 52,300 53,200 54,800 56,100 57,900
53,933 53,478 51,978 51,000 51,782 51,154 49,369 47,542
Nominal increase 1,200 700 1,100 1,300 900 1,600 1,300 1,800
Real Change -455 -1,500 -978 782 -628 -1,785 -1,827 -1,590
CPI
Nominal to Real GDP
BONUS QUESTION (that you need to know how to do):
Rate of inflation from 2001 to 2002? 2.97% (not 3%)
Rate of inflation from 2002 to 2003? 6.73% (not 7%)
The ChangeThe Starting
Point
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Review
1. Explain the 3 redistributive effects of inflation:
2. What is bracket creep?
3. If nominal income is $108,000 and the CPI value is138, what is the real level of income in base year dollars?
4. If the CPI values for 1970 and 1980 were 39.8 and 82.4 respectively, what was the rate of inflation for that decade?
$78,261
107%
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Constructing the CPI
A “market basket” of goods:”Bureau of Labor Statistics.
184 goods and services.
A base period is chosen for indexing.
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Constructing the CPI
The CPI is a weighted average:
The relative importance of a product in the CPI is reflected by its item weight.
Item weight:
the percentage of total expenditure spent on a specific product:
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The Market Basket
Transportation18.0%
Housing32.7% Food
13.7%
Clothing 4.1%
Miscellaneous 9.5%
Health care 5.7%
Entertainment 5.1%
Insurance and pensions 11.2%
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% of total household spending
Item Weight
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Constructing the CPI
The impact on the CPI of a price change for a specific good is calculated as follows:
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percentage change in CPI
item weight
x%∆ in item
price =
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Calculating Price Change Impacts on the CPI
percentage change in CPI
item weight
x%∆ in item
price =
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The Market Basket
Transportation18.0%
Housing32.7% Food
13.7%
Clothing 4.1%
Miscellaneous 9.5%
Health care 5.7%
Entertainment 5.1%
Insurance and pensions 11.2%
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Housing ↑ 10% =
Transport ↑ 5% =
Food ↓ 3% =
(All else unchanged)
Affect on the CPI
%∆ in CPI = 3.759%
-0.411
0.9% 3.27%
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Practice:“Problem sets” @ back of book:
#5 & #6.
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Other gauges of inflation:
(Variations on the CPI):
- The core inflation rate
- PPIs
- The GDP deflator
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The Core Inflation Rate
Core inflation rate:
the CPI excluding changes in food and energy prices.
a more accurate monthly reading of consumer price trends.
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Producer Price Indexes
Three producer price indexes (PPI):
They track average prices received by producers.
crude materials,
intermediate goods,
finished goods.
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Producer Price Indexes
Produce Price Indexes and the CPI:
PPIs and the CPI generally run equal in the long run.
PPIs lead the CPI in the short run:
***They act as an early indicator of changing price levels.
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The GDP Deflator:
The broadest price index is the GDP deflator.
The GDP deflator is a price index that refers to all goods and services included in GDP (C+I+G+X-M).
Unlike the CPI and PPI, it is not limited to a fixed basket.
Its value reflects both:
price changes, and …
market responses to those changes (quantity/proportion changes).
***This usually results in the GDP deflator understating inflation in comparison to the CPI
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5. The Goal – Price Stability- Employment vs. inflation.
- Problems with the CPI.
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The Goal: Price Stability
Every U.S. president since Franklin Roosevelt has decreed price stability to be a foremost policy goal.
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A Numerical Goal
Price stability:
the absence of significant changes in the average price level;
Full Employment and Balanced Growth Act (1978):
Officially defined price stability as:
an inflation rate < 3 %.
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Unemployment Concerns
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Review
1. How is the CPI “Constructed?”
2. . What is the “core inflation rate?”
3. What are the 3 PPIs?
4. How do the PPIs compare to the CPI?
5. What is the relationship between:- price stability, - employment, and- economic growth?
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Practice:CPI & item weight,
“Problem Sets” @ back of book:
Chpt. 7, #5 & #6.
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Unemployment Concerns
Full employment:the lowest rate of unemployment consistent with stable prices.
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Unemployment Concerns
Price stability is balanced against the desire to avoid unemployment and declines in production.
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Problems with CPI
The CPI is not a perfect measure of inflation:
an increase in price may be caused by quality improvements of products.
The comparison of an equal basket of goods over time…
…turns into a comparison of unequal baskets of goods.
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New Products
The CPI is also biased upward when new products whose prices are falling are left out of the market basket.
These are additional reasons not to set a goal of 0% inflation.
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6. The Historical Record:
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The Historical Record
In the long view of history, the U.S. has done a good job in maintaining price stability.
In the short run, however, our inflation performance is very uneven.
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Annual Inflation Rates
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7. Causes of Inflation
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Causes of Inflation
The cause of inflation is rooted in supply and demand.
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Demand-Pull Inflation
Demand-pull inflation:excessive pressure on the demand side of the economy.
“Too much money chasing too few goods.”
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Demand-Pull Inflation
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Cost-Push Inflation
Cost-push inflation:
Higher production costs push product prices up.
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Cost-Push Inflation
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8. Protective Mechanisms:
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Protective Mechanisms
There are two major protective mechanisms against the redistributive effects of inflation:
COLAs
ARMs
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COLAs
Cost-of-living adjustments (COLAs):Market participants can protect themselves by indexing their nominal incomes with a COLA.
automatic adjustments of nominal income
pegged to the inflation rate.
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ARMs
Adjustable-rate mortgage (ARM):adjusts the nominal interest rate to match changing rates of inflation.
Protects the lender.
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The Real Interest Rate
The real interest rate is the nominal interest rate minus the (“anticipated”) inflation rate.
Real interest rate = nominal interest rate – (anticipated) rate of inflation
Real interest rate = nominal interest rate – (actual) rate of inflation
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The Real Interest Rate
Nominal Rate - (“Anticipated”) inflation Rate = Real interest rate
5% -1%6%
10% 6% 4%
