© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Inflation Chapter 7

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Introduction n In 1923, prices in Germany rose a trillion times over. n Prices in Russia, Bulgaria, and some other nations have witnessed a tenfold increase in a year. n In the 1990’s the U.S. inflation rate have risen 1 to 4 percent a year.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Introduction n Although inflation is regarded as a major macro problem in the United States, American inflation rates are comparatively low.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Introduction n This chapter focuses on the following: l What kinds of price increases are referred to as inflation ? l Who is hurt (or helped) by inflation? l What is an appropriate goal for price stability ?

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin What Is Inflation? n Inflation is an increase in the average level of prices, not a change in any specific price.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Average Price n The average price is determined by finding the average price of all output. l A rise in the average price is called inflation. l A fall in the average price is called deflation.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Relative Prices vs. the Price Level n It is possible for individual prices to rise or fall continuously without changing the average price level.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Relative Prices vs. the Price Level n Changes in relative prices may occur in a period of stable average price, or in periods of inflation or deflation. n A relative price is the price of one good in comparison with the price of other goods.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Relative Prices vs. the Price Level n By reallocating resources in the economy, relative price changes are an essential ingredient of the market mechanism. n A general inflation doesn’t perform this market function.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Redistributive Effects of Inflation n Although inflation makes some people worse off, it makes some people better off.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Effects n Price changes are the most familiar effect of inflation. n The effect on economic welfare is shown in the difference between nominal and real income.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Effects n Nominal income is the amount of money income received in a given time period, measured in current dollars. n Real income is income in constant dollars: nominal income adjusted for inflation.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Effects n Two basic lessons about inflation: l Not all prices rise at the same rate during inflation. l Not everyone suffers equally from inflation. l Not all prices rise at the same rate during inflation. l Not everyone suffers equally from inflation.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Changes in 2000

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Income Effects n Even if all prices rose at the same rate, inflation would still redistribute income. n Redistributive effects originate both in expenditure and income patterns.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Income Effects n What looks like a price to a buyer looks like an income to a seller. n If prices are rising, incomes must be rising too.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Nominal Wages and Prices

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Wealth Effects n Winners and losers from inflation depend on the form of wealth they own. n You lose when inflation reduces the real value of wealth.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Real Story of Wealth

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Redistributions n Inflation acts like a tax, taking income or wealth from one group and giving it to another.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Redistributions n The redistributive mechanics of inflation include price effects, income effects, and wealth effects.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Effects n People who prefer goods and services that are increasing in price least quickly end up with a larger share of income.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Income Effects n People whose nominal income rise faster than inflation end up with a larger share of total income.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Wealth Effects n Owners of assets that increase in real value end up better off than others.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Social Tensions n Because of redistributive effects, inflation increases social and economic tensions.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Social Tensions n Tensions between labor and management, between government and the people, and among consumers may overwhelm a society and its institutions.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Social Tensions n Psychotherapists report that inflation stress leads to more frequent marital spats, pessimism, diminished self-confidence, and even sexual insecurity.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Money Illusion n The use of nominal dollars rather than real dollars to gauge changes in one’s income or wealth is called the money illusion.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Money Illusion n Even people whose nominal incomes keep up with inflation often feel oppressed by rising prices.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Money Illusion n They feel cheated when they discover that their higher nominal wages don’t buy additional goods.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Macro Consequences n Inflation has macroeconomic effects as well as the effects on income and wealth redistribution.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Macro Consequences n Inflation can alter the rate and mixes of output by changing consumption, work, saving, investment, and trade behavior.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Uncertainty n One of the most immediate consequences of inflation is uncertainty. n Uncertainties created by changing price levels affect consumption and production decisions.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Shortened Time Horizons n People tend to shorten their time horizons in the face of inflation uncertainties. n Time horizons are shortened as people attempt to spend money before it loses further value.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Shortened Time Horizons n During the German hyperinflation, workers were paid two or three times a day so that they could buy goods in the morning before prices increased in the afternoon. l Hyperinflation is an inflation rate in excess of 200 percent, lasting at least one year.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Speculation n If you expect prices to rise, it makes sense to buy things now for resale later. n Few people will engage in production if it is easy to make speculative profits.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Speculation n People may be encouraged to withhold resources from the production process, hoping to sell them later at higher prices.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Speculation n As such behavior becomes widespread, production declines and unemployment rises.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Bracket Creep n Under our progressive tax system, taxes go up when prices rise. n Savings, investment, and work effort decline.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Bracket Creep n Inflation tends to increase everyone’s income pushing them into a higher tax bracket.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Bracket Creep n Bracket creep is the movement of taxpayers into higher tax brackets (rates) as nominal incomes grow.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Deflation Dangers n Deflation — a falling price level — might not make people happy either. n Deflation reverses the redistributions caused by inflation. n Lenders win and creditors lose.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Deflation Dangers Deflation Dangers n When prices are falling, people on fixed incomes and long-term contracts gain more real income.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Deflation Dangers n Falling price levels have similar macro consequences. n Time horizons get shorter. n Businesses are more reluctant to borrow money or to invest.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Deflation Dangers n People lose confidence in themselves and public institutions when declining price levels deflate their incomes and assets.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Measuring Inflation n Measuring inflation serves two purposes: l Gauges the average rate of inflation. l Identifies its principal victims.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Consumer Price Index (CPI) n The CPI is the most common measure of inflation. n The consumer price index (CPI) is a measure (index) of changes in the average price of consumer goods and services.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Consumer Price Index (CPI) n By observing the extent of price increases, we can calculate the inflation rate. n The inflation rate is the annual percentage rate of increase in the average price level.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Constructing the CPI n The Bureau of Labor Statistics constructs a market basket of goods and services that consumers usually buy. n Specific goods and services are itemized within the broad categories of expenditures.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Constructing the CPI n The CPI is usually expressed in terms of what the market basket costs in a specific base period.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Constructing the CPI n The base period is the time period used for comparative analysis — the basis of indexing, for example, of price changes.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Constructing the CPI n The relative importance of a product in the CPI is reflected in its item weight. n Item weight is the percentage of total expenditure spent on a specific product; used to compute inflation indexes.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Constructing the CPI n The impact on the CPI of a price change for a specific good is calculated as follows: percentage change in CPI = item weight X percentage change in price of item

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Market Basket Transportation 19.0% Housing 32.6% Food 13.6% Clothing 4.7% Miscellaneous 10.5% Health care 5.3% Entertainment 5.1% Insurance and pensions 9.3%

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Producer Price Indexes n There are three producer price indexes (PPI) which keep track of average prices received by producers. n One includes crude materials, another intermediate goods, and the last covers finished goods.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Producer Price Indexes n PPIs are watched as a clue to potential changes in consumer prices. n In the short run, the PPIs usually increase before the CPI. n The PPIs and the CPI generally reflect the same inflation rate over long periods.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The GDP Deflator: n The GDP deflator is a price index that refers to all goods and services included in GDP. l It is the broadest price index is the GDP deflator. l It covers all output including consumer goods, investment goods, and government services.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The GDP Deflator: n The GDP deflator usually registers a lower inflation rate than the CPI. n Unlike the CPI and PPI, the GDP deflator is not limited to a fixed basket. n Its value reflects both price changes and market responses to those changes.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Real vs. Nominal GDP n The GDP deflator is used to adjust nominal output values for changing price levels. l Nominal GDP is the value of final output produced in a given period, measured in the prices of that period (current prices). l Real GDP is the value of final output produced in a given period, adjusted for changing prices.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Real vs. Nominal GDP n Nominal and Real GDP are connected by the GDP deflator:

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Real vs. Nominal GDP n Changes in real GDP are a good measure of how output and living standards are changing.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Goal: Price Stability n Every U.S. president since Franklin Roosevelt has decreed price stability to be a foremost policy goal.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Goal: Price Stability n An explicit numerical goal for price stability was established by the Full Employment and Balanced Growth Act of 1978.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Goal: Price Stability n Price stability is the absence of significant changes in the average price level; officially defined as an inflation rate of less than 3 percent.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Unemployment Concerns n Congress chose the 3 percent rate because of its concern about unemployment.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Unemployment Concerns n The government might have to restrain spending in the economy to keep prices from rising. n This could lead to cutbacks in production and an increase in joblessness.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Unemployment Concerns n A little bit of inflation might be the “price” the economy has to pay to keep unemployment rates from rising. n Some unemployment may be the “price” society has to pay for price stability.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Quality Changes n The CPI is not a perfect measure of inflation because an increase in price may caused by quality improvements.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Quality Changes n Over time, the goods themselves change as a result of quality improvements.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin New Products n The CPI is biased upward when new products whose prices are falling are left out of the market basket.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Historical Record n In the long view of history, the U.S. has done a good job in maintaining price stability. n Upon closer inspection, however, our inflation performance is very uneven.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Historical Record

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Causes of Inflation n The cause of inflation is rooted in supply and demand.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Demand-Pull Inflation n Demand-pull inflation results from excessive pressure on the demand side of the economy. n “Too much money chases too few goods” enabling producers to raise prices.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cost-Push Inflation n The pressure on price could also originate on the supply side. n Higher production costs put upward pressure on product prices.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Protective Mechanisms n Low rates of inflation don’t have the drama of hyperinflation, but they still redistribute real wealth and income. l For example, if prices rise by an average of just 4 percent a year, the real value of $1,000 drops to $822 in five years and to only $676 in ten years.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin COLAs n Market participants can protect themselves by indexing their nominal incomes. n A COLA protects real income from inflation.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin COLAs n Cost-of-living adjustments (COLAs) are automatic adjustments of nominal income to the rate of inflation.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin COLAs n COLAs are commonly used by landlords as well as in labor agreements and government transfer programs.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin ARMs n An adjustable-rate mortgage (ARM) is a mortgage (home loan) that adjusts the nominal interest rate to changing rates of inflation.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin ARMs n ARMs were developed to protect lenders against losses during long term rises in inflation. n The objective is to maintain a stable rate of real interest.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin ARMs n The real interest rate is the nominal interest rate minus the anticipated inflation rate. Real interest rate = nominal interest rate – anticipated interest rate

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin ARMs n If prices rise faster than interest accumulates, the real interest rate will be negative.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Cost of Mismeasurement n Proliferation of COLAs and ARMs makes the CPI a critical statistic in today’s economy. n If CPI goes up, so do government transfer payments, union wages, and nominal interest rates.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Cost of Mismeasurement n According to experts, the CPI overstates inflation by about one percentage point.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Cost of Mismeasurement n Quality improvements, new products, and changes in expenditure patterns may cause inflation to be overestimated.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Cost of Mismeasurement n The CPI’s market basket of goods and services was overhauled in n Based on expenditure patterns, it included more new products and new adjustments for quality improvements.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The End of Inflation? n Inflation is currently hovering around 3-4%.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Historical Stability Historical Stability n On the eve of the first world war, prices in Britain were on average no higher than at the time of the fire of London in l During those 250 years, the longest unbroken run of rising prices was six years.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Historical Stability Historical Stability n Since 1946, by contrast, prices in Britain have risen every year, and the same is true of virtually every other OECD country.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Virtue of Zero n The best inflation rate is one that least affects the behavior of companies, investors, shoppers and workers.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Inflation End of Chapter 7