Inflation Chapter 7 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Principles of Economics: Macroeconomics - Econ101

What Is Inflation? Inflation: An increase in the average level of prices of goods and services The average price level is determined by finding the average price of all output –A rise in the average price level is inflation –A decrease in the average price level is deflation 7-2

Price Changes in 2008 Prices That Rose (%)Prices That Fell (%) Bananas % New cars - 1.1% Bread Eggs Bus fares Computers Textbooks Televisions College tuition Gasoline Average inflation rate: +3.8% The average rate of inflation conceals substantial differences in the price changes of specific products. The impact of inflation on individuals depends in part on which goods and services are consumed. Source: U.S. Bureau of Labor Statistics 7-3

Relative Prices vs. the Price Level It’s possible for individual prices to rise or fall without changing the average price level Relative price: The price of one good in comparison with the price of other goods –In a large economy, relative prices are always changing 7-4

Redistributions Redistributive mechanics of inflation include: –Price effects: Those who buy products that are increasing in price the fastest end up worse off –Income effects: People with nominal incomes rising more slowly than inflation end up worse off –Wealth effects: Those who own assets that are declining in real value end up with less real wealth 7-5

Redistributive Effects of Inflation Although inflation makes some people worse off, it makes others better off The impact on individuals depends on how prices change for the goods and services each person actually buys or sells 7-6 Inflation acts like a tax, taking income or wealth from one group and giving it to another Some are better off while some are worse off

Price Effects If prices rise you can’t buy as many goods and services as you could before The effect on economic welfare is shown in the difference between nominal and real income 7-7

Price Effects Nominal income: The amount of money income received in a given time period, measured in current dollars Real income: Income in constant dollars; nominal income adjusted for inflation 7-8

The Real Story of Wealth Asset Change in Value (%), 1991–2001 Stocks+ 250% Diamonds+ 71 Oil+ 66 Housing+ 56 U.S. farmland+ 49 Average price level+ 32 Silver+ 22 Bonds+ 20 Stamps - 9 Gold- 29 Households hold their wealth in many different forms. As the value of various assets changes, so does a person’s wealth. 7-9

Macro Consequences In addition to redistributing income and wealth, inflation has macroeconomic effects –Uncertainty –Speculation –Bracket Creep –Deflation Dangers 7-10

Uncertainty When price level changes significantly, economic decisions become more difficult Time horizons are shortened as people attempt to spend money before it loses further value Price uncertainties affect production decisions as well 7-11

Speculation If expect prices to rise, buy goods and resources now for resale later Few engage in production if it’s easy to make speculative profits Such speculation may fuel hyperinflation –Hyperinflation: Inflation rate in excess of 200 percent, lasting at least one year 7-12

Bracket Creep Bracket creep: The movement of taxpayers into higher tax brackets (rates) as nominal incomes grow Can reduce disposable income 7-13

Deflation Dangers Deflation reverses redistributions caused by inflation Businesses are more reluctant to borrow money or to invest People lose confidence due to declining price levels deflating incomes and asset values 7-14

Measuring Inflation Measuring inflation serves to gauge the average rate and identify principal victims Common measures include –Consumer Price Index (CPI) –Producer Price Indexes (PPI) –GDP Deflator 7-15

Consumer Price Index (CPI) Consumer price index (CPI): A measure (index) of changes in the average price of consumer goods and services Used to calculate the inflation rate –Inflation rate: The annual percentage rate of increase in the average price level 7-16

Constructing the CPI The Bureau of Labor Statistics determines a market basket of goods and services typically purchased by consumers Prices for each good are tracked monthly Base year: The year used for comparative analysis: the basis for indexing 7-17

The Market Basket To measure changes in average prices, we must first know what goods and services consumers buy. Housing, transportation, and food account for over two-thirds of consumer spending. Source: U.S. Bureau of Labor Statistics, Consumer Expenditure Survey (2007 data) 7-18

Constructing the CPI Item weight: The percentage of total expenditure spent on a specific product; used to compute inflation indexes Core inflation rate: Changes in the CPI, excluding food and energy prices 7-19

YearAnnual YearAnnual of 31

Computing Changes in the CPI The impact of any price change on the average price level depends on the importance of an item in the typical consumer budget The impact on the CPI of a price change for a specific good is calculated as follows: 7-22

The GDP Deflator: GDP deflator: A price index that refers to all goods and services included in GDP, including consumer goods, investment goods, and government services Not limited to a fixed basket Reflects price changes and market responses 7-23

Real vs. Nominal GDP Nominal GDP: The value of final output produced in a given period, measured in the prices of that period (current prices) Real GDP: The value of final output produced in a given period, adjusted for changing prices 7-24

The Goal: Price Stability Price stability: The absence of significant changes in the average price level; officially defined as a rate of inflation of less than 3 percent Explicit goal established by Full Employment and Balanced Growth Act of

Quality Changes The CPI is not a perfect measure of inflation because price increases may be due to quality improvements U.S. Bureau of Labor Statistics does adjust the CPI for quality changes 7-26

New Products CPI is biased upward when new products whose prices are falling are left out of the market basket Market basket is now updated more frequently than previously 7-27

The Historical Record U.S. inflation performance is very uneven During the 1920s and 1930s, consumer prices fell significantly – a general deflation Since the Great Depression average prices have risen almost every year 7-28

The annual rate has varied widely: The highest rate of inflation was 13.5 percent in 1980 (point A ); the lowest rate (1.6 percent) occurred in 2002 (point B ). Annual Inflation Rates Source: U.S. Bureau of Labor Statistics 7-29

Causes of Inflation Changing prices are rooted in supply and demand –Demand-pull inflation results from excessive pressure on the demand side of the economy –Cost-push inflation is due to higher production costs putting upward pressure on supplier’s prices 7-30

The Real Interest Rate Real interest rate: The nominal interest rate minus the anticipated inflation rate –The inflation-adjusted rate of interest The distinction is critical for long-term loans 7-31