Chapter 12 Inflation: How to Gain and Lose at the Same Time

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. What Is Inflation? Inflation – a continuing rise in the general level of prices Dynamic, self-sustaining Suppressed inflation

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. How Is Inflation Measured? The inflation rate between year 0 and year 1 is calculated as follows: If CPI in year 0 = 100 and CPI in Year 1 = 108, then: Inflation Rate in Year 1 = 108 – 100 * 100 = 8% 100 Inflation rate in year 1 = CPI in Year 1 – CPI in Year 0 * 100 CPI in Year 0

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Indexes Consumer Price Index (CPI) = cost-of-living index Implicit price deflator

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Year 01 PCostP 40 lbs grapes $2.00$80.00$2.10$ Knitting Needles $1.00$120.00$1.10$ Cost of Market Basket $200.00$ Constructing the Consumer Price Index

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. How the Consumer Price Index Is Calculated Choose a Base Year Index = Cost of Market Basket year i * 100 Cost of Market Basket in base year Index(Year 0) = ($200/$200) * 100 = 100 Index(Year 1) = ($216/$200) * 100 = 108

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Problems in Measuring the Cost of Living Typical household Substitution bias Introduction of new goods Unmeasured quality changes

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Rate of Inflation Over Time

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. InflationLoan TermsNominal ValueReal Value 0% 5%$1,050 10% 5%$1,050$950 10% inflation 15%$1,150$1,050 Equity Effects People on relatively fixed incomes Creditors and Debtors

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficiency Effects Impact on resource allocation Costs of adjusting to inflation

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Output Effects Positive effect of mild inflation Negative effect of runaway or hyperinflation Pure inflation

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. What Is Money? Money is anything generally acceptable in payment for goods and services and in payment of debt

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Functions of Money Medium of Exchange Measure of Account Store of Value

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Currency and Coins % Traveler’s Checks7.50.5% Demand Deposits % Other Checkable Deposits % Total1, % Source: Federal Reserve System, Feb Federal Reserve System M1

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. M11, % Small-denomination time deposits % Savings deposits3, % Money market mutual funds % Total6, % Source: Federal Reserve System, Feb Federal Reserve System M2

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Commercial Banks and Other Depository Institutions The Business of Banking State versus National Banks Monetary Control Act of 1980 Savings and Loan Institutions Mutual Savings Banks Credit Unions

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Banking Regulation Glass-Steagall Act 1933 Gramm-Leach-Biley Act 1999 Merger wave

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. AssetsLiabilities + Net Worth Reserves: Legal reserves Excess reserves Loans and investments Fixed investments Liabilities: Demand deposits Time Deposits Net Worth Balance Sheet

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Fractional Reserve Banking System Legal reserves -Deposits at Federal Reserve Banks -Vault cash Excess reserves

R 2,000 L 23,000 DD 20,000 NW 5,000 A R 12,000 L 23,000 DD 30,000 NW 11,000 A R 12,000 L 32,000 CD 39,000 NW 5,000 A Money Supply Cash -10,000 DD +10,000 Net

R 12,000 L 32,000 DD 39,000 NW 5,000 A DD B R 3,000 L 32,000 DD 30,000 NW 11,000 A Money Supply Cash -1,000 DD +19,000 Net R

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. BankIncrease in Deposit ($) Increase in Loans ($) Increase in Reserves ($) A10, , , B9, , C8, , D7, , E6, , F5, , ………… ………… Total for all banks100, , , Deposit Creation

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Money Multiplier D  r D = maximum deposit creation E = excess legal reserves r = reserve ratio

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Structure of the Federal Reserve System

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Board of Governors 7 members appointed by the President and confirmed by Congress 14-year terms; reappointment prohibited if member serves full term Chair of the Board selected by President

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Federal Open Market Committee FOMC Meetings FOMC Announcements

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Federal Reserve Controls Legal Reserve Requirement Discount Rate Open Market Operations

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Federal Reserve Targets Interest rate target -Federal funds rate Money growth target

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Quantity Theory of Money M x V = P x Q V Where: V = income velocity P P = price level of final goods and services Q Q = quantity of final goods and services M M = money supply

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Demand Pull Inflation Price level qfqf q S D2D2 D2D2 D1D1 D1D1 D D p1p1 p p2p2 Output demanded and supplied per year

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Cures for Demand Pull Inflation Monetary policy -Raise legal reserve requirement -Raise discount rate -Sell bonds in open market Fiscal policy -Raise taxes -Lower government spending

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost Push Inflation Price level qfqf q S D D p1p1 p p2p2 Output demanded and supplied per year

McGraw-Hill/Irwin Economics of Social Issues, 17/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Is There a Cure for Cost-Push Inflation? Incomes policies Tax-based incomes policy (TIP)