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.

3 1. What is inflation?

4 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.

5 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.

6 Relative Prices vs. the Price Level However… general inflation: obscures and confuses relative price relationships; inhibits the efficient reallocation of resources in the economy.

7 2. Redistributive Effects of Inflation:

8 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. LO2

9 Price Effects

10 Nominal vs. real income Redistribution from price effects: rooted in nominal vs. real income: LO2

11 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. LO2

12 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. LO2

13 Price Changes in 2006 LO2

14 Income Effects Even if all prices rose at the same rate, inflation would still redistribute income. Redistributive effects originate both in expenditure and income patterns. LO2

15 Income Effects Rising prices = rising incomes, …but... … like prices, incomes do not all rise at the same rate. LO2

16 Income Effects

17 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)

18 Nominal Wages and Prices LO2 Productivity increases = Wages up faster than prices. Fringe benefits & payroll taxes increases = Wages up more slowly than prices.

19 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%. LO2

20 The Real Story of Wealth LO2

21 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. LO2

22 In Summary: Price Effects: People who prefer goods and services that are increasing in price the fastest end up with fewer goods and services. LO2

23 In Summary: Income Effects: People whose nominal income rise more slowly than inflation end up with fewer goods and services. LO2

24 In Summary: Wealth Effects: People who own of assets that are declining in real value end up with less real wealth. LO2

25 Nominal Wages and Prices LO2 Productivity increases = Wages up faster than prices. Fringe benefits & payroll taxes increases = Wages up more slowly than prices.

26 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. LO2

27 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. LO2

28 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?

29 3. Macro Consequences:

30 Macro Consequences Micro consequences: redistributing income and wealth; Macro consequences…?

31 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.

32 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.

33 Bracket Creep Bracket creep is the movement of taxpayers into higher tax brackets (rates) as nominal incomes grow.

34 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.

35 Review Consequences of inflation: Societal tensions Money illusion Uncertainty Speculation → Hyperinflation

36 4. Measuring Inflation: -The CPI – Consumer Price Index -Using the CPI. -Construction of the CPI. -Other measures of inflation.

37 Measuring Inflation Measuring inflation serves two purposes: It gauges the average rate of inflation. It identifies its principal victims. LO1

38 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. LO1

39 45,952 Consumer Price Index (CPI) Nominal Income Real Income Year GDP Deflator ,000 49,200 49,900 51,000 52,300 53,200 54,800 56,100 57,900 53,93353,47851,97851,00051,78251,15449,36947,542 Nominal increase 1, ,100 1, ,600 1,300 1,800 Real Change , ,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 Change The Starting Point

40 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, %

41 Constructing the CPI The Bureau of Labor Statistics constructs a market basket of goods and services (184) that consumers usually buy. The base period: the time period used for comparative analysis ‒ the basis of indexing price changes. LO1

42 Constructing the CPI A “market basket” of goods:” Bureau of Labor Statistics. 184 goods and services. A base period is chosen for indexing. LO1

43 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: LO1

44 The Market Basket Transportation 18.0% Housing 32.7% Food 13.7% Clothing 4.1% Miscellaneous 9.5% Health care 5.7% Entertainment 5.1% Insurance and pensions 11.2% LO1 % of total household spending Item Weight

45 Constructing the CPI The impact on the CPI of a price change for a specific good is calculated as follows: LO1 percentage change in CPI item weight x %∆ in item price =

46 Calculating Price Change Impacts on the CPI percentage change in CPI item weight x %∆ in item price =

47 The Market Basket Transportation 18.0% Housing 32.7% Food 13.7% Clothing 4.1% Miscellaneous 9.5% Health care 5.7% Entertainment 5.1% Insurance and pensions 11.2% LO1 Housing ↑ 10% = Transport ↑ 5% = Food ↓ 3% = ( All else unchanged) Affect on the CPI %∆ in CPI =3.759% % 3.27%

48 Practice: “Problem back of book: #5 & #6.

49 Other gauges of inflation: (Variations on the CPI): - The core inflation rate - PPIs - The GDP deflator

50 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. LO1

51 Producer Price Indexes Three producer price indexes (PPI): They track average prices received by producers. crude materials, intermediate goods, finished goods. LO1

52 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.

53 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 LO1

54 Real vs. Nominal GDP (REVIEW) The GDP deflator is used to adjust nominal GDP for changing price levels.

55 5. The Goal – Price Stability -Employment vs. inflation. -Problems with the CPI.

56 The Goal: Price Stability Every U.S. president since Franklin Roosevelt has decreed price stability to be a foremost policy goal. LO3

57 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 %. LO3

58 Unemployment Concerns LO3

59 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?

60 Practice: CPI & item weight, “Problem back of book: Chpt. 7, #5 & #6.

61 Unemployment Concerns Full employment: the lowest rate of unemployment consistent with stable prices. LO3

62 Unemployment Concerns Price stability is balanced against the desire to avoid unemployment and declines in production. LO3

63 Problems with CPI The CPI has certain problems in measuring inflation that also lead us to allow for a certain level of inflation: Quality changes in products. New products.

64 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. LO3

65 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. LO3

66 6. The Historical Record:

67 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.

68 Annual Inflation Rates

69 7. Causes of Inflation

70 Causes of Inflation The cause of inflation is rooted in supply and demand.

71 Demand-Pull Inflation Demand-pull inflation: excessive pressure on the demand side of the economy. “Too much money chasing too few goods.”

72 Demand-Pull Inflation

73 Cost-Push Inflation Cost-push inflation: Higher production costs push product prices up.

74 Cost-Push Inflation

75 8. Protective Mechanisms:

76 Protective Mechanisms There are two major protective mechanisms against the redistributive effects of inflation: COLAs ARMs

77 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.

78 ARMs Adjustable-rate mortgage (ARM): adjusts the nominal interest rate to match changing rates of inflation. Protects the lender.

79 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

80 The Real Interest Rate Nominal Rate - (“Anticipated”) inflation Rate = Real interest rate 5%-1%6% 10%6% 4%

McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Inflation End of Chapter 7