Harcourt Brace & Company Chapter 28 (skip pp ) Money and Inflation

Harcourt Brace & Company Inflation: Its Causes and Costs Inflation is a sustained increase in the price level. It is a continuous increase versus a “once-and-for-all” increase in prices. Inflation deals with the increase in the average of prices and not just significant increases in the price of a few goods.

Harcourt Brace & Company Inflation: Historical Aspects Inflation is commonly measured as the percentage change in the CPI. Deflation, a situation of decreasing prices, last occurred during the 1930’s. In the 1970’s prices rose by about 7 percent per year. From the 1990’s prices rose about 3 percent per year.

Harcourt Brace & Company CPI-U 1992 to the Present

Harcourt Brace & Company The Causes of Inflation Demand-Pull Inflation: Inflation that occurs when the economy is at or above full employment. Cost-Push Inflation: Inflation that occurs when the economy is below full employment

Harcourt Brace & Company Demand-Pull Inflation The government is often cited as the main cause of this type of inflation either by an excessive increase in the money supply or in government spending. Sharp increases in consumer spending or investment spending may be associated with demand-pull inflation.

Harcourt Brace & Company Cost-Push Inflation Causes include increases in resource costs (oil, food, etc), sharply rising wage costs, or excessive regulations. Late 1970’s energy crisis is a classic example of cost-push inflation. Stagflation is a term used to describe an economy that is in a recession while it is experiencing high inflation.

Harcourt Brace & Company Cause of Inflation: The Long Run View The quantity of money available in the economy determines the value of money. Excessive growth in the quantity of money is the primary cause of inflation.

Harcourt Brace & Company Hyperinflation & Inflation Tax Hyperinflation is inflation that exceeds 50 percent per month. – Figure 28-4: Note the relationship between the growth rate of the quantity of money and the price level. Hyperinflation is caused because the government prints too much money to pay for its spending.

Harcourt Brace & Company Hyperinflation & Inflation Tax When the government raises revenue by printing money, it is said to levy an inflation tax. An inflation tax is like a tax on everyone who holds money. The inflation ends when the government institutes fiscal reforms such as cuts in government spending.

Harcourt Brace & Company Relationship Between Money, Inflation and Interest Rates Nominal Interest Rate = Real Interest Rate + Inflation Rate Nominal interest rates are highly correlated with the inflation rate. For evidence, see Figure 28-5.

Harcourt Brace & Company Relationship Between Money, Inflation and Interest Rates If inflation were to increases (e.g. the Fed lets the money supply grow excessively), the result is both a higher inflation rate and a higher nominal interest rate. This is called the Fisher Effect.

Harcourt Brace & Company The Costs of Inflation Fallacy: “Inflation reduces individuals’ incomes and causes living standards to decline.” Fact: For some people, nominal income stays up or exceeds inflation (purchasing power remains the same or actually increases over time).

Harcourt Brace & Company The Costs of Inflation  At least six costs of inflation are identified as: 1. Shoeleather costs 2. Menu Costs 3. Increased variability of relative prices 4. Tax liabilities 5. Confusion and inconvenience 6. Arbitrary redistribution of wealth

Harcourt Brace & Company The Costs of Inflation: Shoeleather Costs With inflation, people have an incentive to minimize their cash holdings. People make more frequent trips to the bank or ATMs. These extra trips take time away from productive activities.

Harcourt Brace & Company The Costs of Inflation: Menu Costs During inflationary times, it is necessary to update price lists and other posted prices. This is a resource consuming process that takes away from other productive activities.

Harcourt Brace & Company The Costs of Inflation: Increased Variability of Relative Prices During times of rising prices, there will be a delay between price increases. While some prices are constant, other prices will be rising. It then becomes difficult to determine relative prices.

Harcourt Brace & Company The Costs of Inflation: Unintended Changes in Tax Liability Inflation tends to raise the tax burden on income earned from savings. Especially a problem with “capital gains.” Some discussion in Congress about indexing capital gains taxes.

Harcourt Brace & Company The Costs of Inflation: Confusion and Inconvenience With rising prices, it is necessary to constantly make corrections in order to compare real revenues, costs, and profits over time.

Harcourt Brace & Company The Costs of Inflation: Arbitrary Redistribution of Wealth With unanticipated or incorrectly anticipated inflation, wealth is redistributed between borrowers and creditors. Borrowers tend to benefit from unanticipated inflation.