7-1 Inflation  We recognize inflation as the second of the two major macroeconomic problems we can face.  The core problems:  What kind of price increases are referred to as “inflation”?  Who is hurt and who is helped by inflation?  What is an appropriate goal for “price stability”?

7-2 Learning Objectives  Know how inflation is measured.  Know why inflation is a socioeconomic problem.  Know the meaning of “price stability.”  Know the broad causes of inflation.

7-3 Runaway Inflation  In 1923 prices in Germany more than doubled every day.  No one saved, invested, or made long-run plans.  Production came to a halt; unemployment increased by a factor of 10.  The economy collapsed.  Ultimately Hitler came to power.  Zimbabwe experienced a similar economic disaster between 2007 and 2010.

7-4 Exercise  The current price of a good is $1.  If its price doubles every day, what will its price be in 10 days? 20 days?  In 10 days, $512.  In 20 days, $524,288.

7-5 What Is Inflation?  Inflation: an increase in the average level of prices, not a change in any specific price of a good.  The prices of specific basket of goods are collected and computed into an average price level for that basket in a year.  A rise in that average price level is inflation.  A decrease in that average price level is deflation.

7-6 Relative Prices  The market mechanism causes the prices of individual goods and services to rise or fall – an essential market function.  Relative price: the price of one good compared to the price of other goods.  Buyers switch from one good to another when their relative prices diverge.  Inflation is a rise in the average price of all goods.  It is not a market function.

7-7 Redistributive Effects of Inflation  Inflation makes some people worse off and others better off.  There are price effects, income effects, and wealth effects.

7-8 Effects of Inflation  Some prices rise and some fall.  Rising prices require you to reallocate your purchasing power to ensure that you get the most satisfaction per dollar spent.  You might reduce buying goods with higher prices and increase buying goods with lower prices.  This can be seen by the difference between nominal income and real income.

7-9 Effects of Inflation  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.  You may get a raise (nominal income increases) – but if it does not rise as fast as inflation, your purchasing power decreases (real income falls).

7-10 Redistribution of Income and Wealth by Inflation  Price effects.  Those who buy products that are increasing in price the fastest end up worse off.  Those who sell products that are increasing in price the fastest end up better off.  Those who buy products that are increasing in price the slowest end up better off.  Those who sell products that are increasing in price the slowest end up worse off.

7-11 Redistribution of Income and Wealth by Inflation  Income effects.  People with nominal incomes rising more slowly than inflation end up worse off.  People with nominal incomes rising faster than inflation end up better off.

7-12 Redistribution of Income and Wealth by Inflation  Wealth effects.  Those who own assets that are declining in real value end up worse off.  Those who own assets that are increasing in real value end up better off.

7-13 Money Illusion  Money illusion: using nominal dollars rather than real dollars to gauge changes in one’s income or wealth.  Exercise:  In the “good old days” a movie ticket was 50 cents and the minimum wage was $1.00.  Compare the purchasing power of the minimum wage today to the “good old days.”  You could buy two movie tickets with one hour’s work before, but not now.

7-14 Exercise in Money Illusion  The inflation rate in 1980 was 13.5%.  In 1979 your income was $10,000.  In 1980 your income was $11,000.  Did your purchasing power increase? Decrease? Stay the same?  Decrease! Your income went up 10% while prices went up 13.5%.

7-15 Macro Consequences of Inflation  Uncertainty: not knowing the prices of goods in the future makes purchasing and production decision making much more difficult.  Speculation: decisions will shift from standard economic activity to betting on the future prices of goods.  Bracket creep: in a progressive tax system, when nominal incomes rise, the taxpayer gets pushed into a higher tax bracket.

7-16 Hyperinflation  Hyperinflation: inflation rate in excess of 200 percent, lasting at least 1 year.  Spending accelerates and production declines.

7-17 Deflation  Deflation: a general decrease in average prices.  This has redistribution effects that are just the opposite of those for inflation.  This has macro consequences also.  Sellers are reluctant to stock inventory.  Buyers are reluctant to buy now.  Businesses are reluctant to borrow funds or invest.  Incomes fall, and asset values decrease.

7-18 Measuring Inflation  Measuring inflation serves two purposes.  Gauging the average rate of inflation.  Identifying its principal victims.

7-19 Consumer Price Index (CPI)  Consumer price index (CPI): a measure (index) of 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.

7-20 Creating a Price Index  Select a “market basket” of goods: a standardized list of goods and services customers usually buy.  Select a base year: the reference year whose dollar value will be used.  Set the price index in the base year always equal to 100.  Measure the prices for the basket of goods in both the current year and in the base year.

7-21 Computing a Price Index  Basket price in the base year = $6,000.  Basket price in the current year = $6,600.  Compute the price index (CPI) for the current year:  X/100 = $6,600/$6,000  X = (6,600 x 100)/6,000  X = 110  CPI in the current year is 110.  A CPI of 110 indicates that prices in the current year are 10% higher than prices in the base year. Price index in current year Basket price in current year Price index base year = Basket price in base year

7-22 Exercise  In 2006 CPI was about 200. * * 1983 was the base year.  In 1983 CPI was about 100. *  These two CPI figures tell us that prices doubled between 1983 and  In 1974 CPI was about 50. *  So prices doubled between 1974 and  If a good was priced at $10 in 1974, what would you expect the price to be in 2006?

7-23 Other Measures of Inflation  Core inflation: changes in CPI, excluding food and energy prices.  Producer price index (PPI): changes in the average prices at intermediate steps of production.  GDP deflator: changes in prices of all goods and services included in GDP.  Used to correct nominal GDP to real GDP.

7-24 Computing Inflation Rate from CPI  CPI in 2006 was  CPI in 2005 was  Compute the inflation rate for 2006:  Inflation rate = ( )x100/195.3 = 3.23% CPI year 2 – CPI year 1 Inflation rate = X 100 CPI year 1

7-25 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.  Established by Full Employment and Balanced Growth Act of 1978.

7-26 The Goal: Price Stability  Measurement concerns.  We are seeking price stability at the lowest rate of unemployment.  From year to year, there are quality improvements in the basket of goods.  New products change the content of the basket of goods we buy.

7-27 The Historical Record The highest and lowest annual inflation rates since WW2 are identified. highest lowest

7-28 Causes of Inflation  Demand-pull inflation: results from excessive pressure to buy on the demand side of the economy.  A booming economy creates shortages.  Too much money pumped into the economy by the Federal Reserve.  Cost-push inflation: due to higher production costs putting pressure on suppliers to push up prices.

7-29 Protective Mechanisms  Cost of living allowances (COLA): nominal incomes are indexed to automatically rise at the same rate as inflation.  Adjustable-rate mortgage (ARM): interest rate on a mortgage rises along with inflation so that lenders do not lose money.

7-30 The Real Interest Rate  Real interest rate: the nominal interest rate minus the anticipated inflation rate.  The borrower pays the nominal rate.  The inflation-adjusted (real) rate of interest:  Protects the lenders. Hurts the borrowers.  Borrowers will pay back loan using more lower-valued dollars, but lenders receive the same purchasing power. Real interest rate = Nominal interest rate – Anticipated rate of inflation

7-31 The Economy Tomorrow  The virtues of inflation.  A little inflation might be a good thing.  The challenge for tomorrow is to find the optimal rate of inflation.  High enough to encourage more spending.  Low enough not to raise the specter of an inflationary flashpoint.  Inflationary flashpoint: the rate of output at which inflationary pressures intensify.

7-32 Revisiting the Learning Objectives  Know how inflation is measured.  Inflation is measured by changes in a price index such as the consumer price index (CPI).

7-33 Revisiting the Learning Objectives  Know why inflation is a socioeconomic problem.  Inflation redistributes income by altering relative prices, income, and wealth.  Some people actually gain from inflation, whereas others suffer a loss of real income or wealth.  Inflation creates uncertainty and speculation and detracts from productive activity.  COLAs and ARMs help protect some people from inflation.

7-34 Revisiting the Learning Objectives  Know the meaning of “price stability.”  The U.S. goal is an inflation rate of less than 3 percent per year.  This goal must be integrated with a potentially conflicting goal of full employment.

7-35 Revisiting the Learning Objectives  Know the broad causes of inflation.  Inflation is caused either by excessive demand (“demand-pull” inflation) or by structural changes in supply (“cost-push” inflation).