Inflation Objectives What is the economic cost of

Inflation

Objectives: What is the economic cost of inflation? Why do policy makers try to maintain a stable rate of inflation?

The Level of Prices Doesn’t Matter…. . Most common complaint about inflation…. . . is that it makes everyone poorer But it doesn’t make everyone poorer Example: 2002 in France with the currency conversion Rate of 6. 55957 francs per euro All contracts were reinstated in euros at the same exchange rate 500, 000 Francs because 76, 224. 51 Euros

The Level of Prices Doesn’t Matter…. . Not everything became cheaper because prices were lower, wages and incomes also lower The real wage is the wage rate divided by the price level. Real income is income divided by the price level. The outcome: the level of prices doesn’t matter

…But the Rate of Change of Prices Does Distinguish between the level of prices and the inflation rate Inflation rate is the percent change per year in a price index – typically the consumer price index Inflation Rate = Price level in year 2 – price level in year 1 Price level in year 1 X 100

The Price Level versus the Inflation Rate, 1968 -2008 Inflation rate Price Level 250 16% 14 200 12 10 150 8 100 6 4 50 2 1968 2008 1970 1980 1990 2000 Year

…But the Rate of Change of Prices Does Economists believe that high rates of inflation impose significant economic costs Most important costs: Shoe-Leather Cost Menu Costs Unit-of-Account Costs

Shoe-Leather Costs People hold money for convenience in making transactions High inflation rate discourages people from holding money because the purchasing power of the cash in your wallet and the funds in your bank account steadily erodes as the overall level of prices rises People search for ways to reduce the amount of money they hold – sometimes at a considerable economic cost

Shoe-leather costs are the increased costs of transactions caused by inflation They are an allusion Shoe-leather costs are substantial in economies with very high inflation rates

Menu Costs Everything we buy has a listed price Menu costs are the real costs of changing listed prices With inflation, have to change prices more often than would if the price level was more or less stable Higher costs for the economy as a whole

Unit-of-Account Costs Role of the dollar as a basis for contracts and calculations is the unit-of-account role of money Can be easily degraded by inflation which causes the purchasing power of a dollar to change over time Dollar next year is worth less than a dollar this year Unit-of-account costs of inflation are the costs arising from the way inflation makes money a less reliable unit of measurement

Winners & Losers from Inflation High inflation rate imposes overall costs on the economy The interest rate on a loan is the % of the loan amount that the borrower must pay to the lender, in addition to the repayment of the loan amount itself Nominal interest rate vs. real interest rates

Winners & Losers from Inflation Nominal interest rate is the interest rate that is actually paid for a loan, unadjusted for the effects of inflation Interest rates on student loans, and loans at banks Real interest rate is the nominal interest rate adjusted for inflation Subtract the inflation rate from the nominal interest rate Nominal Interest rate of 8% - inflation rate of 5% = real interest rate of 3%

Winners & Losers from Inflation Borrower and Lender enter a contract, the contract specifies a nominal interest rate If the actual inflation rate is higher than expected, borrowers gain at the expense of lenders Borrowers will repay their loans with funds that have a lower real value than had been expected Can purchase fewer goods and services than expected due to high inflation rate

Winners & Losers from Inflation If inflation rate is lower than expected, lenders will gain at the expense of borrowers Borrowers must repay their loans with funds that have a higher real value than had been expected

Inflation is Easy; Disinflation is Hard Disinflation is the process of bringing the inflation rate down Policy makers always try to bring inflation back down when it goes above 2% or 3% The best way to avoid putting an economy through a wringer is to reduce inflation

The Cost of Disinflation Inflation rate 12% 16% 14 12 10 10 8 8 6 6 4 2 1978 1980 1982 1984 1986 Year 1988

Measurement & Calculation of Inflation

Objectives: How is the inflation rate measured? What is price index and how is it calculated?

Aggregate Price Level The aggregate price level is a measure of the overall level of prices in the economy How can someone summarize all the prices of all goods and services in an economy with a single number? Through price index

Market Baskets & Price Indexes Pre-Frost Post-Frost Price of Orange $0. 20 $0. 40 Price of Grapefruit 0. 60 1. 00 Price of Lemon 0. 25 0. 45 1. How much has the price of fruit increases? 2. Consumption bundle – the typical basket of goods and services purchased before the price changes 3. Market Baskets is a hypothetical set of consumer purchases of goods and services

Pre-Frost Post-Frost Price of Orange $0. 20 $0. 40 Price of Grapefruit 0. 60 1. 00 Price of Lemon 0. 25 0. 45 Cost of Market Basket (200 oranges, 50 grapefruit, 100 lemons) (200 x $0. 20) + (50 x 0. 60) + (100 x 0. 25) = $95. 00 (200 x $0. 40) + (50 x 1. 00) + (100 x 0. 45) = $175. 00 Economists use this method to calculate changes in the overall price level, track changes in the cost of buying a given market basket

Price index is the overall price level It is always cited along with the year for which the aggregate price level is being measured and the base year Price index in a given year = Cost of market basket in a given year X 100 Cost of market basket in a base year Price index is used to calculate consumer price index and producer price index Price indexes are a basis for measuring inflation

Consumer Price Index Consumer price index (CPI) measures the cost of the market basket of a typical urban American family Intended to show the costs of all purchases by a typical urban family has changed over time Calculated by surveying market prices for a market basket that is constructed to represent the consumption of a typical family of four living in a typical American city

Consumer Price Index Economists believe that the consumer price index systematically overstates the actual rate of inflation 1. CPI measures the cost of buying a given market basket Consumer alter the mix of goods and services they buy, reducing the purchases of products that have become relatively more expensive and increasing purchases of products that have become relatively cheaper

Consumer Price Index 2. Innovation Many goods now didn’t exist Widening of the range of consumer choice – innovation makes a given amount of money worth more CPI somewhat overstates inflation when we think of inflation as measuring the actual change in the cost of living of a typical urban American family

Other Price Measures Producer Price Index (PPI) measures the cost of a typical basket of goods and services, containing raw commodities such as steel, electricity, coal, and so on – purchased by producers Responds more quicker to inflationary or deflationary pressures “early warning signal” of changes in inflation rate

Other Price Measures GDP deflator is not a price index but it serves the same purpose The GDP deflator for a given year is equal to 100 times the ratio of nominal GDP for that year to real GDP for that year expressed in prices of a selected base year