Inflation What Is Inflation Inflation is an increase

Inflation

What Is Inflation? � Inflation is an increase in the average level of prices, not a change in any specific price.

The Average Price � The average price is determined by finding the average price of all output. ◦ A rise in the average price is called inflation. ◦ A fall in the average price is called deflation.

Relative Prices vs. the Price Level � Changes in relative prices may occur in a period of stable average price, or in periods of inflation or deflation. n A relative price is the price of one good in comparison with the price of other goods.

Relative Prices vs. the Price Level � By reallocating resources in the economy, relative price changes are an essential ingredient of the market mechanism. n A general inflation doesn’t perform this market function.

Redistributive Effects of Inflation � Although inflation makes some people worse off, it makes some people better off. � The three major methods inflation redistributes money by are: ◦ The Price Effect ◦ The Income Effect ◦ The Wealth Effect

Price Effects � Nominal income is the amount of money income received in a given time period, measured in current dollars. n Real income is income in constant dollars: nominal income adjusted for inflation.

Price Effects � Two basic lessons about inflation: ◦ Not all prices rise at the same rate during inflation. ◦ Not everyone suffers equally from inflation. Not all prices rise at the same rate during inflation. l Not everyone suffers equally from inflation. l

Price Effects � People who prefer goods and services that are increasing in price least quickly end up with a larger share of income.

Price Changes in 2000

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

Income Effects � What looks like a price to a buyer looks like an income to a seller. If prices are rising, incomes must be rising too. n People whose nominal income rise faster than inflation end up with a larger share of total income. n

Nominal Wages and Prices 200 180 160 140 Prices Wages 120 100 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 YEAR

Wealth Effects � People hold wealth in different forms (accounts, stocks, commodities). � When the value of these changes due to inflation, some people will get wealthier and some will lose wealth.

The Real Story of Wealth

Uncertainty � One of the most immediate consequences of inflation is uncertainty. � Uncertainties created by changing price levels affect consumption and production decisions.

Shortened Time Horizons � People tend to shorten their time horizons in the face of inflation uncertainties. � Time horizons are shortened as people attempt to spend money before it loses further value.

Shortened Time Horizons � During the German hyperinflation, workers were paid two or three times a day so that they could buy goods in the morning before prices increased in the afternoon. l Hyperinflation is an inflation rate in excess of 200 percent, lasting at least one year.

Speculation � If you expect prices to rise, it makes sense to buy things now for resale later. � Few people will engage in production if it is easy to make speculative profits. � People may be encouraged to withhold resources from the production process, hoping to sell them later at higher prices.

Speculation � As such behavior becomes widespread, production declines and unemployment rises.

Bracket Creep � Bracket creep is the movement of taxpayers into higher tax brackets (rates) as nominal incomes grow. � As prices rise, incomes rise, and then taxes rise.

Deflation Dangers � Deflation — a falling price level — might not make people happy either. � Deflation reverses the redistributions caused by inflation. � Lenders win and creditors lose.

Deflation Dangers � When prices are falling, people on fixed incomes and long-term contracts gain more real income.

Deflation Dangers � Falling price levels have similar macro consequences. Time horizons get shorter. n Businesses are more reluctant to borrow money or to invest. n

Deflation Dangers � People lose confidence in themselves and public institutions when declining price levels deflate their incomes and assets.

Measuring Inflation � Measuring inflation serves two purposes: ◦ Gauges the average rate of inflation. ◦ Identifies its principal victims.

Consumer Price Index (CPI) � The CPI is the most common measure of inflation. � The consumer price index (CPI) is a measure (index) of changes in the average price of consumer goods and services.

Consumer Price Index (CPI) � By observing the extent of price increases, we can calculate the inflation rate. n The inflation rate is the annual percentage rate of increase in the average price level.

Constructing the CPI � The Bureau of Labor Statistics constructs a market basket of goods and services that consumers usually buy. � Specific goods and services are itemized within the broad categories of expenditures.

Constructing the CPI � The relative importance of a product in the CPI is reflected in its item weight. n Item weight is the percentage of total expenditure spent on a specific product; used to compute inflation indexes.

Constructing the CPI � The impact on the CPI of a price change for a specific good is calculated as follows: percentage change in CPI = item weight X percentage change in price of item

The Market Basket Transportation 19. 0% Housing 32. 6% Food 13. 6% Insurance and pensions 9. 3% Clothing 4. 7% Entertainment 5. 1% Miscellaneous 10. 5% Health care 5. 3%

Producer Price Indexes � There are three producer price indexes (PPI) which keep track of average prices received by producers. � One includes crude materials, another intermediate goods, and the last covers finished goods.

Producer Price Indexes � PPIs are watched as a clue to potential changes in consumer prices. In the short run, the PPIs usually increase before the CPI. n The PPIs and the CPI generally reflect the same inflation rate over long periods. n

The GDP Deflator: � The GDP deflator is a price index that refers to all goods and services included in GDP. ◦ It is the broadest price index is the GDP deflator. ◦ It covers all output including consumer goods, investment goods, and government services.

The GDP Deflator: � The GDP deflator usually registers a lower inflation rate than the CPI. Unlike the CPI and PPI, the GDP deflator is not limited to a fixed basket. n Its value reflects both price changes and market responses to those changes. n

Real vs. Nominal GDP � The GDP deflator is used to adjust nominal output values for changing price levels. ◦ Nominal GDP is the value of final output produced in a given period, measured in the prices of that period (current prices). ◦ Real GDP is the value of final output produced in a given period, adjusted for changing prices.

Real vs. Nominal GDP � Nominal and Real GDP are connected by the GDP deflator:

The Goal: Price Stability � Price stability is the absence of significant changes in the average price level; officially defined as an inflation rate of less than 3 percent.

Unemployment Concerns �A little bit of inflation might be the “price” the economy has to pay to keep unemployment rates from rising. n Some unemployment may be the “price” society has to pay for price stability.

The Historical Record � In the long view of history, the U. S. has done a good job in maintaining price stability. � Upon closer inspection, however, our inflation performance is very uneven.

The Historical Record 20 Inflation 16 A 12 8 4 B 0 4 8 Deflation 12 1920 1930 1940 1950 1960 1970 1980 1990 2000

Causes of Inflation � Inflation is rooted in supply and demand. � The most common types of inflation come from demand-pull and cost-push.

Demand-Pull Inflation � Demand-pull inflation results from excessive pressure on the demand side of the economy. � “Too much money chases too few goods” enabling producers to raise prices.

Cost-Push Inflation � The pressure on price could also originate on the supply side. � Higher production costs put upward pressure on product prices.

Protective Mechanisms � Low rates of inflation don’t have the drama of hyperinflation, but they still redistribute real wealth and income. ◦ For example, if prices rise by an average of just 4 percent a year, the real value of $1, 000 drops to $822 in five years and to only $676 in ten years.

COLAs � Cost-of-living adjustments (COLAs) are automatic adjustments of nominal income to the rate of inflation. � COLAs are commonly used by landlords as well as in labor agreements and government transfer programs.

ARMs � An adjustable-rate mortgage (ARM) is a mortgage (home loan) that adjusts the nominal interest rate to changing rates of inflation. � ARMs were developed to protect lenders against losses during long term rises in inflation.

ARMs � The real interest rate is the nominal interest rate minus the anticipated inflation rate. Real interest rate = nominal interest rate – anticipated interest rate

ARMs � If prices rise faster than interest accumulates, the real interest rate will be negative.

Inflation End of Chapter 7