Inflation

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 X 100

Price level in year 1

The Price Level versus the Inflation Rate, 1968-2008

Year

Price Level

1968 1970 1980 1990 2000 2008

16%

14

12

10

8

6

4

2

Inflation rate

250

200

150

100

50

…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

Year 1978 1980 1982 1984 1986 1988

16%

14

12

10

8

6

4

2

Inflation rate12%

10

8

6

Inflation rate

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-FrostPrice of Orange $0.20 $0.40Price of Grapefruit 0.60 1.00Price 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

Economists use this method to calculate changes in the overall price level, track changes in the cost of buying a given market basket

Pre-Frost Post-FrostPrice of Orange $0.20 $0.40Price of Grapefruit 0.60 1.00Price of Lemon 0.25 0.45Cost 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

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 is used to calculate consumer price index and producer price index

Price indexes are a basis for measuring inflation

Price index in a given year =

Cost of market basket in a given year X 100

Cost of market basket in a base year

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

Does not use a single base year but two

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