Inflation is defined as an increase in the overall level of prices.

Inflation

Inflation

Inflation is defined as an increase in the overall level of

prices.

When the general price level rises, each unit of currency buys fewer goods and services

inflation is also a decline in the real value of money—a loss of purchasing power in the medium of exchange which is also the monetary unit of account in the economy.

Inflation: General Aspects

Inflation originally referred to the debasement of the currency.

When gold was used as currency, gold coins could be collected by the government (e.g. the king or the ruler of the region), melted down, mixed with other metals such as silver, copper or lead, and reissued at the same nominal value.

Inflation: History

By diluting the gold with other metals, the government could increase the total number of coins issued without also needing to increase the amount of gold used to make them. When the cost of each coin is lowered in this way, the government profits from an increase in seigniorage (/ˈseɪnjərɪdʒ/), that is the net revenue derived from the issuing of currency).

This practice would increase the money supply but at the same time lower the relative value of each coin.

As the relative value of the coins decrease, consumers would need more coins to exchange for the same goods and services. These goods and services would experience a price increase as the value of each coin is reduced.

Inflation: History cont.

economists categorized three separate factors that cause a rise or fall in the price of goods: ◦a change in the value or resource costs of the

good, ◦a change in the price of money which then was

usually a fluctuation in metallic content in the currency, and

◦currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency.

Inflation: History cont.

Following the proliferation of private bank note currency printed during the American Civil War, the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of redeemable bank notes outstripped the quantity of metal available for their redemption.

Inflation: History cont.

A consumer price index (CPI) is a measure of the average price of consumer goods and services purchased by households. It is a price index determined by measuring the price of a standard group of goods meant to represent the typical market basket of a typical urban consumer.

GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all new, domestically produced, final goods and services in an economy.

Measuring the inflation

Producer price indices (PPIs) which measures average changes in prices received by domestic producers for their output.

This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid.

There is also typically a delay between an increase in the PPI and any eventual increase in the CPI.

Producer price index measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset by increasing productivity.

Other widely used price indices for calculating price inflation

Core price indices: because food and oil prices can change quickly due to changes in supply and demand conditions in the food and oil markets, it can be difficult to detect the long run trend in price levels when those prices are included.

Therefore most statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a broad price index like the CPI.

Because core inflation is less affected by short run supply and demand conditions in specific markets, central banks rely on it to better measure the inflationary impact of current monetary policy.

Other widely used price indices for calculating price inflation

Inflation rate in the world

The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.

When the overall price level rises, the value of money falls.

The Classical Theory of Inflation

How the price level is determined and why it might change over time is called the quantity theory of money. The quantity of money available in the

economy determines the value of money. The primary cause of inflation is the growth in

the quantity of money.

The Quantity Theory of Money

Velocity of money

The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

V = (P x Y)/MWhere: V = velocity

P = the price levelY = the quantity of outputM = the quantity of money

Velocity and the Equation of Exchange

Rewriting the equation gives the equation of exchange:

M x V = P x Y

Velocity and the Equation of Exchange

Velocity and the Equation of Exchange

The equation of exchange relates the quantity of money (M) to the nominal value of output (P x Y).

The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one or more of three other variables: the price level must rise, the quantity of output must rise, or the velocity of money must fall.

Velocity and the Quantity Equation

Nominal GDP

Indexes (1960 = 100)

1,500

1,000

500

01960 1965 1970 1975 1980 1985 1990 1995 2000

M2

Nominal GDP, the Quantity of Money, and the Velocity of Money

Velocity

The velocity of money is relatively stable over time.

When the central bank changes the quantity of money, it causes proportionate changes in the nominal value of output (P x Y).

Because money is neutral, money does not affect output.

The Quantity Theory of Money

Hyperinflation is inflation that exceeds 50 percent per month.

Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.

Hyperinflation

Money and Prices During Hyperinflation

(b) Hungary

Money supply

19251924192319221921

Price level

100,000

10,000

1,000

100

Index (Jan. 1921 = 100)

(a) Austria

19251924192319221921

100,000

10,000

1,000

100

Index (Jan. 1921 = 100)

Price level

Money supply

Money and Prices During Hyperinflation

c) Germany

1

100 trillion

1 million

10 billion

1 trillion

100 million

10,000

100

19251924192319221921

Price level

Moneysupply

d) Poland

Money

supply

Price level

Index (Jan. 1921 = 100)

100

10 million

100,000

1 million

10,000

1,000

19251924192319221921

Index (Jan. 1921 = 100)

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.

Hyperinflation and the Inflation Tax

According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount.

The real interest rate stays the same.

The Fisher Effect

rateInflation + rateinterest Real

=rateinterest Nominal

Percent(per year)

0

6

10

15

1960 1965 1970 1975 1980 1985 1990 1995

The Nominal Interest Rate and the Inflation Rate

3

12

Inflation

Nominal interest rate

Shoeleather costs Menu costs Relative price variability Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth

The Costs of Inflation

Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings.

Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings.

Shoeleather Costs

Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts.

The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand.

Also, extra trips to the bank take time away from productive activities.

Shoeleather Costs cont.

Menu costs are the costs of adjusting prices.

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.

Menu Costs

Inflation distorts relative prices. Consumer decisions are distorted,

and markets are less able to allocate resources to their best use.

Relative-Price Variability

Inflation exaggerates the size of capital gains and increases the tax burden on this type of income.

With progressive taxation, capital gains are taxed more heavily.

Inflation-Induced Tax Distortion

The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation.

The after-tax real interest rate falls, making saving less attractive.

Inflation-Induced Tax Distortion

When the central bank increases the money supply and creates inflation, it erodes the real value of the unit of account.

Inflation causes dollars at different times to have different real values.

Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.

Confusion and Inconvenience

Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.

These redistributions occur because many loans in the economy are specified in terms of the unit of account – money.

Arbitrary Redistribution of Wealth

Inflation in Poland

The overall level of prices in an economy adjusts to bring money supply and money demand into balance.

When the central bank increases the supply of money, it causes the price level to rise.

Persistent growth in the quantity of money supplied leads to continuing inflation.

A government can pay for its spending simply by printing more money.

This can result in an “inflation tax” and hyperinflation.

Summary

www.wikipedia.org Czarny B. „Podstawy Ekonomii”, PWE, 2002 www.nbp.pl http://windward.hawaii.edu/facstaff/briggs-p

/Macroeconomics/macrolectures.htm www.money.pl/i/denominacja/inflacja_sm.gif

Bibliography