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Inflation
Germany 1923
* Hyperinflation prices rose a trillion times over* Savings became worthless
* Sacks of money required to buy food
* Borrowing ceased Banking stopped
* Production came to a halt* Unemployment rose tenfold
* German economy all but collapsed
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Inflation
Terms
The CPI Index
Impact of Inflation
Causes of Inflation
Misery Index
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Measuring Inflation Consumer Price Index An index of changes in average price of
consumer goods and services
1. Bureau of Labor Statistics
85 cities/19000 stores/60000 landlords, renters &homeowners each month
2. Record the prices of approximately 80,000 items each mo.
3. Typical market basket 8 major groups (200 categories)
Base period (1982-84)
Item weight x % change in price of item =% change in CPI
Item weight = % of total expenditures spent on a specificproduct
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GDP Deflator
A price index that refers to all goods and servicesincluded in GDP
1. Not based on a fixed basket of goods and services
2. Contents of the basket may change over time toreflect change in consumer and investmentpatterns
3. Value reflects both price changes & marketresponses to those changes via new expenditurepatterns
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Inflation
Inflation An increase in the average level of prices of goodsand services-- Not a reflection of any specific price, some go up
and some go down
Deflation A decrease in the average level of pricesof goods and services
Disinflation A decrease in the rate of inflation
Relative Price the price of one good in comparison withanother i.e. apples and oranges
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Relative Price Changes
Note that relative price changes are an essential
ingredient of the market mechanism
Competitive price is the engine which helps a marketseek its production equilibrium (allocative efficiency)
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Redistributive Effects of Inflation
Price Effects impacts individuals according to price
changes for the goods and services we each buy
Income Effects nominal income vs real income
Wealth Effects -- Changing asset values due toinflation
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Redistributive Effects of Inflation
Price
Some people worse off, others are better off
Those who buy products that are least affected byinflation tend to become relatively better off thanthose who buy products that are more affected byinflation
-- Not all prices rise at the same rate-- Not everyone suffers equally from inflation
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Real Income vs Nominal Income
Real Income = Nominal Income
Price Index
Nominal Income Amount of money received in agiven time period, measured in current dollars
Real Income Income in constant dollars; nominalincome adjusted for inflation
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Redistribution Effects of Inflation
Income
Not all incomes keep pace with inflation
Lenders lent funds at fixed interest rates Retired people Living on fixed incomes
Workers with multiyear contracts that fix wages atpreinflation levels
Since what a buyer pays is what a producer receives,certain producers may gain from inflation If pricesare rising, incomes are rising as well
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Redistribution Effects of Inflation
Wealth
Those who own assets increasing in real value endup better off than others
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Inflation is Like a Tax
Inflation acts just like a tax, taking income or wealthfrom one group and redistributing it to another
-- No assurance that such redistribution is fair or
socially/politically equitable
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Consequences of Inflation Social Tensions labor/management: government/people:
among consumers: may overwhelm a society and itsinstitutions
Money Illusion The use of nominal dollars rather than realdollars to gauge changes in income or wealth a feeling ofbeing cheated
Uncertainty makes people more conservative; causes plans tobe delayed or postponed which can have economic
consequences Speculation people make decisions based on expectations of
price changes
Automatic Tax Increases (Bracket Creep)
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Deflation
Deflation simply reverses the kinds of redistributions
caused by inflation
Falling price levels cause similar macroeconomicconsequences as inflation
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Goal: Price Stability Full Employment and Balanced Growth Act of 1978
-- economic policy goal for inflation < 3% = price stability
Full employment defined as lowest rate of unemploymentconsistent with stable prices
Measurement Capabilities CPI isnt a perfect measure
1. Old products are improved in quality2. New products may not be immediately included in the
market basket
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Causes of Inflation Market transactions entail two converging forces:
1. Demand2. Supply
Explanation of changing prices rooted in one or both of these markets
Demand Pull Inflation Economy at relatively full employment;consumers willing and able to buy more goods and services than the
economy can produce.too much money chasing too few goods
Cost-Push Inflation Producers increase prices to cover increasingcosts or deal with reduced supply
1. Energy Cost Increases2. Natural disasters
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Protective Mechanisms
Market participants desire to avoid the risks ofinflation
1. COLAs Cost of Living Adjustment Automaticadjustments of nominal income to the rate ofinflation
-- Labor Agreements
-- Govt Transfer Payments (Social Security)2. ARMs Adjustable Rate Mortgages
Cost of Mismeasurement CPI overstates inflationrate by 0.7 to 2.0%
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The Misery Index
Rarely has the economy been able to achieve arelatively low unemployment rate and stable prices atthe same time
Historically, increasingly low rates of unemploymentresult in increased incomes and increased spendinggiving us unacceptable levels of inflation
On the other hand, wringing inflationary pressuresout of the economy has at times triggered recessionsand relatively high levels of unemployment
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The Misery Index
The Misery Index is just the sum of the inflation rate
and the unemployment rate
The higher the Index, the more miserable we are
The lower the Index, the less miserable we are
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Conclusion One thing the economy has rarely been able to attain
simultaneously is a low unemployment rate and stableprices
10-61Copyright2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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15
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01950 1960 1970 1980 1990 2000
The Misery Index, 1948-2000