Inflation. Unit 1. What is inflation?

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1 Inflation. Unit 1. What is inflation? Reading Exercise 1. Read the text and answer the questions: 1. What kinds of price increases are referred to as inflation? 2. What is deflation? 3. What are the types of inflation? 4. How can producers stimulate supply-side inflation? Most people associate inflation with price increases on specific goods and services. The economy is not necessarily experiencing inflation, however, every time the price of a cup of coffee goes up. We must be careful to distinguish the phenomenon of inflation from price increases for specific goods. Inflation is an increase in the average level of prices, not a change in any specific price. Suppose you wanted to know the average price of fruit in the supermarket. Surely you would not have much success in seeking out an average fruit- nobody would be quite sure what you had in mind. You might have some success, however, if you sought out the prices of apples, oranges, cherries, and peaches. Knowing the price of each kind of fruit, you could then compute the average price of fruit. The resultant figure would not refer to any particular product, but would convey a sense of how much a typical basket of fruit might cost. By repeating these calculations every day, you could then determine whether fruit prices, on average were changing. On occasion, you might even notice that apple prices rose while orange prices fell, leaving the average price of fruit unchanged. The same kinds of calculations are made to measure inflation in the entire economy, we first determine the average price of all output - the average price level - then look for changes in that average. A rise in the average price level is referred to as inflation. The average price level may fall as well as rise. A decline in average prices - a deflation -occurs when price decreases on some goods and services outweigh price increases on all others. Relative Prices vs. the Price Level Because inflation and deflation are measured in terms of average price levels, it is possible for individual prices to rise or fall continuously without changing the average price level. For example, that the price of apples can rise without increasing the average price of fruit, so long as the price of some other fruit (e.g., oranges) falls. In such circumstances, relative prices are changing, but not average prices. Changes in relative prices may occur in a period of stable average prices, or in periods of inflation or deflation. In fact, in an economy as vast as ours - where literally millions of goods and services are exchanged in the factor and product marketsrelative prices are always changing.

2 TYPES OF INFLATION Demand-Side Forces. The most familiar form of inflation is called demand-pull inflation. The name suggests that demand is pulling up the price level, and this is pretty much what happens. If the demand for goods and services increases faster than production, there simply won't be enough goods and services to go around. Prices will rise as consumers try to outbid one another for the available supply. In the process, the price level will move up, and we will be saddled with inflation. Consumers are not the only potential villains in a demand-pull story. There are three sets of domestic market participants - consumers, business firms, and government agencies - and all of their dollars look alike. A surge in aggregate demand can come about through increased spending by any of these groups. Supply-Side Forces Increased spending is not the only possible explanation for rising prices. There are two sides to every market, and changes in supply conditions can also raise prices. In 1979, for example, the Organization of Petroleum Exporting Countries (OPEC) sharply increased the price of oil. For domestic producers, this action meant a significant increase in the cost of producing goods and services. Accordingly, domestic producers could no longer afford to sell goods at prevailing prices. They had to raise prices. The result was a cost-push inflation. Not all cost-push inflations have such dramatic beginnings. A more common source of cost-push inflation is an increase in labor costs, often resulting from aggressive labor-union bargaining. Producers can also contribute to supply-side inflation. If producers decide they want higher incomes, they may try to attain them by raising profit margins. They can increase profit margins by raising product prices faster than costs. The result is a rising price level - that is, inflation. The distinction between demand-led inflation and supply-led inflation is illustrated in figures1 and 2. Point E is the initial equilibrium and P the initial price level in both cases. In Figure1 prices are pushed up by a rightward shift of the aggregate demand curve. In Figure 2, prices are pushed up by a leftward shift of the aggregate supply curve. Thus an increase in the price level may result from increased aggregate demand, reduced aggregate supply, or a combination of these forces. In the real world, there are no graphs; all we see are rising prices. By themselves, rising prices don't reveal whether supply or demand forces are at work. Sorting out cause and effect is the objective of macroeconomic analysis (and the subject of the following chapters). At this juncture, an awareness of the different possible causes of inflation will help guide that analysis.

3 FIGURE 1. Demand-led inflation AS price level E E' AD' AD real output FIGURE 2. Supply-led inflation AS' price level E' E AS AD real output Exercise 2. Decide if the following statements are true or false. 1. Inflation is generally defined as a persistent rise in the average price level. 2. Changes in relative prices usually occur in a period of stable average prices. 3. Demand-pull inflation occurs when demand for a nation s goods and services outstrips that nation s ability to supply these goods and services. 4. Salary increases can t be the reason of cost-push inflation. 5. Prices for some specific goods can rise without changing average prices. Vocabulary exercises. Exercise 3. Match the words in the column A and their definitions in the column B. A 1.the rate of inflation B a the total income of a nation including al profits, rents, interest, wages, salaries during a specified period 2. price b a plan or course of actions as pursued by a government 3. sustained rise c to make something smaller or less in amount, value, price, etc. 4. value of money d the fixed ratio of changes in the average price level 5. the government policy e constant increase 6. national income f the amount of money asked or paid for something, cost 7. to reduce g estimated value of means of payment

4 Exercise 4. Fill in the gaps with the words or word combinations from the column A (ex.3): Inflation can be defined as... in prices generally. Today the control of inflation is given priority in.... To appreciate why, we have to look at the effects of rising prices- or what is the same thing- a fall in the.... At one time a gently rising... level wasn t viewed with too much concern. It improved the climate for investment and tended... the real burden of servicing the national debt: while interest is fixed in money terms, receipts from taxation increases as... rises. The snag, however, is that, once started, the rise in prices is difficult to contain. At first it becomes uncomfortable, producing undesirable results, both internal and external. Eventually,... increases. The situation is then serious, for it s much more difficult to reserve the trend. Indeed, it can develop into runaway inflation. Describing changes Intransitive verbs (i.e. verbs which don t have an object) increase rise go up Transitive verbs (i.e. verbs which can have an object) increase raise decrease fall drop decrease reduce drop go down decline e.g. The rate of inflation rises quickly. e.g. The government has increased income tax. e.g. the prices of electronic goods have fallen. e.g. We have reduced our prices by 10 percent. These corresponding nouns can also be used: an increase a rise a raise (US= increase in salary) a decrease a fall a drop a decline a reduction Exercise 5. Complete the sentences using a noun or a verb in the correct form from the boxes above: 1. The recent...in overseas investment has been good for the economy. 2. When costs... firms have to... their prices, and, as a result, we can face costpush inflation. 3. The economic model predicts that if savings rise the level of activity in the economy Businesses may be hit by a... in sales during the period of inflation. 5. As inflation progresses it is likely that workers money wages (that is, wages unadjusted for inflation) will be... broadly in line with inflation. 6. Demand for this toothpaste... by 4.5 per cent when the price decreased.

5 Exercise 6. Match the opposites: 1. reduce a increase 2. gradual b fall 3. decrease c expand 4. boom d slow 5. rise e sudden 6. rapid f dramatic decline Exercise 7. Read the sentences and draw the graph: 1. In 1990,company sales were 16 million pounds. 2. In 1991, company sales increased gradually, reaching 16.5 million pounds by the end of the year was a year of healthy growth. Sales exceeded those of the previous year by 1.5 million pounds. 4. In 1993, sales decreased sharply to 15 million pounds due to the launch of a rival product. 5. In 1994, sales recovered slightly, totalling 15.5 million pounds. 6. In 1995,sales improved dramatically, reaching a peak of 19 million pounds

6 Unit 2. Micro and macro consequences of inflation. Reading Exercise1. Read the text carefully and choose the best title for the numbered paragraphs: a. Income Effects b. Uncertainty c. Speculation. d. Bracket Creep e. Price Effects. f. Wealth Effects g. Shortened Time Horizons Micro consequences of inflation. We must distinguish between average prices and relative prices if we are to understand the true consequences of inflation. Popular opinion notwithstanding, it is simply not true that everyone is worse off when prices rise. Although inflation makes some people worse off, it makes other people better off. Some people even get rich when prices rise! The micro consequences of inflation are reflected in redistributions of income and wealth, not general declines in either measure of our economic welfare. Inflation acts just like a tax, tailing income or wealth from some people and giving it to others. This "tax" is levied through changes in prices, changes in incomes, and changes in wealth. 1 Price changes are the most familiar of inflation's pains. The effect of tuition increases on your economic welfare is reflected in the distinction between nominal income and real income. Nominal income is the amount of money you receive in a particular time period; it is measured in current money units. Real income, by contrast, is the purchasing power of that money, as measured by the quantity of goods and services your money will buy. If the number of money you receive every year is always the same, your nominal income doesn't change - but your real income will rise or fall with price changes. Suppose your parents agree to give you $6,000 a year while you are at school. Out of that $6,000 you must pay for your tuition, room and books, and everything else. The budget for your first year at school might look like this: Nominal income $6,000 Consumption - Tuition $ Room Books Everything else 700 Total 6000 First year budget

7 Now suppose tuition increases to $3,500 in your second year, while all other prices remain the same. What will happen to your nominal income? Nothing. Unless your parents take pity on you, you will still be getting $6,000 a year. Your nominal income is unchanged. Your real income, however, will suffer. This is evident in the second year s budget: Second year s budget Nominal income $6000 Consumption - Tuition $ Room Books Everything else 200 Total $6000 You now have to use more of your income to pay tuition. This means you have less income to spend on other things. You will have to cut back somewhere. Since room and books still cost $2300 per year, there is only one place to cut- the category of everything else. After tuition increases, you can spend only $200 per year on movies, clothes, pizzas, and dates- not $700. This $500 reduction in purchasing power represents a real income loss. Even though your nominal income is still $6000, your real income is only $5500. There are two basic lessons about inflation to be learned from this story: Not all prices rise at the same rate during an inflation. Typically, some prices rise very rapidly, others only modestly, and still others not at all. Not everyone suffers equally from inflation. Those people who consume the goods and services that are rising faster in price bear a greater burden of inflation; their real incomes fall more. Other consumers bear a lesser burden, or even none at all depending on how fast the prices rise. 2 The redistributive effects of inflation are not limited to changes in prices. Changes in prices automatically influence nominal incomes also. On average, people's incomes do keep pace with inflation. Again, this is a direct consequence of the circular flow: what one person pays out someone else takes in. If prices are rising, incomes must be rising, too. From this perspective, it makes no sense to say that "inflation hurts everybody." On average, at least, we are no worse off when prices rise, since our (average) incomes increase at the same time. However in reality, some people's incomes rise faster than inflation while others' increase more slowly. 3 The same kind of redistribution occurs between those who hold some form of values and those who do not. Suppose that on January I you deposit $l00 in a savings account, where it earns 5 percent interest until you withdraw it on December 31. At the end of the year you will have more nominal wealth ($105) than you' started with ($100). But what if all prices have doubled in the meantime? In that case, your $105 will buy you no more at the end of the year than $52.50 would have bought you at the beginning. In other words, inflation in this case reduces the real value of your savings,

8 and you end up worse off than those individuals who spent all their income earlier in the year! By altering relative prices, incomes, and the real value of wealth, then, inflation turns out to be a mechanism for redistributing incomes. The redistribute mechanics of inflation include Income effects. People, whose nominal incomes rise faster than the rate of inflation, end up with a larger share of total income. Price effects. People who prefer goods and services that are increasing in price least quickly end up with a larger share of real income. Wealth effects. People who own assets that are increasing in real value end up better off than others. Social Tensions. Because of its redistributive effects, inflation also increases social and economic tensions. Tensions - between labor and management, between government and the people, and among consumers - may overwhelm a society and its institutions. Despair. With prices changing all the time, a person's comfortable habits are easily upset. People are compelled to cope with a whole new dimension of uncertainty. Should they continue to save part of their incomes, even though the real value of savings is falling? Should they be shopping for different goods and services, at different stores? All these worries seem to accumulate quickly when prices start to rise rapidly. Money Illusion. Even those people whose nominal incomes "keep up" with inflation often feel oppressed by rising prices. People feel that they deserve any increases in wages they receive. When they then discover that their higher (nominal) wages don't buy any additional goods, they feel cheated. They feel worse off, even though they have not suffered any actual loss of real income. This is a phenomenon economists call money illusion. Macro Consequences of Inflation. Although redistributions of income and wealth are the primary consequences of inflation, inflation has macroeconomic effects as well. Inflation can alter the rate and mix of output by changing consumption, work, saving, investment, and trade behavior. 4 When the average price level is changing significantly in either direction, economic decisions become increasingly difficult. Should you commit yourself to four years of college, for example, if you are not sure that you or your parents will be able to afford the full costs? In a period of stable prices you can at least be fairly certain of what a college education will cost over a period of years. But if prices are rising, you can no longer be sure how large the bill will be. Under such circumstances, many individuals may decide not to enter college rather than risk the possibility of being driven out later by rising costs. The uncertainties created by changing price levels affect production decisions as well. Imagine a firm that is considering building a new factory. If construction costs or prices change rapidly during this period, the firm may find that it is unable to complete the factory or to operate it profitably. The firm may decide to do without a new plant.

9 Inflation need not always lead to a cutback in consumption and production. On the contrary, it s possible that it will just as easily induce people to buy more goods and services now, before prices rise further. Whichever response consumers and producers make decreasing or increasing their rate of expenditure - the economy is likely to suffer in the end. People shorten their time horizons in the face of inflation uncertainties. If consumers and producers postpone or cancel their expenditure plans, the demand for goods and services will fall. Therefore, production of goods and services will fall as well. 5 Inflation threatens not only to reduce the level of economic activity but to change its very nature. If you really expect prices to rise, it makes sense to buy goods and resources now for resale later. If prices rise fast enough, you can make a handsome profit. These are the kinds of thoughts that motivate people to buy houses, precious metals, commodities, and other assets. If it s too easy to make a profit,, few people will engage in production; instead, everyone will be buying and selling existing goods. As such behavior becomes widespread, production will decline and unemployment will rise. 6 Even people who don't speculate may find their productive activities disrupted by inflation. If prices are rising exceptionally fast, people must buy basic necessities as quickly as possible, while they can still afford them. In general, then, we expect inflation to alter market behavior. The rates of saving and investment will tend to decline when people shorten their time horizons and face the future with less confidence. This reduced level of saving and investment will in turn retard economic growth. 7 Another reason why savings, investment, and work effort decline when prices rise is that taxes go up, too. Federal income tax rates are progressive; that is, tax rates are higher for larger incomes. The intent of these progressive rates is to redistribute income from rich to poor. However, inflation tends to increase everyone's income. In the process, people are pushed into higher tax brackets, and confront higher tax rates. Exercise 2. For each question, choose the correct answer. 1. Real income is... a) the amount of money you receive in a particular time period. b) the purchasing power of money measured by the quantity of goods and services you can buy. c) your salary. 2. during the inflation period,... a) all prices rise at the same rate. b) some prices rise rapidly while others not at all. c) some specific prices increase. 3. Real income of people who consume goods and services that are rising faster in price... a) falls more.

10 b) rises faster. 4. If the rate of inflation rises slower than your nominal income you end up... a) with a larger share of total income. b) with a lesser share of total income. 5. The uncertainties generated by inflation... a) always lead to a cutback in consumption and production. b) makes consumers and producers postpone their expenditure plans. c) makes people postpone or cancel their expenditure plans or may induce people buy goods before prices rise faster. 6. One of the reasons why savings, investments and work efforts decline when prices rise is... a) speculative profits b) high tax rates c) price effect Vocabulary exercises Exercise 3. Read the sentences and complete them with the most suitable word/ word combination: speculation income social and economic tensions nominal income wealth purchasing power 1. is the amount of money you can get in a particular time period. 2. Increased incomes of the society have led to increased. of money. 3. The primary micro consequences of inflation are redistributions of and. 4. Due to the redistributive effect of inflation people have to go through. 5. If prices rise fast enough, is widespread. It means that many people prefer to buy and sell commodities for short-term profit instead of being engaged in production. Exercise 4. Match the words from the columns A and B to make word combinations: 1. social a uncertainties 2. to redistribute b rates 3. purchasing c a profit 4. price d tensions 5. inflation e effect 6. to make f power 7. tax g income

11 Exercise 5. Complete each sentence by taking the first part from the box A and the second from the box B. A 1.During the mid 1970s, when industrialized nations were experiencing high inflation rates, 2.. If everyone s income increased at the rate of inflation, 3.High interest rates tend to discourage investment by businesses 4.During the German hyperinflation of 1923, when prices doubled every week, 5.Some economists suggest that people like to hold a relatively high proportion of their assets 6.The impact of inflation on individuals depends on 7.Although the public sector still reaps some gain from inflation, B a. as they increase the cost of borrowing funds. b. inflation stress tends to create political backlash. c. how the prices of the goods and services each person buys or sells actually change. d. savings as a proportion of income rose! e. inflation wouldn t have such a large redistributive effect. f. in a form which can be quickly converted into cash when the future is uncertain. g. people tried to buy basic necessities as quickly as possible

12 Unit 3. Measuring inflation Reading Exercise 1. Read the text and fill in the sentences which were moved out from the text: a. Unlike the CPI, the GNP deflator is not based on a fixed basket of goods and services. b. Once we know what the typical consumer buys, it is relatively easy to calculate the average price of a market basket. c. Until we know how fast prices are rising and which groups are suffering the greatest loss of real income, we can hardly begin to design appropriate public policies. d. By observing the extent to which prices increase, we can calculate the inflation rate. e. Many people s incomes depend on changes in the CPI. In view of the macro and micro consequences of inflation, the measurement of inflation serves two purposes: to gauge the average rate of inflation and to identify its principal victims. 1. Consumer Price Index The most common measure of inflation is the Consumer Price Index (CPI). As its name suggests, the CPI is a mechanism for measuring changes in the average price of consumer goods and services. It is analogous to the fruit price index we discussed earlier. The CPI does not refer to the price of any particular good, but rather to the average price of all consumer goods. By itself, the "average price" of consumer goods is not a very useful number. Once we know the average price of consumer goods, however, we are able to observe whether that average rises - that is, whether inflation is occurring. 2. We can get a better sense of how inflation is measured - how it affects the distribution of income - by observing how the CPI is constructed. The process begins by identifying a "market basket" of goods and services the typical consumer buys. 3.. Suppose, for example, that the market basket cost $100 in 2000, and that one year later the same basket of goods and services cost $110. on the basis of those two shopping trips, we could conclude that consumer prices had risen by 10 percent in one year that the rate of inflation was 10 percent per annum. The GNP Deflator The broadest price index is the GNP deflator. The GNP deflator covers all output, including consumer goods, investment goods, and government services.4.. Rather, it allows the contents of the basket to change with people's consumption and investment patterns. The GNP deflator is therefore not a pure measure of price change. Its value reflects both price changes and market responses to those price changes, as reflected in new expenditure patterns. Hence the GNP deflator typically registers a lower inflation rate than the CPI.

13 Cost-of-Living Adjustments For many consumers, changes in a price index are more than a matter of idle curiosity.5.. Real income, of course, is always affected by changes in consumer prices. But in a more immediate sense, the size of many paychecks (nominal income) is directly tied to the CPI. Steelworkers, for example, get a raise of $0.01 per hour every time the CPI increases by 0.3 point. In such years as 1980, when the CPI rose by 23.1 points, such raises can be substantial (over $1,000 per year in this case). These raises come about because the workers' wage contracts include a cost-of-living adjustment (COLA), which automatically adjusts their nominal wages to changing prices. The objective of the COLA is to maintain the workers' real wages in an inflationary period. In private industry, those workers with COLA adjustments seldom have full protection against inflation; the adjustments are only partial Retired workers are even worse off; they seldom get any inflation adjustments in their private pensions. Vocabulary exercises. Exercise 2. Choose the correct answer according to the text: 1. Inflation to gauge its rate and identify principal victims. a) is measured b) is counted c) is calculated 2. The process of measuring inflation begins by a set of typical goods or services consumers buy. a) equating b) identifying 3. Foreign investment produces about 5% of the a) GNP b) COLA c) CPI 4. Stock is necessary to draw up a company s balance sheet. a) value b) valuation c) appraisal 5. Hence there s a significant element of error in the CPI insofar as it is intended changes in the average prices paid by consumers. a) to adjust b) to verify c) to gauge Exercise 3. Find words in the text which mean the following: a) measure of the rise in prices b) a set of figures showing the movement of prices of everyday goods and services bought over a period of time c) goods and services which are usually bought by typical consumers d) to alter or correct something e) the average amount of money each person spends on everyday items such as accommodation, food, heating, transport, clothes, etc. f) the using up of food, goods, energy and resources by people, organizations and countries

14 Exercise 4. Replace the words in italics with the words from the box. security prices money volume anticipated output extent index number disruptive cost of living Difficulties in measuring changes in the general level of prices. 1. The difficulty of measuring changes in the general level of prices is that different kinds of price- wholesale prices, retail prices,...(prices for items of financial value- stocks, shares, etc.), import prices change differently. 2. Since we are mainly interested in the...(degree) to which the value of money has altered between one date and another, it can be measured as a relative change by means of an... (a sign by which the level of something can be measured). 3.The government is trying to bring the...(the amount of money you have to pay for buying all the food, clothes, etc. that you need to live) down.. 4. Modest rates of inflation- particularly if they are constant, and thus... (predictable)- may actually stimulate... (the quantity of goods produced by a worker, a machine or an organization) because if producers are sure that prices continue to rise at the same rate, they will have an incentive to produce now for sale later ( at higher prices). 5. High rates of inflation are not necessarily...(preventing something from continuing in its usual way and causing troubles). Many countries do grow and prosper despite much higher inflation rates than in our country, because they have adjusted to persistently increasing prices.6. According to the supporters of the monetary approach, growth of...(the total amount of money) exceeding growth of aggregate production volume is one of the most important reasons of inflation.