INTRODUCTION INFLATION WHAT IS INFLATION? INTRODUCTION RELATIVE PRICES VS. THE PRICE LEVEL RELATIVE PRICES VS. THE PRICE LEVEL

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1 Chapter 7 INFLATION INTRODUCTION In 1923, prices in Germany rose a trillion times over. Prices in Russia, Bulgaria, and some other nations have witnessed a tenfold increase in a year. In the 1990 s the U.S. inflation rate have risen 1 to 4 percent a year. Although inflation is regarded as a major macro problem in the United States, American inflation rates are comparatively low. 2 INTRODUCTION WHAT IS INFLATION? This chapter focuses on the following: What kinds of price increases are referred to as inflation? Who is hurt (or helped) by inflation? What is an appropriate goal for price stability? Inflation is an increase in the average level of prices, not a change in any specific 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. 3 4 RELATIVE PRICES VS. THE PRICE LEVEL It is possible for individual prices to rise or fall continuously without changing the average price level. Changes in relative prices may occur in a period of stable average price, or in periods of inflation or deflation. 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. General inflation doesn t perform this market function. 5 6

2 REDISTRIBUTIVE EFFECTS OF INFLATION Although inflation makes some people worse off, it makes some people better off. Price changes are the most familiar effect of inflation. The effect on economic welfare is shown in the difference between nominal and real income. Two basic lessons about inflation: Not all prices rise at the same rate during inflation. Not everyone suffers equally from inflation. PRICE EFFECTS Nominal income is the amount of money income received in a given time period, measured in current dollars. Real income is income in constant dollars: nominal income adjusted for inflation. 7 8 PRICE CHANGES IN 2000 INCOME EFFECTS Even if all prices rose at the same rate, inflation would still redistribute income. Redistributive effects originate both in expenditure and income patterns. What looks like a price to a buyer looks like an income to a seller. If prices are rising, incomes must be rising too WEALTH EFFECTS THE REAL STORY OF WEALTH Winners and losers from inflation depend on the form of wealth they own. You lose when inflation reduces the real value of wealth

3 REDISTRIBUTIONS Inflation acts like a tax, taking income or wealth from one group and giving it to another. The redistributive mechanics of inflation include: price effects income effects wealth effects REDISTRIBUTIVE MECHANICS Price Effect: People who prefer goods and services that are increasing in price least quickly end up with a larger share of income. Income Effect: People whose nominal income rise faster than inflation end up with a larger share of total income. Wealth Effect: Owners of assets that increase in real value end up better off than others MONEY ILLUSION The use of nominal dollars rather than real dollars to gauge changes in one s income or wealth is called the money illusion. Even people whose nominal incomes keep up with inflation often feel oppressed by rising prices. People can feel cheated when they realize their nominally rising salaries buy the same or fewer goods than before. MACRO CONSEQUENCES Inflation has macroeconomic effects as well as the effects on income and wealth redistribution. Inflation can alter the rate and mixes of output by changing consumption, work, saving, investment, and trade behavior UNCERTAINTY AND TIME HORIZONS Uncertainties created by changing price levels affect consumption and production decisions. Time horizons are shortened as people attempt to spend money before it loses further value. 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. Hyperinflation is an inflation rate in excess of 200 percent, lasting at least one year. 17 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. As such behavior becomes widespread, production declines and unemployment rises. 18

4 BRACKET CREEP Under our progressive tax system, taxes go up when prices rise. Savings, investment, and work effort decline. Inflation tends to increase everyone s income pushing them into a higher tax bracket (though not as bad in America due to our brackets being inflationadjusted). of course, the AMT is another matter Bracket creep is the movement of taxpayers into higher tax brackets (rates) as nominal incomes grow. 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. 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. Businesses are more reluctant to borrow money or to invest. 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. The inflation rate is the annual percentage rate of increase in the average price level

5 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. The CPI is usually expressed in terms of what the market basket costs in a specific base period. 25 CONSUMER PRICE INDEX (SOURCE BLS.GOV) What goods and services does the CPI cover? BLS has classified all expenditure items into more than 200 categories, arranged into eight major groups. FOOD AND BEVERAGES (cereal, milk, coffee, chicken, wine, full service meals, snacks) HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture) APPAREL (men's shirts and sweaters, women's dresses, jewelry) TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance) 26 CPI CATEGORIES (CONTINUED): MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services) RECREATION (televisions, toys, pets and pet products, sports equipment, admissions); EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories); OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses). CONSTRUCTING THE CPI The base period is the time period used for comparative analysis the basis of indexing, for example, of price changes. The relative importance of a product in the CPI is reflected in its item weight. 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 Insurance and pensions 9.3% Transportation 19.0% Housing 32.6% Food 13.6% Clothing 4.7% Miscellaneous 10.5% Entertainment 5.1% Health care 5.3% 29 30

6 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. The PPIs and the CPI generally reflect the same inflation rate over long periods 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. Its value reflects both price changes and market responses to those changes 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: 35 Changes in real GDP are a good measure of how output and living standards are changing. 36

7 THE GOAL: PRICE STABILITY Every U.S. president since Franklin Roosevelt has decreed price stability to be a foremost policy goal. An explicit numerical goal for price stability was established by the Full Employment and Balanced Growth Act of Price stability is the absence of significant changes in the average price level; officially defined as an inflation rate of less than 3 percent. 37 UNEMPLOYMENT CONCERNS Congress chose the 3 percent rate because of its concern about unemployment. The government might have to restrain spending in the economy to keep prices from rising. This could lead to cutbacks in production and an increase in joblessness. 38 UNEMPLOYMENT CONCERNS A little bit of inflation might be the price the economy has to pay to keep unemployment rates from rising. Likewise, some unemployment may be the price society has to pay for price stability. PROBLEM WITH CPI: QUALITY CHANGES The CPI is not a perfect measure of inflation because an increase in price may caused by quality improvements. Over time, the goods themselves change as a result of quality improvements PROBLEM WITH CPI: NEW PRODUCTS The CPI is biased upward when new products whose prices are falling are left out of the market basket. 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

8 THE HISTORICAL RECORD CAUSES OF INFLATION A Inflation The cause of inflation is rooted in supply and demand. The two types of inflation are: 8 4 Demand-pull inflation Cost-push inflation 0 B Deflation 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 Market participants can protect themselves by indexing their nominal incomes. A COLA protects real income from inflation. 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

9 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. The objective is to maintain a stable rate of real interest. ARMS The real interest rate is the nominal interest rate minus the anticipated inflation rate. Real interest rate = nominal interest rate anticipated inflation rate If prices rise faster than interest accumulates, the real interest rate will be negative THE COST OF MISMEASUREMENT Proliferation of COLAs and ARMs makes the CPI a critical statistic in today s economy. If CPI goes up, so do government transfer payments, union wages, and nominal interest rates. 51 THE COST OF MISMEASUREMENT According to experts, the CPI overstates inflation by about one percentage point. Quality improvements, new products, and changes in expenditure patterns may cause inflation to be overestimated. The CPI s market basket of goods and services was overhauled in Based on expenditure patterns, it included more new products and new adjustments for quality improvements. 52 THE END OF INFLATION? Inflation is currently hovering around 3-4%. According to the CPI data on bls.gov the unadjusted inflation rate for July 2010(TTM) was 1.2% The best inflation rate is one that least affects the behavior of companies, investors, shoppers and workers. End of Chapter 7 INFLATION 53