chapter iv: prices and inflation
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Chapter IV: Prices and Inflation. A. Measuring prices and inflation B. The AS-AD Model and inflation C. Cost-push and demand-pull inflation D. Inflation as a monetary phenomenon E. Effects of inflation and inflation hedging F. Controlling inflation. Distinguishing real and nominal values. - PowerPoint PPT PresentationTRANSCRIPT
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Chapter IV: Prices and Inflation
A. Measuring prices and inflation
B. The AS-AD Model and inflation
C. Cost-push and demand-pull inflation
D. Inflation as a monetary phenomenon
E. Effects of inflation and inflation hedging
F. Controlling inflation
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Distinguishing real and nominal values Keynes had reasons to treat
the aggregate price level as given, but in many instances the price level will change over time
In this case we need to know more about the price deflator for GDP
It allows to distinguish between real GDP growth and nominal values of GDP
First we look at how prices are measured
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Measuring prices:Two approaches Prices are often given with reference
to a standard product for raw materials Other prices are given as a compound measure
for a basket of goods and services Example:
When newspapers write about oil prices, they usually mean one of two reference crudes: Brent from the North Sea, or West Texas Intermediate (WTI)
When ministers from the Organization of the Petroleum Exporting Countries (OPEC) discuss prices, they usually refer to a basket of heavier cartel crudes, which trade at a discount to WTI and Brent
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Consumer price index (CPI) An important indicator is the
consumer price index (CPI) It attempts to measure the evolution,
over time, of the cost of living of a typical household
It implies definition of A typical household A typical basket of goods and services
of that household
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Constructing the CPI
What do we need to construct a CPI? A base year t0 (in Germany 2000)
A “typical household” (in Germany various types)
A “basket” with “typical” of goods and services of the household (xi,0 ) for t0 (in Germany about 750)
Prices of the base year pi,0 and current prices pi,t for that basket
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Two types of price indices
If the weights xi,0 of the base period remain fixed, it will give us a “Laspeyres index”
If the weights are updated every period (flexible basket), xi,t, we obtain a “Paasche index”
∑
∑
=
=
⋅
⋅= n
iii
i
n
iti
Laspeyrest
xp
xpPI
10,0,
0,1
,
∑
∑
=
=
⋅
⋅= n
itii
n
ititi
Paaschet
xp
xpPI
1,0,
1,,
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The CPI according to Laspeyres
overstates the cost of living
Problems of the Laspeyres index
Reasons: The following is not measured Shoppers revise shopping plan in response to
changes in price relativities (substitution bias) There are new products that are not incorporated
in the original basket There are improvements in the quality of products and
services (quality bias)
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Problems of the Paasche index The Paasche index
Is more difficult to administer (the denominator has to be re-calculated every year)
Requires quantity data for each year, which may be difficult to obtain
Could be misleading, because each time different quantities are used, and therefore changes may not solely be attributable to price changes
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Impact of CPI on public and private agents In the U.S., the CPI affects the income of almost
80 million people as a result of statutory action Social Security beneficiaries, Military and Federal civil service retirees, Food stamp recipients
Changes in the CPI also affect the cost of lunches for children who eat lunch at school
Some private firms and individuals use the CPI to keep rents, royalties, alimony payments and child support payments in line with prices
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“Chain-linked” indices
To alleviate the burden of the traditional CPI on the federal budget, the US Bureau of Labor Statistics publishes chain-weighted indexes using a rolling base year since 1995
Other countries followed
€
PI tLaspeyres=
pi,t ⋅i=1
n
∑ xi,t− j
pi,t− j ⋅xi,t− j
i=1
n
∑,where j = 2
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Real GDP
Real GDP is measured in prices of a base year
For instance:Real GDP of 2005 (in prices of 2000):
€
GDP2005real = pi,2000
output ⋅xi,2005output
i=1
n
∑ − pi,2000input ⋅xi,2005
input
i=1
n
∑
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Real GDP and the GDP deflator
Nominal GDPReal GDP
The GDP deflator is defined as follows:
GDP deflator =
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Reading
Reading 4-1“Fighting America’s inflation flab”, The Economist, October 5, 2000(on methodological tricks with indices)
Abel, Bernanke and Croushore, Chapter 2 (only 2.4 and 2.5)
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CPI and GDP deflator:Differences The CPI is a Laspeyres index, whereas
the GDP deflator is a Paasche index The difference depends on what basket
of goods we use to calculate the index Is it best to use the same one
(of the reference year)? Or should we use the one at time t,
which changes period by period? The answer is not obvious!
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Example: Oil shock (1)
Suppose we choose the Laspeyres index and take the time-zero basket fixed
There is an oil shock at time 0, the oil price skyrockets: households reduce the demand for gasoline
and cars increase the use of substitute means
of transportation (for instance subways)
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Example: Oil shock (2)
At time t the actual basket of goods includes much less gasoline than at time zero, but the Laspeyres formula does not take it into account, so it will overstate inflation
The Paasche tends to understate inflation instead, because it gives a smaller weight to gasoline (the share of gasoline expenditures at time t)
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Reading: Oil shock and prices
18
Reading 4-2“Pistol pointed at the heart”, The Economist, May 29th, 2008
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Differences between CPIand GDP deflator: summary
Price index GDP deflator
Goods and services
Only private goods and services are
included
All private and public goods are
included
International trade
No distinction between national or international goods
and services
Only national goods and
services are summarized
Basket Fixed composition
Flexible composition
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The inflation rate and the growth rateThe annual inflation rate is calculated as
The annual growth rate is calculated as
€
π t +1 =Pt +1
Pt
−1 ⎡
⎣ ⎢
⎤
⎦ ⎥×100
€
gt +1 =GDPt +1
real
GDPtreal
−1 ⎡
⎣ ⎢
⎤
⎦ ⎥×100
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International GDP deflators1971-2005: North and South America
Source: Worldbank; own calculations
GDP Deflators: North America
0
20
40
60
80
100
120
140
160
197119731975197719791981198319851987198919911993199519971999200120032005
United States
Canada
Mexico
GDP Deflators: South America
0
20
40
60
80
100
120
140
160
180
197119731975 197719791981198319851987 198919911993199519971999 200120032005
Argentina
Brazil
Other South America
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International GDP deflators1971-2005: Europe and Asia
GDP Deflators: Europe
0
20
40
60
80
100
120
140
160
1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
EU 25
EU 15
Other Europe
GDP Deflators: Asia
0
20
40
60
80
100
120
1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
China
Japan
Korea
Source: Worldbank; own calculations
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World inflation
0
5
10
15
20
25
Jan91
Jan92
Jan93
Jan94
Jan95
Jan96
Jan97
Jan98
Jan99
Jan00
Jan01
Jan02
Jan03
Jan04
Source: Worldbank
Developingeconomies
High revenue economies
Consumer price inflation, median for developing- and GDP weighted mean for high-income
Per
cent
age
incr
ease
p.a
.
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Inflation history of the United States
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A useful link
http://www.bls.gov/data/inflation_calculator.htm
25
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Inflation in the Euro area, recent trends (HICP)
26
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World inflation
27
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Inflation in transition economies
28
Inflation rates of transition economies even dwarf those of Latin America in the early 1990s
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The AS-AD modeland inflation
If the AS curve is steeper, a
variation of the AD changes GDP at constant prices
and triggers an increase of the
price deflator
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Output and employment
This seems to suggest that there is a positive relationship between the price level and output for varying AD functions
Given the production function: Is there a tradeoff between unemployment and price stability? I.e. If we want more employment, we have to accept higher prices?
This hypothesis is expressed in the so-called “Phillips curve”
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Phillips curve
Unemployment
Infl
ati
on
2 3 4 5 6 7
8
7
6
5
4
3
2
1
Source: Economic Report to the President, 1985
Phillips curve
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Phillips curve The discussion about the Phillips curve is
very much related to Keynesian demand management
Unfortunately there is no trade off between unemployment and inflation
The Phillips curve simply overlooks long term reactions on the supply side
Let’s see what happens if the economy is constrained by its potential
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The AS-AD modeland inflation
In the long run the AS curve is vertical,
the expansion of output is only
temporary In the long run we
return to potential output at point C
All we have achieved is an
increase of the price level
B
A
C
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Long run Phillips curve
In the long run employment is to remain at its “natural” level (“natural employment”)
So the Phillips curve tradeoff works only in the short term
(We shall come back to this when we discuss demand pull inflation)
Let us come back to the price increase induced by shifting along the AS curve
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Price level increaseand inflation Is this price increase called inflation? For most people it is, but economists
speak of inflation only if it is reoccurring and persistent
So the case discussed here is a one-time price adjustment only, not necessarily inflation
How then is inflation generated?
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Why is there inflation? Inflation could result from activist
economic policies There are two types of mechanisms:
Cost push Demand pull
Each on its own will provoke price increases, but not necessarily inflation
However both mechanisms in tandem could cause inflation indeed
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Oil shock and policy reactions Let’s assume there is an oil price shock as
in the example discussed It would shift the supply curve to the left
creating a price increase and reducing production
Reduced production entails unemployment The government reacts with expansionary
fiscal policies
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Cost-push inflation
Price level
Aggregate output
Inflation is dueto accommodating
fiscal policy
GDPpotential
Each time the priceincrease feeds
back into wagesand costs
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Government demand asa driving force of inflation Let’s assume that the “natural rate of
employment” is reached, but there is residual structural unemployment
The government does not tolerate this and expands government outlays to inflate aggregate demand
It must drive prices up, which then feed back into wages and costs shifting the AS curve to the left
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Demand-pull inflation
Price level
Aggregate outputGDPpot GDPtarget
Fiscal policy drivesprices up,
and each time the price increase
feeds back into wagesand costs
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“Inflation is always and everywhere
a monetary phenomenon”
Milton Friedman 1912-2006, Nobel prize in 1976
The role of monetary policy
But neither cost push nor demand pull could provoke inflation without monetary
expansion
But neither cost push nor demand pull could provoke inflation without monetary
expansion
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Views on inflation: the monetarists
1
1: initial equilibrium
1’ 1’: expansion of money supply and of AD
2’
2’: expansion of money supply and of AD
2
2: restoration of “natural output” level
3
3: restoration of “natural output” level
3’4
Price level
Aggregate outputGDPnatural
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Inflation and the supply of money
Growth rate of the money supply in percent
Gro
wth
rate
of
the Inflati
on
1930
1920
1950
1870
1890
1880
1900
19601980
1940
1970 1910
Increase in Inflation and money supply in the USA(10 years annual average)
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Reading
Reading 4-3“An old enemy rears its head”, The Economist, May 22nd, 2008
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Once more:the Phillips curve
Activist fiscal or monetary policies trying to push employment beyond the “natural employment rate” should show up in the Phillips curve
Let’s have a look at the Phillips curve for Germany
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Phillips curve for Germany
Years
1961 to 1996
Unemployment rate in %
Inflati
on r
ate
in
%
Unemployment rate in %
Years
1961 to 1973
Inflati
on r
ate
in
%
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“Natural unemployment”and hysteresis As the short-term tradeoff between
unemployment and inflation is exploited, there are “irreversible” structural effects
People thrown out of job loose their qualification and become “structurally unemployed”
This process is called “hysteresis” It is exacerbated by structural changes
in the economy (the production function)
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Inflation and hysteresisof unemployment
Phillips curve for Germany
1961 to 1996
Unemployment rate in %
Inflati
on r
ate
in
%
un2un
1 un3
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The dynamics of the Phillips curve
π
uThe shift toward the right supports hysteresis
Turning clock-wise does in fact support the thesis that expansionary policy is followed by inflation
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Reading
Abel, Bernanke and Croushore, Chapter 12.1 and 12.2
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Creeping progression and “inflation tax” As the income tax is progressive, inflation will
automatically increase the tax burden relative to GDP in real terms (“bracket creep”)
There is an “inflation tax” on money holdings The counterpart is “seignorage” It could diminish welfare by reducing cash
holdings below the optimum for transactions The “inflation tax” hits the poor more than the
rich, because the latter can hedge assets against inflation
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Inflation and distortions of allocation Inflation can cause serious distortions on
the allocation of capital because the tax system ignores inflationary gains
(losses), and it charges certain activities too heavily (lightly)
profits could be inflated by deficient accounting which (inter alia) fixes depreciation at historical costs leads to difficulties in evaluating inventory flows treats dividends and debt charges differently
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Inflation and distortions of allocation If inflation is expected, consumers could reduce
savings to spend more on consumption, which would increase the costs of investment, and reduce growth
Inflation entails uncertainty, which could affect consumers’ and investors’ behavior negatively
Accounting techniques could be improved to adjust for inflation, but this leads to higher information costs
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Inflation and redistribution There are distributional arguments against
inflation. It is alleged to let profit income earners benefit more
than wage earners to penalize nominal income earners
Pensioners?Fixed-income earners (from securities etc.)?
to benefit debtors at the expense of creditors to make the the government
win at the expense of the private sector
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Hedging against inflation The distributional effects largely depend on
whether inflation is expected, or not If inflation is expected, it could be built into
contracts One way of incorporating unforeseeable inflation
is to use indexing Indexing is also an incentive for governments
to control the price level It is crucial to distinguish between “passive”
contract from self-referencing contracts
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“Scala mobile” in Italy An example for a self-referencing indexing
scheme is the “scala mobile” in Italy From 1946 until 1992, Italy had linked wage
increases to the CPI This lead to continuous inflationary pressures
that were hard to resist by monetary policies Moreover the Banca d’Italia was dependent on
the government In 1992 the “scala mobile” was repealed The central bank became more independent
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Prohibition of indexation in Germany In 1948 indexation was prohibited in Germany It was only permitted by Bundesbank authorization,
and permissions were rare The introduction of the euro in 1999 changed this
policy, but the indexation of wages and leasing fees is still forbidden
The central government has heralded an inflation-indexed bond with a volume of 10 billion € for the year of 2005
Nowadays more than 26 countries worldwide offer inflation-indexed bonds
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Reading
Abel, Bernanke and Croushore,
Chapter 12.3
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Different “types” of inflation
There are different types of inflation: creeping, rapid, and hyperinflation
The German hyperinflation is a striking example of money expansion driving the inflation rate
This experience qualifies as a “controlled experiment” and support Friedman’s thesis that
“inflation is always and everywhere a monetary phenomenon”
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Example:Germany after WW I
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The German hyperinflation 1922-23
Whole sale price index
1,E+00
1,E+01
1,E+02
1,E+03
1,E+04
1,E+05
1,E+06
1,E+07
1,E+08
1,E+09
1,E+10
1,E+11
1,E+12
July 1914 Jan 1919 July 1919 Jan 1920 Jan 1921 July 1921 Jan 1922 July 1922 Jan 1923 July 1923 Nov 1923
Whole sale price index
1,E+00
1,E+01
1,E+02
1,E+03
1,E+04
1,E+05
1,E+06
1,E+07
1,E+08
1,E+09
1,E+10
1,E+11
1,E+12
July 1914 Jan 1919 July 1919 Jan 1920 Jan 1921 July 1921 Jan 1922 July 1922 Jan 1923 July 1923 Nov 1923
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Is inflation under control now? Today, both the Fed and the European
Central Bank are independent institutions with conservative monetary policies
The two world currencies, the dollar and the euro, show little signs of inflation
Many countries have “anchored” their currencies in one of the world currencies
Sometimes anchoring even entails deflation (e.g. Argentina)
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Discussion 4:Inflationary risks and corporate management
Why should firms be concerned about inflation?
What strategies can be adopted to hedge inflationary risks at the firm level?
Do firms need inflationary risk management where currency boards appear to guarantee price stability?