macro l20 inflation

8/8/2019 Macro L20 Inflation

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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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01950 1960 1970 1980 1990 2000

The Misery Index, 1948-2000

macro l20 inflation

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