Chapter 7 - Inflation
What happened in Germany in 1920?
Hyperinflation - it was more worthwhile to sweep money down the drain or use it as a toy
Macroeconomic effects of Inflation
Inflation has the following macroeconomic effects: 1) Uncertainty. 2) Bracket creep. 3) Speculation.
Inflation rate equation
Inflation rate = [(Price levelYear 2 - Price levelYear 1) ÷ Price levelYear 1] × 100
Hyperinflation
Inflation rate in excess of 200 percent, lasting at least one year. •With hyperinflation, spending accelerates and production declines.
Should we just aim for deflation instead?
NO, deflation reverses the redistribution effects of inflation. •Sellers are more reluctant to stock inventory. •Buyers are more reluctant to make purchases. •Businesses are more reluctant to borrow money or to invest. •Incomes and asset values decrease.
2) Income effects
NOMINAL income - The amount of money income received in a given time period, measured in current dollars. •AS MEASURED (inflation included) REAL income - Income in constant dollars; nominal income adjusted for inflation. •AFTER the effects of INFLATION have been removed. These have the same relevance as nominal and real GDP Real income reflects purchasing power
Real Interest Rate Equation
Real interest rate = Nominal interest rate −Anticipated rate of inflation
What happened in Germany in 1923?
Runaway inflation •Prices more than doubled every day. •No one could afford to save, invest, lend money, or make long-term plans. •Production of goods and services came to a halt. •Unemployment rose tenfold. •The economy all but collapsed.
What is the Third Goal Of Macroeconomics?
Stable Prices
How is the CPI created?
Steps in constructing the CPI: 1) IDENTIFY a market basket of goods. •Market basket: A standardized list of goods and services a typical consumer buys. 2) SELECT a base year. •Base year: The year used for comparative analysis; the basis for indexing price changes. •The price level in the base year is arbitrarily designated at 100. 3) MEASURE the prices for the basket of goods in both the current year and in the base year.
1) Quality Changes
The CPI simply monitors the price of specific goods over time, and old products become better over time due to quality improvements. •Hence increases in the price of products tend to exaggerate the true rate of inflation. •Ex: TVs
Price Stability
The absence of significant changes in the average price level; officially defined as a rate of inflation of less than 3 percent. •Established in the Full Employment and Balanced Growth Act of 19 78.
Inflation rate
The annual percentage rate of increase in the average price level.
2) Bracket Creep
The movement of taxpayers into higher tax brackets (rates) as nominal incomes grow. •Each year U.S.A. federal taxes are updated to account for inflation using the Consumer Price Index (CPI)
Real interest rate
The nominal interest rate minus the anticipated inflation rate. Ex: If income went up by 3%, and inflation went up by 5%, you real income decreased by 2% If income went up by 3%, and inflation went up by 2%, your real income increased by 1%
Item Weights
The percentage of total expenditure spent on a specific product; used to compute inflation indexes. •The relative importance of a product in consumer budgets is reflected in its item weight.
Relative price
The price of one good in comparison with the price of other goods. Relative prices are always changing. Relative prices are an essential ingredient of the market mechanism. •A rise in relative prices alerts producers to increase their output and cut back on other production. •A general inflation—an increase in the average price level—doesn't perform this same market function.
People end up WORSE OFF if...
- People buy products at constant prices and sell products at quickly increasing prices - Their nominal (including inflation) incomes RISE SLOWER than the rate of inflation (Income) - Their assets are DECLINING in REAL value (Wealth)
People end up BETTER OFF if...
- People buy products at quickly increasing prices and sell products at constant prices (Price) - Their nominal incomes RISES FASTER than the rate of inflation (Income) - Their assets are INCREASING in REAL value (Wealth)
Protective Mechanisms for managing inflation
1) Cost of Living Adjustments (COLAs) •Ex: Labor contracts, Social Security •Cost-of-living adjustment (COLA): Automatic adjustments of nominal income to the rate of inflation. 2.) Indexing •Contracts, Tax brackets 3) Adjustable Interest Rates •Mortgages (ARM) •credit cards •securities
Why is there inflation? What are the causes?
1) Excessive demand. •DEMAND-PULL inflation. •This is like the example of tulip mania in 1600 Netherlands 2) Structural changes in supply. •COST-PUSH inflation •Throughout the Coronavirus, supply chains have stopped, prices of inputs increased rapidly, creating inflationary pressure on prices for certain goods
Redistributive effects of inflation include...
1) Price effects 2) Income effects 3) Wealth effects
Other Price Indices
1) Producer Price Indexes 2) The GDP Deflator
Limitations of the CPI
1) Quality Changes 2) New Products 3) Averages don't reflect individual lives
Why should we measure inflation?
1) To gauge the average rate of inflation. 2) To identify those who gain or lose as a result
3 questions to understand what inflation is:
1) What kind of price increases are referred to as "inflation"? 2) Who is hurt (or helped) by inflation? 3) What is an appropriate goal for "price stability"?
The most commonly used price indexes are...
•Consumer Price Index (CPI) •Producer Price Index (PPI) •GDP deflator
3) Averages don't reflect individual lives
•The basket of goods represents a typical persons spending - an average •We've seen before than averages don't reflect individual differences •Any basket of goods is a rough guess at what we buy Ex: You may spend a lot more money on Fast Food than me Ex: I spend more money on collector mugs
What is the goal of stable prices?
Price stability
Socioeconomic / Micro effects of inflation
Although inflation makes some people worse off, it makes other people better off. This is microeconomic variance. There is a redistribution of income and wealth due to inflation.
What is Deflation?
A decrease in the average level of prices of goods and services. •Deflation is much more rare than inflation Deflation reverses the redistribution effects of inflation. •Sellers are more reluctant to stock inventory. •Buyers are more reluctant to make purchases. •Businesses are more reluctant to borrow money or to invest. •Incomes and asset values decrease.
Consumer Price Index (CPI)
A measure (index) of changes in the average price of consumer goods and services. •Is the most common measure of inflation. •Bureau of Labor Statistics collects prices on these items on a monthly basis.
What is the goal of most societies?
A modest and consistent rate of inflation that is predictable and consistent
What is the goal of most societies?
A modest and consistent rate of inflation that is predictable and consistent.
2) GDP Deflator
A price index that refers to all goods and services included in GDP. Used to adjust nominal GDP statistics for changing price levels. (Nominal GDP: The value of final output produced in a given period, measured in the prices of that period (current prices). Real GDP: The value of final output produced in a given period, adjusted for changing prices.) •Doesn't reflect a typical consumer. Reflects all of production in society
What is inflation?
An increase in the average level of prices of goods and services. •A rise in the average price level is referred to as inflation. •NOT the price of just ONE GOOD, by definition. Ex: If mango prices go up, NOT accurate to say mangos inflation. If the prices of many grocery goods goes up, ACCURATE to say grocery inflation
Computing Changes in CPI
CPI of a price change for a specific good: "Item weight" × "Percentage change in price of item = Percentage change in CPI"
2) New Products
New products only get included when a new base year, and new basket is created •Ex: iPhone introduced in 2007 •Not everyone bought one at once. •At some point common enough •Makes year to year comparisons tough
1) Uncertainty
Not knowing the prices of goods in the future makes purchasing and production decisions more difficult. Ex: If I was constantly changing how much of your grade each assignment is worth... •In societies with great instability, production can grind to a halt
1) Producer price indexes
PPI's keep track of average prices received by producers. Each of the three PPI's cover: 1) Crude/Raw materials. 2) Intermediate goods. 3) Finished goods. •The PPIs are closely watched price indexes because they tend to lead changes in the Consumer Price Index (CPI).
1) Price effects
People who BUY products: •Better off for constant prices •Worse off for products with prices increasing quickly People who SELL products: •Better off for prices increasing quickly •Worse off for prices staying constant
3) Speculation
The purchase and sale of goods for the sole purpose of taking advantage of changes in prices in short windows of time. Ex: Day trading stocks Ex: Buying up all the Clorox wipes in a pandemic •Speculation doesn't produce anything meaningful for society •Not the same thing as supply chain and distribution, which does add value •If speculative profits become too easy, few people will engage in production. •Instead everyone will be buying and selling existing goods. •If enough speculation goes on, people may withhold resources from the production process, hoping to sell them later at higher prices, which may fuel hyperinflation.
Money illusion
The use of nominal dollars rather than real dollars to gauge changes in one's income or wealth. •E.g., "I used to get paid only a $1 an hour!"
The Right amount of Inflation
There are times when a little inflation might be a good thing. •Expectations of rising prices can encourage more spending. •The challenge for the economy tomorrow is to find the optimal rate of inflation—the one that's just high enough to encourage more spending, but not so high as to raise the specter of an inflationary flashpoint.
3) Wealth Effects
Wealth is your stored value. •People who own assets that are DECLINING in REAL value end up WORSE off. Ex: a bond that pays $1000/ year falls in value, with inflation •People who own assets that are INCREASING in REAL value end up BETTER off. •Homes tend to raise in prices faster than inflation •The S&P 500 (stock market) tends to increase much faster than inflation •That's why stocks are generally a good retirement investment
