Macroeconomics (Chapter 5)

NOTE: OF SHOE LEATHER COSTS II the real costs of inflation arise from actions taken to "economize" on cash holdings: more frequent and smaller withdrawals cost consumers and businesses time with OC - a real cost of inflation. Banks process more transactions, increasing costs - another real cost of inflation.

NOTE: OF SHOE LEATHER COSTS II

deflation

a decrease in the price level over a specified period of time. Or, a negative inflation rate.

income taxes

which type of taxes are indexed?

deflating

A process of dividing a nominal quantity by a price index (such as the CPI) to express the quantity in real terms. Converting current dollar values (nominal quantity) into real terms (real quantity)

GENERAL NOTE: INTERFERENCE WITH LONG RUN PLANNING some decisions have a long time horizon (erratic inflation makes planning risky). Retirement planning requires an estimated cost for your desired life-style. (save too little and you live less well in the future. Save too much and you live less well now). Given the costs of inflation, most economists agree that low and stable inflation promotes a healthy economy.

GENERAL NOTE: INTERFERENCE WITH LONG RUN PLANNING

GENERAL NOTE: UNEXPECTED REDISTRIBUTION OF WEALTH unexpected inflation redistributes wealth. Unexpectedly high inflation hurts workers (with non-indexed contracts) and benefits employers. (Fixed salaries lose purchasing power). High inflation benefits borrowers at the expense of lenders. (borrowers repay with dollars worth less than anticipated). Although redistribution by itself does not destroy wealth, unexpected inflation confuses incentives.

GENERAL NOTE: UNEXPECTED REDISTRIBUTION OF WEALTH

business cycles (movements in inflation are closely related to the overall movements of the economy - up or down).

In the short run, what causes the aggregate price level to rise (inflation) or fall (deflation)?

NOTE: SHOE LEATHER COSTS holding cash is convenient because it lubricates economic transactions. If there is no inflation, cash holds its value over time. Inflation reduces purchasing power and raises the cost of holding cash to consumers and businesses.

NOTE: SHOE LEATHER COSTS

NOTE: Taxes the US tax code is complex containing hundreds of provisions and tax codes that are not indexed. These taxes can seriously distort the incentives for people to work, save, and invest. (lower savings and investment means lower economic growth - a cost of inflation). (Distorted economic incentives lead to lower economic efficiency - a real cost of inflation).

NOTE: Taxes

indexing

The practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index like the CPI - done to prevent erosion of the purchasing power of the nominal quantity. (some contracts are _______ by law - social security payments, labor contracts, etc.)

inflation

an increase in the price level over a specified period of time.

(CPI1 - CPI2) / (CPI1) * 100%

how do you calculate the inflation rate, say from period 1 to period 2?

money supply (the overall level of prices is determined by changes in the money supply. Too much money chasing too few goods).

in the long run, what causes the aggregate price level to rise (inflation) or fall (deflation)?

real quantity

measured in physical terms, in terms of goods and services.

nominal quantity

measured in terms of its current dollar value

shoe leather cost

refers to the cost of time and effort that people spend trying to counter-act the effects of inflation, such as holding less cash and having to make additional trips to the bank. The term comes from the fact that more walking is required to go to the bank and get cash and spend it, thus wearing put shoes more quickly.

nominal interest rate

the annual percentage increase in the nominal value of a financial asset. (close positive relationship between inflation rates and these).

real interest rate

the annual percentage increase in the purchasing power of a financial asset.

menu cost

the cost to a firm resulting from changing its prices. It refers to the costs of changing nominal prices in general. It may include updating computer systems, re-tagging items, and hiring consultants. (during times of high inflation these can be significant).

aggregate price level

the overall measure of prices in a given country or region at a particular point in time. Measured by the CPI.

fisher-effect (Irving Fisher)

the tendency for nominal interest rates to be high when inflation is high and low when inflation is low. This happens because borrowers and lenders keep their eye toward there real interest rates.

producer price index

this is a wholesale price index and measures the cost of a typical basket of goods and services purchased by producers - raw materials such as steel, electricity, coal, etc. Economists often regard trends in the _______________ as an early signal predicting changes in the price of manufactured goods.

hyperinflation

this is an extremely high inflation rate. This means about 500% or 1000%.

inflation rate

this is the annual percentage change in the average price level. It varies from country to country.

consumer price index (CPI)

this measures the cost of a typical consumer's consumption bundle - standard basket of goods and services in that period relative to the cost of the same basket of goods and services in some predetermined year, called the base year.

bracket creep

this occurs when a household is moved into a higher tax bracket due to increases in nominal but not real income. Happens mostly when taxes are not indexed to inflation.

the quantity theory of money (definition)

this theory states that the money supply has a direct, proportional relationship with the price level. For example, if the currency in circulation increased, there would be a proportional increase in the price of goods.

noise in the prices system, distortions of the tax system, shoe leather costs, menu costs, unexpected redistribution of wealth, interference with long run planning.

what are the 6 true costs of inflation?

Producer Price Index, GDP deflator.

what are the two other price measures before the CPI that are widely sued to calculate price changes in the economy?

underestimating living standard improvements, increase in government spending (because of indexed social security contracts).

what are two problems that come with overstating the inflation rate?

quality adjustment bias (CPI ignores improvements in the quality of products and introduction of new products. no internet and cell phones in 1985.) substitution bias (CPI ignores the possibility that the consumer may substitute a cheaper product for a more expensive one. EX: renting rather than buying a house. Also, when the price of a good increases, consumers buy less and substitute other goods).

what are two reasons that explain why the CPI may overstate the inflation rate?

the cost of production, the value buyers place on buying an additional unit.

what do prices in general transmit information about?

GDP Deflator = nominal GDP in 1999 / real GDP in 1999.

what is the formula for GDP Deflator for the year 1999?

(M)(V) = (P)(Y). (M is the supply of money, V is the velocity of money, P is the price level and Y is the output, or GDP).

what is the formula for the quantity theory of money?