Econ 1041 Chapter 7: Inflation

b. Workers and Employers

Ex post %Δreal wage = %Δnominal wage - π ^change in purchasing power --->Wages are set today, but we do not know what π will be. All we know is πe Ex ante %Δreal wage = %Δnominal wage - πe

_______ than expected inflation helps employers and harms workers

Higher

___________ than expected inflation helps borrowers and harms lenders

Higher

________ is a continuous increase in the overall level of prices

Inflation

_______ than expected inflation helps workers and harms employers

Lower

_____________ than expected inflation helps lenders and harms borrowers

Lower

All else equal, the fast ___ grows, the higher the _________ _______

M, inflation rate

A Theory of Inflation

MV = PY -A useful rule of thumb: %ΔM + %ΔV = %ΔP + %ΔY Where %ΔP is the inflation rate -Y depends on "real" things like technology, physical and human capital, and labor. SO: changes in the money supply (M) do not affect Y -For the purposes of this class, assume that M and V are unrelated

Deflation typically causes an increase in ____________

bankruptcies

The _______ inflation rate is intended to look at the underlying inflation rate

core

How to create a price index for a particular bundle of goods (called a "market basket")

--->Define a market basket --->Calculate the cost of the market basket each time --->Find the ratio of each period's cost to the base year's cost --->To calculate the inflation rate from one period to the next, find the growth rate of the CPI New value - old value / old value

The basic idea of inflation

--->If the money supply raises and the amount of stuff for sale stays the same, then prices will rise --->"Too much money chasing too few goods." -Persistent inflation occurs when the money supply rises faster than production

New goods are not included in the market basket until their use is widespread

--->Often new goods fall in price over time --->The CPI misses the price decline because the goods are not included for a while ----->*CPI overstates inflation*

Deflation has some of the same problems as inflation

--->Random income redistribution --->Blurred Price signals -In addition, deflation *increases* the real value of debt

After a period of time what happens to these currencies?

-Eventually, the money becomes worthless so the monetary system collapses

5. Inflation makes it more difficult to plan long-term

-How much should you save to retire? -How much should you save to buy a house? -How much should you save to send kid to college?

If inflation is this simple, why do some countries still have problems with it? (2)

-In most cases, these countries: 1. Have governments that spend more than they can collect in taxes or borrow AND 2. Have a central bank that is NOT politically independent --->So: To cover its spending, the government tells the central bank to print money

Suppose a farmer has $1000 in debt. The price of corn is $5/bu.

-In real terms, the farmer has to produce and sell 200 bu of corn to pay the debt -Suppose the price of corn falls to $4/bu --->To repay the loan, the farmer now has to produce and sell 250 bu of corn

How is inflation measured?

-Inflation is measured as the rate of growth of a price index

4. Blurred Price Signals

-Inflation makes it more difficult to keep track of prices -In micro you will learn that the efficiency of markets is reduced when price signals are blurred

The quantity equation

-Recall: Real GDP = Nominal GDP / GDP Deflator Nominal GDP = GDP Deflator x Real GDP Nominal GDP = P x Y Also: Money supply = M V = Nominal GDP / Money Supply V = (P x Y) / M OR MV = PY ---> Quantity equation Total Spending = Nominal GDP

a. Borrowers and Lenders

-Recall: ex post (afterwards) r = i - π -When a loan is made, π is not year known. The best we have is an expected inflation rate (πe) ex ante (beforehand) r = i - πe

It is hard to measure quality changes

-Suppose a computer cost $1,000. Then a new, improved version comes out that costs $1,100 --->Is the higher price due to the improvements or is it just a price increase?

The CPI (Consumer Price Index)

-The CPI tracks the cost of buying a particular set of goods and services -The CPI tracks thousands of goods and services. --For our example, we will only have three goods in our market basket

What is an example of a previous price index we have used?

-The GDP deflator

3. Distortions caused by U.S. tax laws

-The U.S. tax code taxes nominal, not real income -e.g. Suppose you put $10,000 into a bank account that pays 5% interest (i = 5%) --->In one year, you will have $500 in interest -Suppose that over the course of the year, the inflation rate is 6% ex post r = i - π ex post r = 5% - 6% = -1% -You will still have to pay tax on the $500 --->The tax further erodes the incentive to save. The inflation makes it worse

Why does this matter?

-The inflation rate calculated with the CPI is used to calculate: --->The cost of living adjustment in social security --->Wage increases in labor negotiations --->To index the tax rates

How to calculate an inflation rate:

-The rate of growth of any variable of x is: Δx/x --->In our case, the inflation rate is: = Change in the price index/the starting price index = New index - old index / old index

When is there not any inflation?

-There is not any inflation unless, *on average*, prices have increased

Substitution Bias

-This problem arises because people will substitute cheaper goods for more expensive goods when relative prices change. But the CPI's market basket doesn't change -e.g. Suppose the CPI's market basket includes 5 apples and 5 oranges. Then suppose orange prices rise relative to apple prices. Then a typical family buys 8 apples and 2 oranges. The CPI still calculates the cost of 5 apples and 5 oranges --->*CPI overstates inflation*

1. Random redistributions of income

-Two examples: a. Borrowers and Lenders b. Workers and Employers

Hyper Inflation

-a very high rate of inflation (50%+ per month)

Do NOT confuse deflation with *disinflation*

-disinflation means the inflation rate is lower but still positive π = 5% to π = 3% ---> rising slower vs. π = -2% --->deflation

Producer Price Index (PPI)

-is calculated like the CPI *except* that its market basket contains raw materials, intermediate goods, and wage rates ( i.e. things that producers buy)

Deflation

-means the inflation rate is *negative* (so on average, prices are falling)

2. People on fixed incomes are always hurt

-retired people depend on pensions and annuities for income. Some pensions and all annuities pay a fixed amount per month --->higher prices make their income less and less valuable

Velocity of Money (V)

-tells us how frequently an average dollar is spent each year V = nominal GDP / money supply -e.g. Nominal GDP = $1000 Money supply = $ 250 ---> V = 4

GDP Deflator

-the GDP deflator measures the prices of ALL final goods and services produced domestically --->In contrast, the CPI measures the prices of *some* consumer goods including those produced in other countries and imported

The "core" inflation rate

-the inflation rate calculated using the CPI with the market basket *excluding* energy and food

The Quantity theory of money

-there is an inverse relationship between the quantity of money and the value of money (all else equal) Value of money = 1 / P --->Price level

_______ and ______ prices fluctuates much more than the prices of other goods in the CPI's market basket

energy and food

Suppose workers get an 8% increase in nominal wages and πe = 5%

ex ante %Δreal wage = 8% - 5% = 3% -Suppose inflation turns out to be 8% ex post %Δreal wage = 8% - 8% = 0% -Suppose inflation turns out to be 2% ex post %Δreal wage = 8% - 2% = 6%

Suppose i = 10% and πe = 6%

ex ante r = 10% - 6% = 4% -Over the course of the loan, lets suppose the *actual* inflation rate (π) is 3% ex post r = 10% - 3% = 7% -Suppose instead, the *actual* inflation rate (π) was 8% ex post r = 10% - 8% = 2%

Two worst cases of hyper inflation:

1. Hungary Aug 1945 to July 1946 --->In the month of July 1946 inflation rate was 4.19 x 10 ^16 2. Zimbabwe March 2007 to Nov 2008 --->In the month of Nov 2008 inflation rate was 2.96 x 10 ^ 10

Other Price Indexes (2)

1. Producer Price Index (PPI) 2. GDP Deflator

What are the costs of inflation? (5)

1. Random redistributions of income 2. People on fixed incomes are always hurt 3. Distortions caused by U.S. tax laws 4. Blurred price signals 5. Inflation makes it more difficult to plan long-term

Problems with the CPI

1. Substitution Bias 2. It's hard to measure quality changes 3. New goods are not included in the market basket until their use is widespread

What causes inflation? (2)

1. The basic idea 2. The Quantity theory of money

What if M grows by 10%?

10 + 0 = *7* + 3

What if M grows by 15%?

15 + 0 = *12* + 3

The ___________ _______ ________ is the index used to calculate the inflation rate reported in the popular press

Consumer Price Index

CPI =

(Cost of the market basket for the year in question) / (Cost of the market basket in the base year) x 100

Using the previous equation, suppose Y grows by 3%. If M grows by 5% and V is constant, then:

5 + 0 = *2* + 3

The ______ is calculated just like in our example, except the ______'s market basket has thousands of goods and services

CPI

-To create a price index, you must pick a base year. Lets choose year 2:

Year 1 = ($7/$12) x 100 = 58.33 Year 2 = ($12/$12) x 100 = 100 Year 3 = ($13/$12) x 100 = 108.33 Year 4 = ($15/$12) x 100 = 125 --->Prices in year 4 are 125% of prices in the base year

In our market basket, there will be: -->3 loaves of bread -->2 gallons of milk -->1 bag of oranges

Year 1 lf of Bread 1 gal Milk 1 bag oranges 1 $0.50 $1.00 $3.50 2 $1.00 $2.00 $5.00 3 $1.50 $2.00 $4.50 4 $2.00 $1.50 $6.00

In our example the inflation rates are:

Year 1 to Year 2 = (100 - 58.33) / 58.33 = .7144 = 71.44% Year 2 to Year 3 = (108.33 - 100) / 100 = .0833 = 8.33% Year 3 to Year 4 = (125 - 108.33) / 108.33 = .1539 = 15.39%

Calculate the cost of the market basket for each year

Year 1: 3 x $0.50 + 2 x $1.00 + 1 x $3.50 = $7.00 Year 2: 3 x $1.00 + 2 x $2.00 + 1 x $5.00 = $12.00 Year 3: 3 x $1.50 + 2 x $2.00 + 1 x $4.50 = $13.00 Year 4: 3 x $2.00 + 2 x $1.50 + 1 x $6.00 = $15.00

Debt is always set in __________ terms

nominal

At all times, some _________ are rising and some __________ are falling

prices