Econ Chapter 7

Macro consequences

Although microeconomic redistributions of income and wealth are the primary consequences of inflation, it also has macroeconomic effects as well - Uncertainty, speculation, bracket creep

Causes of inflation

Demand-pull inflation Cost-push inflation Profit push

Income effects

Even if all prices rose at the same rate, inflation would still redistribute income. The redistributive effects of inflation originate not only in expenditure patterns but also income patterns. Some people have fixed incomes that don't go up with inflation. - Fixed income groups include retired people who depend primarily on private pensions and workers with multi-year contracts that fix wages at pre inflation levels - Lenders (like banks) that have lent funds at fixed interest rates also suffer real income losses when price levels rise. They continue to receive interest payments fixed in nominal dollars that have increasingly less real value - However, not all market participants suffer real income decline when prices rise. Some people's nominal income rises faster than average prices, thereby boosting their real incomes. If students pay higher tuition, the university will take in more income. When nominal incomes colleges receive rise faster than average prices, they actually benefit from inflation. Their real incomes rise and they can buy more stuff. - When the price of this text book goes up, my nominal income goes up. If the text price rises faster than other prices, my real income increases as well.

Historical record

From 1800 to 1945, prices both rose and fell, leaving the average price level unchanged. Since then, prices have risen nearly every year but at widely different rates

Social tensions

In a sense, inflation acts just like a tax, taking income or wealth from one group and giving it to another. However we have no idea if this particular tax will be taken from the rich and given to the poor. In reality, inflation often redistributes income in the opposite direction, increasing social tensions.

Real income

Income in constant dollars; nominal income adjusted for inflation

Hyperinflation

Inflation rate in excess of 200%, lasting at least 1 year

Speculation

Inflation threatens not only to reduce the level of economic activity but to change its very nature - If you expect prices to rise, it makes sense to buy goods and resources now for resale later. These are the kinds of thoughts that motivate people to buy houses, precious metals, and other assets - But such speculation, if carried too far, can detract from the production process. If speculative profits become too easy, few people will engage in production. Instead, everyone will be buying or selling existing goods. People may even be encouraged to withhold resources from the production process, hoping to sell them later at higher prices - Such speculation may fuel hyperinflation, as spending accelerates and production declines. This happened in Germany in the 1920s, China 1948-1949, in Russia in the early 1990s and in Zimbabwe 2007-2009

GDP deflator

The GDP deflator is a price index used to adjust nominal GDP statistics for changing price levels. Recall that nominal GDP refers to the current-dollar value of output, whereas real GDP denotes the inflation-adjusted value of output - These two measure of output are connected by the GDP deflator: Real GDP = nominal GDP/GDP deflator x 100

Producer price index (PPI)

The PPIs keep track of average prices received by producers - One index includes crude materials, the other covers intermediate goods, and the last covers finished goods - The 3 PPIs don't include all producer rices, but primarily those in mining, agriculture, and manufacturing - Over long periods of time, PPIs and CPI generally reflect the same level of inflation. In the sort run, however, the PPIs usually increase before the CPI because it takes time for producer's price increases to be reflected in the prices consumers pay For this reason, the PPIs are watched closely as a clue to potential changes in consumer prices

Price stability

The absence of significant changes in the average price level; officially defined as a rate of inflation of less than 3 percent

Nominal income

The amount of money income received in a given time period, measured in current dollars

Inflation rate

The annual percentage of increase in the average price level

Redistributive Effects of Inflation

The distinction between relative and average prices helps us determine who's hurt by inflation--and who's helped - Although inflation makes some people worse off, it makes other people better off - The micro consequences of inflation are reflected in redistributions of income and wealth, not general declines in measures of our economic welfare - These distributions occur because people buy different combinations of goods and services, own different assets, and sell different goods and services (including labor). The impact of inflation on individuals therefore depends on how prices change for the goods and services each person actually buys or sells

Measuring inflation

The measurement of inflation serves two purposes: to gauge the average rate of inflation and to identify its principle victims - Most common measure of inflation is the Consumer Price Index (CPI)

Bracket creep

The movement of taxpayers into higher tax brackets (rates) as nominal incomes grow - Federal tax rates are progressive (tax rates are higher for larger incomes) - Inflation increases everyone's income so they are pushed into higher tax brackets and confront higher tax rates

Real interest rates

The nominal interest rate minus the anticipated inflation rate Real interest rate = nominal interest rate - anticipated rate of inflation

Item weight

The percentage of total expenditure spent on a specific product; used to compute inflation indexes - All price changes do not have the same impact on inflation rate. The effect of a specific price change on the inflation rate depends on the product's relative importance in consumer budgets - College tuition may be very large in your personal budget, but only 1.5% of all consumer expenditure is spent on college tuition. Thus, the item weight for college tuition in the average consumer buffet is only 0.0152 - Housing costs absorb a far larger share of the typical consumer budget. The item weight for housing is 0.341. - Thus, rent increases have a much larger impact on the CPI than do tuition hikes

Relative price

The price of one good in comparison with the price of other goods - Because inflation and deflation are measured in terms of average price levels, it's possible for individual prices to rise and fall continuously without changing the average price level - An increase in the relative price of apples simply means that apples have become more expensive in comparison to other fruits (or any other goods and services) Changes in relative prices may occur in a period of stable average prices, or in periods of inflation or deflation - In fact, in an economy as vast as ours, relative prices are always changing and are an essential part of the market mechanism - When the market price of Web-Design services rises relative to other goods and services. This relative price alerts Web-design producers to increase their output - A general inflation doesn't perform this same market function. If all prices rise at the same rate, price increases for specific goods are of little value as market signals

Uncertainty

When the average price level is changing significantly in either direction, economic decisions become more difficult - Inflation makes long term decisions even more difficult. Should you commit to 4 years of college, if you aren't certain that you or your parents will be able to afford the full costs - Price uncertainties affect production decisions as well. Imagine a firm that wants to build a new factory. - Typically the construction of the factory takes 2 years or more. If construction costs change rapidly, the firm may find that its unable to complete the factory, depriving the economy of new investment and expanded production possibilities

Deflation dangers

When prices are falling, people on fixed incomes and long-term contracts gain more real income. Lenders win and creditors lose. People who hold cash or bonds win. Homeowners and stamp collectors lose. A deflation simply reverses the kinds of redistribution caused by inflation - A falling price level also has similar macro consequences. Businesses are more reluctant to borrow money or to invest

Deflation

A decrease in the average price level of goods and services - This is a rare phenomenon - the U.S. has not experienced any general deflation since 1940

Consumer price index

A measure of changes in the average price of consumer goods and services - Analogous to the fruit price index example. The CPI doesn't refer to the price of any particular good but to the average price of all consumer goods - By observing how much this "average price" increases, we can calculate the inflation rate

Virtue of Zero

A monetary policy where a bank lowers interest rates to 0 for a short while in order to stimualte the economy

ARM

A mortgage (home loan) that adjusts the nominal interest rate to changing rates of inflation - If inflation rate stays higher than the nominal interest rate during this period, he lender will end up with less real wealth than was initially lent - To protect against such losses, the banking industry offers home loans with adjustable interest rates - A mortgage paying 5% interest rate in a stable (3% inflation) price environment may later require to pay 9% if the inflation jumps to 7% This would keep the real interest rate at 2%

Inflation

An increase in the average level of prices of goods and services (not a change in any specific price). This does not mean that all prices are rising. In fact, many prices fall, even during periods of general inflation - We first determine the average price of all output (the average price level) and then look for changes in that average. A rise in the price level is referred to as inflation - This is like averaging the prices of apples, oranges, bananas, etc. to find the avg price of fruit. By repeating these calculations every day, you could then determine whether fruit prices, on average, were changing. You might even notice that apple prices rose while orange prices fell, leaving the average price of fruit unchanged

COLA

Automatic adjustments of nominal income to the rate of inflation - Market participants can protect themselves from inflation by indexing their nominal incomes, as is done with Social Security benefits. In any year that the rate of inflation exceeds 3%, Social Security benefits go up automatically by the same percentage as the inflation rate. This cost-of-living adjustment (COLA)ensures that nomina benefits keep pace with the rising prices COLAs have also become more common in loan agreements. As we observed earlier, debtors win and creditors lose when the price level rises . Suppose a loan requires interest payments equal to 5% of the amount borrowed. If the rate of inflation jumps to 7%, prices will be rising faster than interest is accumulating. - Thus the real interest rate (inflation-adjusted rate of interest) will actually be negative. Th interest payments made in future years will buy fewer goods that can be bought today - The distinction between real and nominal interest rates is important for long term loan like home mortgages - leads to ARMs

Protective mechanisms

COLAs and ARMs help protect real incomes from inflation. Universal indexing, however, wouldn't eliminate inflationary redistribution of income and wealth.

cost-push inflation

Caused by substantial increase in prices of raw materials where no suitable alternative is available - When Hurricane Katrina destroyed oil-producing facilities in the Gulf, oil prices increased abruptly, raising transportation and production costs in a broad array of industries. To cover these higher costs, producers raised output prices

Core inflation rate

Changes in the CPI, excluding food and energy prices - The core inflation rate excludes changes in food and energy prices, which have a lot of month to month variation

Two important things to note

Not all prices rise at the same rate during an inflation period - In our example, tuition increased substantially, while other prices remained steady. Hence the average price increase wasn't representative of any good or service. Typically, some prices rise rapidly, others only modestly, and some actually fall Not everyone suffers equally from inflation - Those who consume the goods and services that are rising faster in price bear a greater burden of inflation; their real incomes fall further

Quality changes

Not included in CPI, but probably should be taken into account. Part of the reason goods are more expensive is because they have become better

The redistributive methods of inflation

Price effects - People who buy products that are increasing in price the fasted end up worse off Income effects - People whose nominal income rise more slowly than the rate of inflation end up worse off Wealth effects - People who own assets that are declining in real value end up worse off

Price effects

Price effects are the most visible cost of inflation - 10 years ago tuition was 1,000 at a public university. Today its 6,500 for public and 25,000 for private (8-fold increase) - The effect of tuition increases on your economic welfare is reflected in the distinction between nominal income and real income - Nominal income is the amount of money you receive in a particular time period; it's measured in current dollars. Real income is the purchasing power of that money, as measured by the quantity of goods and services your dollars will buy - If the number of dollars you receive every year is the same, your nominal income doesn't change--but your real income will rise or fall with price changes

How is CPI calculated

The process begins by identifying a market basket of goods and services the typical consumer buys - The Bureau of Labor Statistics surveys a large sample of families every year to determine what goods and services consumers actually buy - Within these broad categories of expenditure, the Bureau itemizes specific goods and services Once we know what a typical consumer buys, it's relatively easy to calculate the average price of a market basket. The Bureau of Labor statistics goes shopping and records all the prices and can then calculate CPI - In practice CPI is usually expressed in terms of what the market basket cost in a specific base year. The price level in the base year is arbritrality designed as 100. In the case of CPI, the average price level for the period 1982-84 is usually used as the base for computing price changes. Thus, the price index for that base year s set at 100 - In January 2009, the CPI registered 212. In other words, it cost $212 in 2009 to buy the same market baskets that cost only $100 in the base year. Prices increased by an average of 112% over that period

Wealth effect

The tendency for people to increase their consumption spending when the value of their financial and real assets rises and to decrease their consumption spending when the value of those assets falls.

Demand-pull inflation

The upward pressure on prices that follows a shortage in supply Suppose the economy was already producing at capacity but consumers were able and willing to buy even more goods - As consumers sought to acquire more goods, producers would raise prices. The end result would be a demand-driven rise in average prices, or demand-pull inflation

Money illusion

The use of nominal dollars rather than real dollars to gauge changes in one's income or wealth - Even those whose nominal incomes keep up with inflation often feel oppressed by rising prices - People feel that they deserve any increases in wages they receive - When they later discover that their higher nominal wages don't buy additional goods, they feel cheated even though they haven't suffered any actual loss of real income

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 time period, adjusted for changing prices - Changes in real GDP are good measures

Base year

The year used for comparative analysis; the basis of indexing, for example, of price changes

Why did Congress choose 3% inflation rather than zero inflation as the benchmark for price stability?

Unemployment - To keep prices from rising, the government might have to restrain spending in the economy - Such restraints could lead to cutbacks in production and increase joblessness - A little bit inflation might be the "price" the government has to pay to keep unemployment rates from rising Quality changes - The CPI isn't a perfect measure of inflation. In essence, the CPI simply monitors the price of specific goods over time - However, over time, the goods themselves change and have better quality - The U.S. Bureau of Labor Statistics doe adjust CPI for quality, but this is subjective and quality improvements are often undervalued

Wealth Effects

Winners and losers of the inflation game are also selected on the basis of the assets they hold - Suppose you deposit $100 in a savings account on January 1st, where it earns 5% interest. At the end of the year you will have $105 (more nominal wealth). But what if all prices have doubled in the meantime. In that case, your $105 will buy you no more at the end of the year than $52.50 would have bought you at the beginning of the year - Inflation in this case reduces the real value of your savings, and you end up worse off then individuals who spent their income earlier in the year

profit push inflation

inflation that occurs when businesses use market power to restrict output in order to push up prices and profits