Macroeconomics

1. Macroeconomics Unit 7 Inflation Top Five Concepts

2. Introduction Is inflation really an economic problem today? How does inflation affect your life, your earnings, and your future? What about deflation? Why should we be worried about prices falling? Isn’t this better than prices increasing? Both inflation and deflation are discussed in the unit along with the causes and effects of both. Methods used to measure inflation are also discussed.

3. Concept 1: Inflation/Deflation In the past, one of our greatest economic concerns was inflation. Inflation is an increase in the average level of prices of goods and services. It is based on an increase in average prices, not on a change in any specific price. A survey is taken of all output and price changes are averaged by the U.S. government. Inflation is an economic concern because it reduces the value of money and increases the cost of purchasing goods and services.

4. Concept 1: Inflation/Deflation Deflation is a decrease in the average level of prices of goods and services. Deflation is rare in the U.S. and other countries. It last happened in the U.S. in 1940, and in Japan in 1995 and 2000. Deflation is an economic concern because even though prices may be declining, the value or price of investments or real estate may also decline. Imagine buying a home for $150,000 and three years later discovering that it is only worth $125,000. That is the danger of deflation.

5. Relative Price Inflation and deflation are measured using average prices. However it is likely that prices of some items rise while others fall or remain the same. Sometimes we compare prices by using relative prices. The relative price is the price of one good in comparison with the price of other goods. Since inflation and deflation are measured using averages, prices could be increasing or decreasing on some items, and yet the inflation rate may be unchanged. Relative prices can change without affecting the overall rate of inflation or deflation.

6. Concept 2: Effects of Inflation Inflation can make some people better or worse off in terms of income, expenses, or wealth. How can some people be better off during times of inflation? The effect of inflation on an individual will depend upon the combination of goods and services the individual purchases. Individual wealth and income can increase or decrease due to inflation. It depends upon whether your income or wealth follows the rate of inflation.

7. Concept 2: Price Effects of Inflation The first way that inflation can affect you is through rising prices. Price effects of inflation relate to the effect of rising prices for goods and services on individuals. The extent to which price effects will affect your ability to purchase goods and services depends upon your real vs. nominal income. Nominal income is the amount of income received in a given time period, measured in current dollars.

8. Concept 2: Price Effects of Inflation Real income is income in constant dollars; nominal income that is adjusted for inflation using a price index. If your nominal income does not change during the year, yet average prices have risen 5%, your real income has declined around 5%. For example if your salary was $30,000/year, and average prices increased 5% during the year, you have lost $1500 in purchasing power ($30,000 X .05). Your income does not purchase as many goods and services due to inflation by the end of the year.

9. Concept 2: Price Effects of Inflation Not all prices of goods and services rise at the same rate. Therefore you could experience a higher loss of real income if the items you purchase rise at a faster rate. Individuals who purchase items that have increases in price lower than the average will not suffer as much, if at all. How can individuals retain their ability to purchase the same amount of goods and services during times of inflation? It depends upon whether their income or wealth increases too.

10. Concept 2: Income Effects of Inflation The Income effects of inflation refers to the rate at which individual income rises during inflation. Ideally during times of inflation, your income rises at a rate that at least matches the inflation rate. Individuals on fixed incomes (Social Security, pensions, and Unemployment for example) are affected more by inflation than those whose income keeps pace. Generally when prices rise so do incomes, on average. Many people receive cost of living adjustments (COLA) to their incomes which helps protect income against inflation.

11. Concept 2: Wealth Effects of Inflation Wealth effects of inflation refer to the rate at which your assets increase in value compared to inflation. If your assets increase in value at a rate higher than inflation, you are better off. Examples of assets include savings accounts, homes, stocks, bonds, precious metals, jewelry, etc.

12. Concept 2: Redistributive Effects of Inflation Let’s examine how inflation redistributes income and wealth. Price effects: People who buy goods and services that are increasing in price at a slower rate end up with a larger share of real income. Income effects: People whose nominal incomes rise faster than the rate of inflation end up with a larger share of total income. Wealth effects: People who own assets that are increasing in real value at a greater rate than inflation increase their real wealth.

13. Money Illusion Often people believe that they have been affected by inflation even though their income has risen as fast as inflation. The money illusion is the use of nominal dollars rather than real dollars to gauge changes in one’s income or wealth. People affected by the money illusion remember the cost of items say 30 or 40 years ago but not their incomes or wealth in the past. Remember when gasoline was $0.30 a gallon or bread was $0.50 a loaf?

14. Concept 3: Macro Effects of Inflation Individual and business decisions are often affected by inflation. The first consequence of inflation is called uncertainty. Under economic conditions of uncertainty, people and businesses tend to make short-term decisions only. People will postpone major purchases. Companies delay capital expansion projects, investments in technology. The result of the reduction in spending by consumers and business is an increase in unemployment as demand falls.

15. Concept 3: Macro Effects of Inflation An extreme level of inflation is called hyperinflation. During hyperinflation the inflation rate is above 200 percent for at least a year or more. Hyperinflation recently occurred in Russia during the early 1990s. The currency essentially becomes worthless and spending declines. The second consequence of inflation is speculation. Under speculation people and companies will alter buying and spending activity if higher rates of inflation are anticipated.

16. Concept 3: Macro Effects of Inflation Under speculation people will buy necessary goods now to avoid price increases. Businesses will increase production now and increase inventories to be sold later at a higher profit. Another result of inflation is bracket creep. This is the movement of taxpayers into higher tax brackets (rates) as nominal incomes grow. If incomes rise under inflation, more taxpayers enter higher federal tax brackets and pay more taxes resulting in an increase in federal tax collections.

17. Concept 4: Measuring Inflation The Consumer Price Index (CPI) is a common index used to measure the change in the average price of consumer goods and services. The CPI is commonly used to measure changes in the inflation rate, which is the annual percentage rate of increase in the average price level. The CPI consists of a base period, set to equal 100. As prices increase the number increases (for example, to 102.5, to reflect a 2.5% increase).

18. Concept 4: Measuring Inflation Consumer surveys are conducted by the government on the typical goods consumers purchase. Each category of items has a weight which is used to produce the index. Housing, transportation, and food costs have more importance than other costs like entertainment, health care, clothing. The item weight is multiplied by the percentage change in price, and all items are added together to produce the CPI.

19. Transportation 19.1% Housing 32.7% Food 13.2% Insurance and pensions 9.6% Clothing 4.3% Miscellaneous 10.3% Entertainment 5.1% Health care 5.8% Consumer Spending by CategoryUsed to Compute the CPISource: Bureau of Labor Statistics, 2002 data Notice that housing, transportation, and food costs have the highest weights when calculating the CPI.

20. Concept 4: Measuring Inflation The producer price index (PPI) is another index used to track inflation. This index actually contains three different price indexes that cover producer (manufacturer) costs for raw materials, intermediate goods, and finished goods. The producer price index will increase before the CPI. Note that the PPI does not cover all producers – mostly those in manufacturing, mining, and agriculture. The service sector is not included in the PPI.

21. Concept 4: Measuring Inflation The GDP Deflator is used by the government as a price index for all output (GDP). It includes all output including consumer goods, investment goods, and government services. It is used to adjust nominal GDP values to reflect price changes. The components of the GDP deflator tend to have more price stability and less volatility than other indexes.

22. Concept 4: Measuring Inflation The calculation to use the GDP Deflator is similar to the one used for calculating Real GDP. Real GDP = nominal GDP / GDP Deflator Note: GDP Deflator values may be stated as a percent (24%) or an index (134.7). If an index is used, you must either divide the nominal GDP by the index and multiply the result by 100, or if a percent is used, divide nominal GDP by 1 + the decimal equivalent of the percentage.

23. Concept 4: Measuring Inflation If nominal GDP = $10 trillion in 2000, and $5.7 trillion in 1990, what is the real GDP in 2000 based upon 1990 prices? If the value for the GDP Deflator is 24%, then Real GDP = $10 trillion / 1.24 = $8.06 trillion (1990 prices) Now you can compare the 1990 nominal GDP of $5.7 trillion with the real GDP in 2000 of $8.06 trillion to measure true growth.

24. Concept 4: Measuring Inflation Another GDP deflator problem: If nominal GDP is $6,225.6 billion and the GDP deflator is 134.7, then real GDP is: ($6,225.6 billion/134.7) X 100 = $4,621.8 billion

25. Inflation Goals The government’s goal with inflation is to keep it below 3% per year. This leads to price stability. Similar to an unemployment rate of 4 – 6 percent for full employment, an inflation rate of 3% or less is viewed as maintaining stable prices. CPI and other measurements do not accurately account for technological improvements in the quality and features of products (VCRs, PCs). By allowing some inflation to exist, this reduces the potential error in the CPI which does not account for technological improvements.

26. Historical Inflation Rates Historically, inflation has varied considerably over time. The most recent incident of high inflation was in the late 1970s and 1980 with a peak rate of 13.5% in 1980. In any given year inflation rates for other countries can vary significantly from the U.S.

27. Concept 5: Causes of Inflation Demand-Pull inflation is caused by excessive consumer demand for goods and services. This occurs when consumers have plenty of savings, higher incomes, easy credit and low interest rates. The high demand for goods and services produces an increase in prices as inventories are depleted and production is increased.

28. Concept 5: Causes of Inflation Cost-Push inflation is not caused by excessive consumer demand but by rising factor costs (land, labor, capital) for companies. The increase in factor costs is passed to consumers by increasing the selling price of the good or service. Common dramatic factor cost increases include natural disasters like droughts, hurricanes, floods. Also OPEC increases in crude oil prices and significant wage increases for workers can cause cost-push inflation.

29. Inflation Protection To protect wages from inflation, many employees have cost-of-living adjustments (COLA) to their wages. COLA is an automatic adjustment to the nominal income based upon the rate of inflation. Union contracts frequently have COLA as part of the contract. Many employers provide COLA protection to their workers outside of union contracts. Social Security benefits are now subject to COLA adjustments on an annual basis.

30. Inflation Protection Cost-of-living adjustments also occur in many loan agreements. Mortgages, car loans, lines of credit can be tied to the rate of inflation. An example is the adjustable rate mortgage (ARM) which automatically increases or decreases its interest rate and payment amount based upon the rate of inflation. Adjustments in interest rates and payment amounts can occur on an annual basis or more frequently depending upon the terms of the loan.

31. Inflation Protection Banks and other financial entities are highly concerned about interest rates and their loan portfolios. Often the Real Interest Rate is calculated as a tool for comparison. Real interest rate = nominal interest rate – anticipated rate of inflation. This calculation is important when setting rates for long-term loans. A positive real interest rate is desired to ensure profitability.

32. Inflation Protection For example: If the future expected rate of inflation is 4% and nominal interest rates are 6%, the real interest rate is: 6% - 4% = 2% 2% is the real rate of interest.

33. Summary • Inflation, deflation. • Relative price. • Price, income, wealth effects of inflation. • Money Illusion. • Hyperinflation, bracket creep. • CPI and its components. • PPI • GDP Deflator • Demand-Pull and Cost-Push Inflation • COLAs, ARMs, Real Interest Rate