Inflation

1. Inflation Chapter 7

2. What Is Inflation? • Inflation is an increase in the average level of prices, not a change in any specific price.

3. The Average Price • The average price is determined by finding the average price of all output. • A rise in the average price is called inflation. • A fall in the average price is called deflation. LO1

4. Relative Prices vs. the Price Level • Relative price is the price of one good in comparison with the price of other goods. • A general inflation may prevent relative price changes from reallocating resources in the economy.

5. Redistributive Effects of Inflation • Although inflation makes some people worse off, it makes some people better off. LO2

6. Price Effects • Price changes are the most familiar effect of inflation. • The effect on economic welfare is shown in the difference between nominal and real income. LO2

7. Price Effects • Nominal income is the amount of money income received in a given time period, measured in current dollars. Real income is income in constant dollars: nominal income adjusted for inflation. LO2

8. Price Effects • Two basic lessons about inflation: • Not all prices rise at the same rate during inflation. • Not everyone suffers equally from inflation. LO2

9. Price Changes in 2006 LO2

10. Income Effects • Even if all prices rose at the same rate, inflation would still redistribute income. • Redistributive effects originate both in expenditure and income patterns. LO2

11. Income Effects • What looks like a price to a buyer looks like an income to a seller. If prices are rising, incomes must be rising too. LO2

12. Nominal Wages and Prices LO2

13. Wealth Effects • Winners and losers from inflation depend on the form of wealth they own. • You lose when inflation reduces the real value of wealth. LO2

14. The Real Story of Wealth LO2

15. Redistributions • The redistributive mechanics of inflation include price effects, income effects, and wealth effects. • Inflation acts like a tax, taking income or wealth from one group and giving it to another. LO2

16. Price Effects • People who prefer goods and services that are increasing in price the fastest end up with fewer goods and services. LO2

17. Income Effects • People whose nominal income rise more slowly than inflation end up with fewer goods and services. LO2

18. Wealth Effects • People who own of assets that are declining in real value end up with less real wealth. LO2

19. Social Tensions • Tensions between labor and management, between government and the people, and among consumers may overwhelm a society and its institutions. LO2

20. Money Illusion • The use of nominal dollars rather than real dollars to gauge changes in one’s income or wealth is called the money illusion. LO2

21. Macro Consequences • In addition to redistributing income and wealth, inflation has macroeconomic effects as well.

22. Uncertainty • People tend to shorten their time horizons in the face of inflation uncertainties. • Time horizons are shortened as people attempt to spend money before it loses further value.

23. Speculation • Few people will engage in production if it is easy to make speculative profits. • Such speculation may fuel hyperinflation. • Hyperinflation is an inflation rate in excess of 200 percent, lasting at least one year.

24. Bracket Creep • Bracket creep is the movement of taxpayers into higher tax brackets (rates) as nominal incomes grow.

25. Deflation Dangers • Deflation occurs when the price level falls. • Deflation reverses the redistributions caused by inflation ‒ lenders win and creditors lose.

26. Measuring Inflation • Measuring inflation serves two purposes: • Gauges the average rate of inflation. • Identifies its principal victims. LO1

27. Consumer Price Index (CPI) • The consumer price index(CPI) is a measure (index) of changes in the average price of consumer goods and services. • It can be used to calculate the inflation rate. LO1

28. Consumer Price Index (CPI) • The inflation rate is the annual percentage rate of increase in the average price level. LO1

29. Constructing the CPI • The Bureau of Labor Statistics constructs a market basket of goods and services that consumers usually buy. • The base period is the time period used for comparative analysis ‒ the basis of indexing price changes. LO1

30. Constructing the CPI • The relative importance of a product in the CPI is reflected in the item weight. Item weight is the percentage of total expenditure spent on a specific product; used to compute inflation indexes. LO1

31. Constructing the CPI • The impact on the CPI of a price change for a specific good is calculated as follows: percentage change in CPI = item weight X percentage change in price of item LO1

32. The Market Basket Transportation 18.0% Housing 32.7% Food 13.7% Insurance and pensions 11.2% Clothing 4.1% Miscellaneous 9.5% Entertainment 5.1% Health care 5.7% LO1

33. The Core Rate • The Labor Department uses the core inflation rate to get a more accurate monthly reading of consumer price trends. • The core inflation rate measures changes in the CPI while excluding changes in food and energy prices. LO1

34. Producer Price Indexes • There are three producer price indexes (PPI) which keep track of average prices received by producers. • One includes crude materials, another intermediate goods, and the last covers finished goods. LO1

35. The GDP Deflator: • The broadest price index is the GDP deflator. • The GDP deflator is a price index that refers to all goods and services included in GDP. LO1

36. The GDP Deflator: • The GDP deflator covers all output including consumer goods, investment goods, and government services. Unlike the CPI and PPI, it is not limited to a fixed basket. Its value reflects both price changes and market responses to those changes. LO1

37. Real vs. Nominal GDP • The GDP deflator is used to adjust nominal GDP for changing price levels. • Nominal GDP is the value of final output produced in a given period, measured in the prices of that period (current prices). • Real GDP is the value of final output produced in a given period, adjusted for changing prices.

38. Real vs. Nominal GDP • Nominal and Real GDP are connected by the GDP deflator:

39. The Goal: Price Stability • Every U.S. president since Franklin Roosevelt has decreed price stability to be a foremost policy goal. LO3

40. A Numerical Goal • An explicit numerical goal for price stability was established by the Full Employment and Balanced Growth Act of 1978. • Price stability is the absence of significant changes in the average price level; officially defined as an inflation rate of less than 3 percent. LO3

41. Unemployment Concerns • The goal of full employment is defined as the lowest rate of unemployment consistent with stable prices. • There might be a trade-off between declining inflation and rising unemployment. LO3

42. Quality Changes • The CPI is not a perfect measure of inflation because an increase in price may caused by quality improvements. • Over time, the goods themselves change as a result of quality improvements. LO3

43. New Products • The CPI is biased upward when new products whose prices are falling are left out of the market basket. LO3

44. The Historical Record • In the long view of history, the U.S. has done a good job in maintaining price stability. • Upon closer inspection, however, our inflation performance is very uneven.

45. Annual Inflation Rates

46. Causes of Inflation • The cause of inflation is rooted in supply and demand.

47. Demand-Pull Inflation • Demand-pull inflation results from excessive pressure on the demand side of the economy. • “Too much money chases too few goods” enabling producers to raise prices.

48. Cost-Push Inflation • The pressure on price could also originate on the supply side. • Higher production costs put upward pressure on product prices.

49. Protective Mechanisms • Low rates of inflation don’t have the drama of hyperinflation, but they still redistribute real wealth and income.

50. COLAs • Market participants can protect themselves by indexing their nominal incomes. • Cost-of-living adjustments(COLAs) are automatic adjustments of nominal income to the rate of inflation.