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Chapter 07:Infation

  Copyright © 2013 by The McGraw-Hill Companies, Inc !ll rights reser"e# McGraw-Hill$Irwin

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Infation

• We recognize infation as the second othe two major macroeconomic

problems we can ace.•  The core problems:

 – What kind o price increases are reerred toas “infation”?

 – Who is hrt and who is helped b! infation?

 – What is an appropriate goal or “pricestabilit!”?

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"earning #bjecti$es

• %&'%(. )now how infation is measred.

• %&'%*. )now wh! infation is a

socioeconomic problem.• %&'%+. )now the meaning o “price

stabilit!.”

• %&'%,. )now the broad cases oinfation.

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-nawa! Infation

• In (*+ prices in /erman! more thandobled e$er! da!. – 0o one sa$ed1 in$ested1 or made long'rn

plans.

 – 2rodction came to a halt3 nemplo!mentincreased b! a actor o (%.

 – The econom! collapsed.

 – 4ltimatel! 5itler came to power.

• 6imbabwe e7perienced a similar economicdisaster between *%%& and *%(%.

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87ercise

•  The crrent price o a good is 9(.

• I its price dobles e$er! da!1 what

will its price be in (% da!s? *% da!s?• In (% da!s1 9(*.

• In *% da!s1 9*,1*;;.

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What Is Infation?

• Infation: an increase in the a$eragele$el o prices1 not a change in an!speci

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-elati$e 2rices

•  The market mechanism cases theprices o indi$idal goods and ser$icesto rise or all > an essential marketnction. – Relative price: the price o one good

compared to the price o other goods. – !ers switch rom one good to another

when their relati$e prices di$erge.• Infation is a rise in the a$erage price o

all goods. – It is not a market nction.

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-edistribti$e 8@ects o

Infation• Infation makes some people worse

o@ and others better o@.

•  There are price e@ects1 incomee@ects1 and wealth e@ects.

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8@ects o Infation

• Aome prices rise and some all.

• -ising prices reBire !o to reallocate !or

prchasing power to ensre that !o getthe most satisaction per dollar spent.

 – Co might redce b!ing goods with higherprices and increase b!ing goods with lower

prices.•  This can be seen b! the di@erence between

nominal income and real income.

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8@ects o Infation

• Nominal income: the amont o mone!income recei$ed in a gi$en time period1measred in crrent dollars.

• Real income: income in constant dollars3nominal income adjsted or infation.

•  Co ma! get a raise Dnominal income

increasesE > bt i it does not rise as astas infation1 !or prchasing powerdecreases Dreal income allsE.

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-edistribtion o Income and

Wealth b! Infation• Price eects.

 – Those who b! prodcts that are increasingin price the astest end p worse o@.

 – Those who sell prodcts that are increasingin price the astest end p better o@.

 – Those who b! prodcts that are increasing

in price the slowest end p better o@. – Those who sell prodcts that are increasing

in price the slowest end p worse o@.

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-edistribtion o Income and

Wealth b! Infation• Income eects. 

 – 2eople with nominal incomes rising more

slowl! than infation end p worse o@. – 2eople with nominal incomes rising aster

than infation end p better o@.

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-edistribtion o Income and

Wealth b! Infation• Wealth eects. 

 – Those who own assets that are declining

in real $ale end p worse o@.

 – Those who own assets that areincreasing in real $ale end p better

o@.

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Fone! Illsion

• Money illusion: sing nominal dollarsrather than real dollars to gage changesin oneGs income or wealth.

• 87ercise: – In the “good old da!s” a mo$ie ticket was %

cents and the minimm wage was 9(.%%.

 – Hompare the prchasing power o theminimm wage toda! to the “good old da!s.”

 – Co cold b! two mo$ie tickets with onehorGs work beore1 bt not now.

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87ercise in Fone! Illsion

•  The infation rate in (;% was (+..

• In (& !or income was 9(%1%%%.

• In (;% !or income was 9((1%%%.

• Jid !or prchasing power increase?Jecrease? Ata! the same?

• JecreaseK Cor income went p (%while prices went p (+..

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Facro HonseBences o

Infation• 4ncertaint!: not knowing the prices o

goods in the tre makes prchasingand prodction decision making mch

more diLclt.• Apeclation: decisions will shit rom

standard economic acti$it! to betting onthe tre prices o goods.

• racket creep: in a progressi$e ta7s!stem1 when nominal incomes rise1 theta7pa!er gets pshed into a higher ta7bracket.

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5!perinfation

• yperinfation: infation rate in e7cess o*%% percent1 lasting at least ( !ear.

• Apending accelerates and prodction declines.

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Jefation

• !efation: a general decrease in a$erageprices.

•

 This has redistribtion e@ects that are jstthe opposite o those or infation.

•  This has macro conseBences also. – Aellers are relctant to stock in$entor!.

 –

!ers are relctant to b! now. – sinesses are relctant to borrow nds or

in$est.

 – Incomes all1 and asset $ales decrease.

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Feasring Infation

• Feasring infation ser$es twoprposes.

 – /aging the a$erage rate o infation. – Identi!ing its principal $ictims.

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Honsmer 2rice Inde7 DH2IE

• Consumer price inde" DCPIE: ameasre Dinde7E o the a$erage price o

consmer goods and ser$ices. – 4sed to calclate the infation rate.

• Infation rate: the annal percentagerate o increase in the a$erage price

le$el.

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Hreating a 2rice Inde7

• Aelect a “market basket” o goods: astandardized list o goods andser$ices cstomers sall! b!.

• Aelect a base !ear: the reerence !earwhose dollar $ale will be sed.

• Aet the price inde7 in the base !ear 

alwa!s eBal to (%%.• Feasre the prices or the basket o

goods in both the crrent !ear and inthe base !ear.

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Hompting a 2rice Inde7

• asket price in the base !ear M 9N1%%%.

• asket price in the crrent !ear M 9N1N%%.

• Hompte the price inde7 DH2IE or the crrent !ear: – OP(%% M 9N1N%%P9N1%%%

 – O M DN1N%% 7 (%%EPN1%%%

 – O M ((%• H2I in the crrent !ear is ((%.

• = H2I o ((% indicates that prices in the crrent!ear are (% higher than prices in the base !ear.

Price inde" in current year #as$et price in current yearPrice inde" %ase year & #as$et price in %ase year

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87ercise

• In *%%N H2I was abot *%%.Q• Q (;+ was the base !ear.

• In (;+ H2I was abot (%%.Q

•  These two H2I

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#ther Feasres o Infation

• Core infation: changes in H2I1e7clding ood and energ! prices.

• Producer price inde" 'PPI(: changes in the a$erage prices atintermediate steps o prodction.

•

)!P defator: changes in prices o allgoods and ser$ices inclded in /J2.

 – 4sed to correct nominal /J2 to real /J2.

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Hompting Infation -ate rom

H2I

• H2I in *%%N was *%(.N.

• H2I in *%% was (.+.

• Hompte the infation rate or *%%N:

• Infation rate M D*%(.N'(.+E7(%%P(.+M +.*+

  CPI year 2 – CPI year 1  Inflation rate = X 100  CPI year 1 

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 The /oal: 2rice Atabilit!

• Price sta%ility: the absence osigni

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 The /oal: 2rice Atabilit!

• Feasrement concerns.

 – We are seeking price stabilit! at the

lowest rate o nemplo!ment. – Rrom !ear to !ear1 there are Balit!

impro$ements in the basket o goods.

 – 0ew prodcts change the content o thebasket o goods we b!.

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 The 5istorical -ecord

 The highest and lowest annal infation rates since WW* are identi

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Hases o Infation

• !emand*pull infation: resltsrom e7cessi$e pressre to b! on

the demand side o the econom!. – = booming econom! creates shortages.

 – Too mch mone! pmped into theeconom! b! the Rederal -eser$e.

• Cost*push infation: 

de to higherprodction costs ptting pressre onsppliers to psh p prices.

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2rotecti$e Fechanisms

• Cost o+ livin, allo-ances 'C/(: nominal incomes are inde7ed to

atomaticall! rise at the same rate asinfation.

• d1usta%le*rate mort,a,e 'RM(: 

interest rate on a mortgage risesalong with infation so that lenders donot lose mone!.

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 The 8conom! Tomorrow

•  The $irtes o infation. – = little infation might be a good thing.

•

 The challenge or tomorrow is to

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-e$isiting the "earning

#bjecti$es• %&'%(. )now how infation is measred.

 – Infation is measred b! changes in a price

inde7 sch as the consmer price inde7DH2IE.

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-e$isiting the "earning

#bjecti$es• %&'%*. )now wh! infation is a

socioeconomic problem. – Infation redistribtes income b! altering

relati$e prices1 income1 and wealth. – Aome people actall! gain rom infation1

whereas others s@er a loss o real income orwealth.

 – Infation creates ncertaint! and speclationand detracts rom prodcti$e acti$it!.

 – H#"=s and =-Fs help protect some peoplerom infation.

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-e$isiting the "earning

#bjecti$es• %&'%,. )now the broad cases o infation.

 – Infation is cased either b! e7cessi$e

demand D“demand'pll” infationE or b!strctral changes in sppl! D“cost'psh”infationE.