Lecture 4 ~ Macroeconomics

Basic Elements of Macroeconomics

Macroeconomic Objectives

• Distinction between microeconomics and macroeconomics

• The major macroeconomic issues

– economic growth

– unemployment

– inflation

– balance of payments and exchange rates

• balance of payments deficits and surpluses

• exchange rate movements

Economic growth (average % per annum), Unemployment (average %), Inflation (average % per

annum)

Macroeconomics

• MACRO is concerned with economic aggregates and averages.

• Aggregates:Gross Domestic Product (GDP) is a standard

measure of aggregate economic activityThe rate of unemployment

• Averages:The Average level of prices & the rate of

inflation

Gross Domestic Product: GDP

• Gross Domestic Product (GDP) is a standard measure of aggregate economic activityGDP measures the total value of the economy’s

output of final goods & services.GDP also measures the income earned by the

economy’s factors of production – labour, land & capital.

GDP

• GDP can be measured in NOMINAL or in REAL termsNominal: the € value of the economy’s outputReal: Nominal GDP divided by the average

price of all goods & services.The economy’s rate of growth is measured by

the annual percentage change in real GDP.

Average Growth Rates (%): 1960-2002

IRL EU USA JPN

1961-70 4.2 4.9 4.2 10.1

1971-80 4.7 3.0 3.2 4.4

1981-90 3.6 2.4 3.2 4.2

1991-00 7.0 2.1 3.4 1.3

1998-02 8.7 2.9 3.7 0.7

Source: European Commission

0

2

4

6

8

10

12

1960 1970 1980 1990 2000

Ireland

EU

Growth Rates (%): 1960 – 2002.

Source: European Commission

Measuring GDP

• GDP can be defined as: • The market value of all final goods & services

produced in a given time period (one year)• Market value simply means the money value of

the economy’s outputIf we produce 1m computers at a price of

€1,000 each the market value is €1,000m• To aggregate over different goods we must

measure in money terms – market value

Measuring GDP

• Final Goods: Goods & services which are purchased & consumed by the final user

• Other goods & services which are used in the production of final goods are not counted in GDP – intermediate goods

• Including intermediate goods would imply double counting & overstate GDP

Measuring GDP

• Consider the following example

• Three stages in producing a litre of milkFarmer produces raw milk & sells it to a dairy

for processingDairy sells it to a retailer who then sells it to the

consumerIn € terms what contribution does the litre of

milk make to GDP?

Measuring GDP

• Suppose the farmer has zero costs and: Processor pays farmer €0.70Retailer pays the processor €1.20Consumer pays the retailer €1.50

• Total value of all transactions is €3.40• The contribution to GDP is the value of the final

purchase (€1.50) not the total value of all transactions (€3.40) WHY?

Measuring GDP

• The processor pays the farmer €0.70 per litreAs the farmer has zero costs his income = €0.70

• The processor sells to the retailer at €1.20 per litreHence the processor’s net income = €0.50

• The retailer sells to the consumer at €1.50 Hence the retailer’s net income = €0.30

Measuring GDP

• Hence the net income or VALUE ADDED at each stage is:Farmer: €0.70Processor: €0.50Retailer: €0.30

• Total: €1.50• Which equals final expenditure by the consumer

Measuring GDP

• The purchase of raw milk by the processor from the farmer is an intermediate purchase

• It is part of the farmer’s income but not the processor’s income

• To include it in both would lead to double counting & overstate GDP

• The same holds for the purchase of processed milk by the the retailer

Measuring GDP

• GDP is the sum of the net income or value added at each stage of production

• This sum equals the market value of the final purchase

• The economy's GDP is measured in two waysThe Expenditure MethodThe Income Method

Calculating GDP: Expenditure Method

• GDP = total amount spent on all final goods in a given year

• Final goods & services are bought by 4 sectors:Individual Consumers or HouseholdsFirmsGovernment The Foreign Sector or Rest of the World

(ROW)

Calculating GDP: Expenditure Method

Expenditure by:Households: Consumption (C)Firms: Gross Investment (I)Government: Purchases of goods & services

(G)ROW: Expenditure on exports (EX) less

domestic expenditure on imports (IM): net exports NX = (EX – IM)

• Total expenditure on GDP = C + I + G + NX

Calculating GDP: Expenditure Method

• Consumption (C): Household or personal expenditure on goods & services

• Investment (I): Expenditure by firms on fixed capital formation plus changes in inventories

• Government Expenditure (G) includes:Wages & salaries paid to all government

employeesExpenditures on office supplies, military

equipment, roads etc.• It does not include transfer payments

Calculating GDP: Expenditure Method

• Net Exports (NX) = Exports - Imports• Exports : sales of domestically produced goods &

services to foreigners • Imports: domestic purchases of foreign produced

goods & services• Denote GDP as Y: Hence Y is the sum of four

different types of expenditure. That is:

• Y = C + I + G + NX

Origins of GDP, 2001 Ireland UK US

Sector of the Economy % of GDP % of GDP % of GDP

Agriculture 3.7 1.1 1.4

Mining 0.4 3.3 1.4

Manufacturing 40.8 18.4 15.8

Utilities 0.9 1.6 2.3

Construction 4.3 5.2 4.7

Wholesale & retail trade, Restaurants & Hotels

7.7 15.9 15.9

Transport, Storage & Communications

3.8 8.0 6.0

Finance, Insurance, Real Estate & Business Services

13.0 24.1 19.6

Community, personal & social services

9.5 11.3 22.1

Other 55.5 11.1 10.8

Total 100.00 100.00 100.00

Nominal & Real GDP

• GDP is measured in money terms (€’s)• Suppose the economy produces n different final

goods & services (computers, potatoes, phones etc.)

• Let Qi = the output of any good i (number of computers etc)

• Let Pi = the price of good i in €’s

• PiQi = nominal or money value Qi

Nominal & Real GDP

• As there are n goods & services, nominal GDP is:Y = P1Q1 + P2Q2 + … + PnQn

• Suppose we want to compare GDP in two years 1 & 2

• Suppose there are two goods A & B• QAi & QBi = production in each year, i = 1,2• PAi & PBi = prices in each year, i = 1,2

Nominal & Real GDP

• Nominal GDP in each year is:• Y1 = PA1QA1 + PB1QB1

• Y2 = PA2QA2 + PB2QB2

• Y1 & Y2 measure nominal GDP at current year prices• Y can change for two reasons• Production changes and/or prices change• If we want to compare economic activity in the two

years we need to exclude the effects of price changes.

Nominal & Real GDP

• QA1 = 10, QB1 = 15, PA1 = €10, PB1 = €5• Y1 = €175• QA2 = 20, QB2 = 30, PA2 = €12, PB2 = €6• Y2 = €420• Production of each good has doubled (100%

increase) but Y has increased by 140%• The rise in nominal GDP overstates the

increase in economic activity

Nominal & Real GDP

• Real GDP corrects for this by measuring the value of each year’s production at constant prices

• Suppose we use Year 1 prices: the base year• Year 1 GDP at year 1 prices is €175• Year 2 GDP at year 1 prices is:

• PA1QA2 + PB1QB2 = €350

Nominal & Real GDP

• Hence: evaluating each year’s production at constant (year 1) prices gives:Real GDP in year 1 = €175 Real GDP in year 2 = €350

• Increase = 100% which reflects the increase in production only

• Nominal GDP evaluates production at current prices

• Real GDP evaluates production at constant prices

Nominal & Real GDP

• Note: we can also use year 2 as the base year:

• Y1 at year 2 prices = €210

• Y2 at year 2 prices = €420

• Increase = 100%• The following graph shows Irish nominal & real

GDP over 1995-2000: Real GDP is measured at 1995 prices

0

20

40

60

80

100

1995 1996 1997 1998 1999 2000

Nominal

Real

Irish Nominal & Real (1995 prices) GDP£billion

Source: National Income & Expenditure

GDP & Economic Welfare

• Real GDP is a measure of economic activity• It is not necessarily a good measure of economic

welfare or economic well-being• Increases in real GDP imply that the economy is

producing more goods & services & that we can increase consumption

• However GDP excludes activities which may affect overall economic welfare

GDP & Economic Welfare

• Pollution: Increases in real GDP may result in increased pollution which reduces economic welfare. The cost of pollution is not included in GDP

• GDP does not reflect the distribution of income and economic inequalities.

• Non-Market Activities such as home-making & volunteer services may increase welfare but are not included in GDP

GDP & GNP

• GNP is Gross National Product:• GNP = GDP + Net Factor Income from the Rest of

the World (NFI)• In any given year Irish residents & firms make and

receive payments to & from the ROW (other than those for exports & imports) – interest, dividends, profits etc.

GDP & GNP

• Irish households may own foreign assets:Shares in UK or US firms & receive annual

dividends Deposits in foreign banks & receive annual

interest payments• Irish firms may receive profits from investment in

other countries• These payments are an income flow from the

ROW to Ireland

GDP & GNP

• Foreign households may own Irish assets:Shares in Irish firms & receive annual

dividends Deposits in Irish banks & receive annual

interest payments• US firms operating in Ireland may send the profits

back to their parent firm in America• These payments are an income flow from Ireland

to the ROW

GDP & GNP

• Net Factor Income (NFI) is:• NFI = interest, dividends profits etc. received from

the ROW minus similar payments to the ROW• GNP = GDP + NFI• In large countries the difference tends to be small.• For Ireland it is large: Typically NFI < 0 & GDP >

GNP• In 2000 NFI was approximately -£12.8b or 16% of

GDP

0

20

40

60

80

100

1995 1996 1997 1998 1999 2000

GDP

GNP

Irish Real GDP & GNP (1995 prices)£billion

Source: National Income & Expenditure

Real GDP and GNP growth rates compared, 1991 – 2002

0%

2%

4%

6%

8%

10%

12%

1991 1996 2001

GDP GNP

Real GDP and GNP compared(1995 prices)

25

35

45

55

65

75

85

95

105

1990 1992 1994 1996 1998 2000 2002

bill

ion

€

GDP

GNP

fig

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

1970 1975 1980 1985 1990 1995 2000

Ann

ual g

row

th r

ate

(%)

UK

France USA

Germany

Growth rates in selected industrial countriesGrowth rates in selected industrial countriesGrowth rates in selected industrial countriesGrowth rates in selected industrial countries

Irish and US growth rates compared, 1991 – 2002

-2%

0%

2%

4%

6%

8%

10%

12%

1991 1996 2001

IRL

USA

Economic Growth andthe Business Cycle

• Growth in actual and potential output

• Economic growth and the business cycle

– fluctuations in actual growth

O

Nat

iona

l out

put

Time

Potential output

Actualoutput

The business cycle

Economic Growth andthe Business Cycle

• Growth in actual and potential output

• Economic growth and the business cycle

– fluctuations in actual growth

– the phases of the business cycle

O

Nat

iona

l out

put

Time

Potential output

Actualoutput

1

2

3

4

1

2

34

The business cycle

Economic Growth andthe Business Cycle

• Growth in actual and potential output

• Economic growth and the business cycle

– fluctuations in actual growth

– the phases of the business cycle

– trend growth

O

Nat

iona

l out

put

Time

Potential output

Actualoutput

Trendoutput

The business cycle

Economic Growth andthe Business Cycle

• Economic growth and the business cycle

– fluctuations in actual growth

– the phases of the business cycle

– trend growth

– the business cycle in practice

• the irregularity of the cycle

• the length of the phases

• the magnitude of the phases

Economic Growth andthe Business Cycle

• Causes of actual growth

– aggregate demand

– aggregate demand relative to potential output

• Actual growth in practice

– experience since 1970

Real GDP Ireland 1960-99 (£ Billion, 1998 Prices)

50

11

61

£10

£100

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999

1973-75 Recession

Recession Mid 80’s

Celtic Tiger

Recession Early 90’s

Fig. 24.1Fluctuations in U.S. Real GDP,

1920-1999

Economic Growth andthe Business Cycle

• Causes of potential growth– increases in the quantity of factors

• capital• labour• land and raw materials• the problem of diminishing returns

– increases in factor productivity

• Policies to achieve growth– demand-side and supply-side policies– market-orientated & interventionist policies

Macroeconomic Policies

• Crucial to distinguish between:• Growth policies (long-run) and Stabilisation

policies (short-run)Growth policies attempt to increase the long-

run or average growth rateStabilisation policies attempt to dampen the

business cycle – keep actual GDP close to the trend

Macroeconomic Policies

• Growth Policies – support for education, training, R&D etc.

• Stabilisation Policies: Two typesFiscal or Budgetary Policy – changes in rates of

taxation, government expenditure plans etc.Monetary Policy – changes in interest rates &

exchange rates.

Macroeconomic Policies

• We will see that Irish participation in the euro means:

• A complete sacrifice of monetary independence Irish interest rates etc. now determined in

Frankfurt• Strict limitations on fiscal policy

The Stability Pact

Aggregate Demand and Supply

• The aggregate demand curve

O

Pri

ce le

vel

National output

AD

Aggregate demand and aggregate supply

Aggregate Demand and Supply

• The aggregate demand curve

– Why aggregate demand curves slope downwards

• import effect

O

Pri

ce le

vel

National output

AD

Aggregate demand and aggregate supply

Aggregate Demand and Supply

• The aggregate demand curve

– Why aggregate demand curves slope downwards

• import effect

• interest-rate effect

O

Pri

ce le

vel

National output

AD

Aggregate demand and aggregate supply

Aggregate Demand and Supply

• The aggregate demand curve

– Why aggregate demand curves slope downwards

• import effect

• interest-rate effect

• savings effect

O

Pri

ce le

vel

National output

AD

Aggregate demand and aggregate supply

Aggregate Demand and Supply• The aggregate demand curve

– Why aggregate demand curves slope downwards

• import effect

• interest-rate effect

• savings effect

• The aggregate supply curve

O

Pri

ce le

vel

National output

AS

AD

Aggregate demand and aggregate supply

Aggregate Demand and Supply

• The aggregate demand curve

– Why aggregate demand curves slope downwards

• import effect

• interest-rate effect

• savings effect

• The aggregate supply curve

– Why aggregate supply curves generally slope upwards

O

Pri

ce le

vel

National output

AS

AD

Aggregate demand and aggregate supply

Aggregate Demand and Supply

• The aggregate demand curve

– Why aggregate demand curves slope downwards• import effect

• interest-rate effect

• savings effect

• The aggregate supply curve

– Why aggregate supply curves generally slope upwards

• Equilibrium

O

Pri

ce le

vel

National output

AS

AD

Pe

Aggregate demand and aggregate supply

O

Pri

ce le

vel

National output

AS

AD

Pe

P2

ab

Aggregate demand and aggregate supply

Aggregate Demand and Supply

• The aggregate demand curve– Why aggregate demand curves slope downwards

• import effect

• interest-rate effect

• savings effect

• The aggregate supply curve– Why AS curves generally slope upwards

• Equilibrium– Effect of a shift in the AD curve

Unemployment

• Unemployment is the total number of people not working but seeking employment in the economy

• The rate of unemployment is the percentage of the labour force who are unemployedLabour force: Number employed plus the

number unemployed

0

2

4

6

8

10

12

14

16

18

1960 1970 1980 1990 2000

Ireland

EU

Unemployment Rates (%): 1960 – 2002.

Source: European Commission

fig

0

2

4

6

8

10

12

14

1970 1975 1980 1985 1990 1995 2000

Une

mpl

oym

ent (

% o

f wor

kfor

ce)

UK

France USA

Germany

Unemployment rates in selected industrial countries

Unemployment

• Unemployment and the labour market

– the aggregate demand and supply of labour

– equilibrium in the model

Qe

Aggregate demand and supply of labour

O

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ASL

ADL

We

Unemployment

• Unemployment and the labour market

– the aggregate demand and supply of labour

– equilibrium in the model

– disequilibrium unemployment

O

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ASL

ADL

We

W2

B A

Disequilibrium unemployment

Q2 Q1

Unemployment

• Unemployment and the labour market

– the aggregate demand and supply of labour

– equilibrium in the model

– disequilibrium unemployment

– equilibrium unemployment

Equilibrium unemployment

O

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ADL

We

ASL

e

Qe

Q2QeO

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ASL

ADL

We

N

e d

Equilibrium unemployment

Equilibrium and disequilibrium unemployment

O

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ADL

We

e

Qe

ASL

O

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ASL

ADL

We

W2

b a

e

Disequilibriumunemployment

Equilibrium and disequilibrium unemployment

O

Ave

rag

e (r

ea

l) w

ag

e ra

te

No. of workers

ASL

ADL

We

W2

b a

e

N

c

Equilibriumunemployment

Disequilibriumunemployment

Equilibrium and disequilibrium unemployment

Unemployment

• Disequilibrium unemployment

– real-wage (classical) unemployment

– demand-deficient (cyclical) unemployment

– unemployment arising from a growth in the labour supply

Unemployment

• Equilibrium unemployment

– frictional (search) unemployment

– structural unemployment

• changing pattern of demand

• technological unemployment

• regional unemployment

– seasonal unemployment

The CPI & Inflation

• Inflation is normally measured by the annual percentage change in the Consumer Price Index (CPI)

• The CPI is an average price of a standard basket of goods & services

• It is measured by comparing the cost of a fixed basket at each year’s prices

The CPI & Inflation

• Example; Consider three goods: A, B & C

• Suppose that in a given year (year 1) the typical household purchases:

• 1 unit of A at €100 per unit: €100

• 10 units of B at €8 per unit: €80

• 20 units of C at €6 per unit: €120

• Total cost at Year 1 prices = €300

The CPI & Inflation

• Suppose in a subsequent year (year 2) the prices are:

• €105 for A, €10 for B & €6.25 for C• The same quantities will cost:• A: 1 at €105 €105• B: 10 at €10 €100• C: 20 at €6.25 €125• Total cost at Year 1 prices = €330

The CPI & Inflation

• Cost of the fixed basket (same quantities of each good)

• At year 1 prices: €300• At year 2 prices: €330• Hence relative to year 1, the average price of the

same basket in year 2 is 330/300 = 1.1• Hence the CPI compares the cost of a fixed basket

of goods & services at the prices in each year

The CPI & Inflation

• Note that the CPI is a price index• A price index measures the average price of a

fixed basket of goods & services relative to the prices in the base year.

• In Ireland the CPI is computed in two stagesA price index is computed for each commodity

group – housing, fuel, clothing, food etc.The CPI is the weighed average of these indices

using base year expenditure weights.

The CPI & Inflation

• Price index for each commodity group is:• Current year price

divided by• Base year price• Year 1 (base year) prices:

A €100: B €8: C €6• Year 2 prices:

A €105: B €10: C €6.25

The CPI & Inflation

• Year 1 Indices (base year)A 100/100 = 1B 8/8 = 1 C 6/8 = 1

• Year 2 Indices:A 105/100 = 1.05B 10/8 = 1.25 C 6.25/6 = 1.04

The CPI & Inflation

• Base year expenditure weights:• Base year expenditure on each good

Divided by• Total base year expenditure (€300)

A: 100/300 = 0.33B: 80/300 = 0.27C: 125/300 = 0.4

Price Indices Weights

Base Year

Year 2

A 1 1.05 0.33

B 1 1.25 0.27

C 1 1.04 0.40

CPI = Sum of Indices times the Weights

Price Indices times Weight

Base Year

Year 2

0.33 0.35

0.27 0.33

0.40 0.42

1.00 1.1

Irish CPI Weights: % (Base Dec. 2001)

• Food 20.8• Alcohol

11.9• Tobacco 4.4• Clothing 4.9• Fuel & Light 3.3• Housing 9.7

• Durable Household Goods 3.6

• Other Goods5.8• Transport 15.4• Services 20.2

• TOTAL: 100%

0

5

10

15

20

25

1960 1970 1980 1990 2000

Ireland

EU

Inflation Rates (%): 1960 – 2002.

Source: European Commission

fig

-2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

1965 1970 1975 1980 1985 1990 1995 2000

Infla

tion

(% in

crea

se in

reta

il pr

ices

)

UK

EU 15 Japan

USA

Inflation rates in selected industrial countries

Inflation

• Types of inflation– demand pull

Demand-pull inflation

O

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vel

National output

AS

AD1

P1

Q1

O

Pri

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vel

National output

AS

AD1

P1

Q1

AD2

Demand-pull inflation

O

Pri

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vel

National output

AS

AD1

P1

Q1

AD2

P2

Q2

Demand-pull inflation

Inflation

• Types of inflation– demand pull– cost push

• wage push

• profit push

• import-price push

Cost-push inflation

O

Pri

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vel

National output

AS1

AD

P1

Q1

O

Pri

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vel

National output

AS1

AD

P1

Q1

AS2

Cost-push inflation

O

Pri

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vel

National output

AS1

AD

P1

Q1

AS2

P2

Q2

Cost-push inflation

Inflation• Types of inflation

– demand pull

– cost push

• wage push

• profit push

• import-price push

– the interaction of demand-pull and cost-push inflation

The interaction of demand-pull and cost-push inflation

O

Pri

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vel

National output

AS1

AD1

P1

O

Pri

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vel

National output

AS1

AD1

P1

AS2

AD2

P2

The interaction of demand-pull and cost-push inflation

O

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vel

National output

AS1

AD1

P1

AD2

P2

AS3

AD3

P3

AS2

The interaction of demand-pull and cost-push inflation

Inflation

• Types of inflation– demand pull– cost push

• wage push• profit push• import-price push

– the interaction of demand-pull and cost-push inflation

– structural (demand shift)

Inflation

• Types of inflation– demand pull– cost push

• wage push• profit push• import-price push

– the interaction of demand-pull and cost-push inflation

– structural (demand shift)– expectations and inflation

Inflation

• Policies to tackle inflation– demand-side policies– supply-side policies

Nominal & Real Quantities

• A nominal quantity is measured in current euro terms

• A real quantity is measured in physical terms – quantities of goods & services

• Two examples: Real wages & incomesReal interest rates

Nominal & Real Quantities

• Suppose a household earns €30,000 in 2001 and €31,500 in 2002 (a 5% increase)

• Is the household better-off? Does the 5% increase in nominal income permit it to buy more goods & services?

• The answer depends on the CPI• In any year the household’s real income is:

Its nominal income/CPI

Real & Nominal Interest Rates

• Suppose you save €100 at a bank with an annual deposit interest rate of 5%.

• After 1 year you will have €105: €100 capital plus €5 interest.

• The €5 the nominal interest on your savings• Question: are you better or worse off by saving

€100 for 1 year?• OR: Does €105 buy more or less than €100 would

one year ago?

Real & Nominal Interest Rates

• Suppose that over the year the CPI increases by 5%

• This means that the real purchasing power of €105 at the end of the year is the same as the real purchasing power of €100 at the start of the year

• OR: the real return on your saving is zero.

Real & Nominal Interest Rates

• To be more formal let:• i = the nominal interest rate (5% in the previous

example)• π = rate of inflation (% change in CPI)• The the real rate of interest (r) is:

r = i – π

Real & Nominal Interest Rates

• Let i = 5% & π = 4%• The the real rate of interest (r) is:• r = i – π = 5 – 4 = 1%• Hence if you save €100 at 5% your real return is

1%• That is: €105 buys 1% more than €100 did a year

ago.

Real & Nominal Interest Rates

• Let i = 5% & π = 6%• The the real rate of interest (r) is:• r = i – π = 5 – 6 = -1%• Hence if you save €100 at 5% your real return is -

1%• That is: €105 buys 1% less than €100 did a year

ago.

Actual & Expected Inflation

• Many contracts are agreed in nominal termsYou deposit €100 in a bank at a nominal fixed

interest of 5%Unions agree to a nominal wage increase of 5%

etc.• When the contract is agreed the expected real

return is:The nominal or money increase minus the

expected inflation rate over the contract period

Actual & Expected Inflation

• For example: If you expect inflation to be 3% then saving at 5% nominal interest means that you expect a real return of 2%.

• However the expected real outcome will only be realised if the actual inflation rate equals the expected inflation rate

• Two examples:Savers & BorrowersWorkers & Employers

Savers & Borrowers

• Normally the nominal interest rate for borrowing is greater than the nominal rate for saving

• Let saving rate = 5%• And borrowing rate = 7%• Suppose both savers & borrowers expect inflation

to be 4% over the coming year.• Expected real return to saving = 1% per year• Expected real cost of borrowing = 3% per year

Real & Nominal Interest Rates

• Suppose the expected or forecasted inflation rate turns out to be incorrect & actual inflation is 6% rather than 4%

• That is: inflation is 2% higher than expected• Actual real return to saving = 5 – 6 = -1%• Actual real cost of borrowing = 7 – 6 = +1%• Hence, an unanticipated rise in inflation makes

savers (lenders) worse-off and borrowers better-off.

Real & Nominal Interest Rates

• Conversely actual inflation is 3% rather than 4%

• That is: inflation is 1% lower than expected• Actual real return to saving = 5 – 3 = 2%• Actual real cost of borrowing = 7 – 3 = 4%• Hence, an unanticipated fall in inflation

makes savers (lenders) better-off and borrowers worse-off.

Real & Nominal Interest Rates

• The the real rate of interest (r) is:• r = i – π OR the nominal rate is:• i = r + π• Hence, given r, nominal interest rates (i) will be

positively correlated with inflation• The Fisher Effect: Nominal interest rates tend to

be high (low) when inflation is high (low)

Workers & Employers

• Suppose workers (unions) & employers expect inflation to be 5% and agree a nominal wage increase of 5%. Hence:

• Workers expect their real standard of living to be maintained

• Employers expect the real cost of hiring labour to be constant

Workers & Employers

• Suppose actual inflation turns out to be 6% over the contract period.

• That is: unanticipated inflation = +1%• Result: real wages fall by 1%• Workers are worse-off because real living

standards have declined• Employers are better-off because the real cost of

hiring labour has fallen

Workers & Employers

• Suppose actual inflation turns out to be 4% over the contract period.

• That is: unanticipated inflation = -1%• Result: real wages increase by 1%• Workers are better-off because real living

standards have increased• Employers are worse-off because the real cost of

hiring labour has increased

The Costs of Inflation

• These examples suggest that so long as inflation is correctly forecast it is not a problem.

• Let π = actual inflation, πe = expected inflation• Suppose: π = πe: Inflationary expectations are

always correct• So long as nominal interest rates, wages etc.

change with expected inflation• Real interest rates & real wages will be constant

The Costs of Inflation

• Suppose savers will accept a real return of 3%• If π = πe = 2% • A nominal interest rate i = 5%• Gives a real rate: r = i – π = 3%• If π = πe = 10% • A nominal interest rate i = 13%• Gives a real rate: r = i – π = 3%

The Costs of Inflation

• Likewise, if money wages always rise in line with inflation then real wages will be constant at all inflation rates

• If the % change in money wages = πe and π = πe

• Then the real wage will be the same irrespective of the rate of inflation

• Why then is high inflation considered a problem?

The Costs of Inflation

• High inflation can impose costs especially if it is unexpected.

• We have seen that when contracts are fixed in money terms an unanticipated rise in inflation leads to a redistribution of income:From savers to borrowersFrom workers to employers

The Costs of Inflation

• Irish wage bargaining process – Social Partnership• Fixes nominal wage increases for a 2/3 year period• If inflation is higher than expected real wages &

incomes will be lower than expected• This happened in 2000-01 & the current

agreement (PPF) had to be renegotiated.

The Costs of Inflation

• Inflation can also distort the tax system.• Suppose: First €10,000 of income is tax exempt &

all additional income is taxed at 20%• A household earning €20,000 would pay

Zero on the first €10,00020% or €2,000 on the next €10,000Total tax = €2,000 or 10% of total income

The Costs of Inflation

• Suppose: Over time income doubles to €40,000 but real incomes remain the same (money income rises with inflation)

• A household earning €40,000 would payZero on the first €10,00020% or €6,000 on the next €30,000Total tax = €6,000 or 15% of total income

The Costs of Inflation

• Hence unexpected increases in inflation can lead to a redistribution of income & wealth:Between savers & borrowersBetween workers & employersBetween taxpayers & government

The Costs of Inflation

• To avoid these problems interest rates, wages, pensions and tax bands are sometimes indexed to the rate of inflation

• In the previous example the tax exempt band would be raised to €20,000:

• A household earning €40,000 would payZero on the first €20,00020% or €4,000 on the next €30,000Total tax = €4,000 or 10% of total income

The Costs of Inflation

• Inflation has other costs:• “Shoe-Leather” Costs:• Inflation erodes the real value or purchasing

power of cash holdings• The higher the inflation rate, the greater the

amount of cash required to finance a given volume of transactions – see example 19.8

The Costs of Inflation

• Distorting the Price System:• Let P = CPI, Px = price of good X• Px/P = the relative price of X• Suppose P rises in line with wages, costs etc.• An increase in Px/P is a signal that it is profitable

to increase the production of X• In an efficient economy resources will be allocated

towards goods whose relative prices are rising & away from those whose relative prices are falling

The Costs of Inflation

• When inflation is high & variable there is “noise” in the price system

• More difficult to interpret relative price changes• Leading to distortions in resource allocation

Is The CPI a Good Measure of Inflation?

• Inflation is normally measured by the % change in the CPI.

• The CPI suffers from the problems of Substitution Bias and Quality Adjustment Bias

• Boskin Commission (US, 1996) estimates that these effects can overstate inflation by 1-2% per year.

Is The CPI a Good Measure of Inflation?

• Substitution Bias• The CPI is a weighted average of the prices of

goods & services in the “typical” consumption basket

• This basket may change over time because:• Relative prices change – less expensive goods are

substituted for more expensive goods• Tastes change or new goods become available –

how much olive oil was bought in Ireland 30 years ago?

Is The CPI a Good Measure of Inflation?

• Quality Adjustment Bias:• The CPI does not adjust for changes in quality• Suppose that the price of this year’s computer is

10% higher than last year’s. • This years’s model may have more memory, faster

processing speed etc.• The price per unit of computing power may have

increased by less than 10% over may have fallen