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Chapter 5Inflation and the Price Level
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Which Bond Movie is more
profitable?
USD 456 Million USD 202 Million
2002 1981
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Compare It based on the
living cost
If you bought corn flake in 1981,
the price is $ 1.12. But If you
bought corn flake in 2002, the
price is $ 3.00
You have $ 3000 income during
1981, and can buy around 3000
boxes of corn flakes, but your$6000 in 2002 only can buy
around 2000 boxes of corn flakes
in 2002
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So, Which Bond Movie is more
profitable?
Yes! The For Your Eyes Only is more
profitable than Die Another Day!
How you know it? Based on the Living Cost!
Why the living cost is different in one year toother years? Because the Inflation!
www.rayebrahm.com
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What is Inflation?
It is a rise of the general price level of goods
and services in a certain period of time
If the price is increasing, you just can buyfewer goods
In other words, inflation shows the erosions
of Purchasing Power of Money
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How to Measure CPI?
yearbaseinservicesandgoodsofbasketyearBaseofCost
yearcurrentinservicesandgoodsofbasketyearBaseofCostCPI
Cost of Living CPI = 1050 / 850 = 1.31
2000 Spending Monthly Cost in 2000
Rent (2 bedroom apartment) $500
Hamburgers (60 at $2 each) 120
Movie tickets (10 at $6 each) 60
Sweaters (4 at $30) 120
Monthly expenditures $800
2005 Spending Monthly Cost in 2005
Rent (2 bedroom apartment) $630
Hamburgers (60 at $2.50 each) 150
Movie tickets (10 at $7 each) 70
Sweaters (4 at $50) 200
Monthly expenditures $1,050
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INTERMEZZO
WHAT IS BASKET? In economy, basket means a group of goods
and services.
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Is there any other way to measure
Inflation?
Yes! There are many other ways to measure
inflation. The key is that inflation is measured
by price index
Price Index is a measure of the average price
of a given class of goods or services relative to
the same goods and services in a base year.
The measurement of price index is: CPI,
Producer Price Index, Commodity Price Index,
and Core Price Index.
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Inflation Adjustment
CPI can be used to adjust economic data toeliminate the effects of inflation.
There are two ways to do inflation
adjustment: Deflating and Indexing Deflating is the process of adjusting the
nominal quantity to real quantity because of
inflation Indexing is the process of preventing the
purchasing power of nominal quantity from
being eroded by inflation
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Deflating ExampleReal Wages
Real wage is the purchasing power ofworker's nominal wages
The real wage for any given period is
calculated by dividing the nominal wage bythe CPI for that period
US production worker wages
CPI uses 1982 1984 as base year
Real wages were higher in 1970Year Average Wage
1970 $3.40
2004 $15.68
CPI
0.388
1.889
Real Average Wage
$3.40 / 0.388 = $8.76
$15.68 / 1.889 = $8.30
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Indexing ExampleAdjusting for Inflation
An indexed labor contract First year wage is $12 per hour
Real wages rise by 2% per year for next 2 years
Relevant price index is 1.00 in first year, 1.05 inthe second, and 1.10 in the third
Nominal wage is real wage times the price
indexYear Real Wage
1 $12.00
2 $12.24
3 $12.48
Price Index
1.00
1.05
1.10
Nominal Wage
$12.00
$12.85
$13.73
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Does CPI Measure TRUE
Inflation?
Quality Adjustment Bias CPI only measures the changes of Price, not the quality. Even though
the corn flake of today is probably much better than the 1981 corn
flake, the CPI only captures the price.
Substitution Bias Again, CPI does not measure the switching effect because of the price
changes of substitution goods
In 1981, Corn Flake and Star Honey is the same. But suddenly there
was frost in US and made the Corn Price increasing in double. Then,people changes to Star Honey and didnt consume Corn Flake, a switch
that doesnt make the standard of living worse. In other word, it
creates a bias in measuring the living cost.
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The Causes of Inflation
Demand-pull inflation caused by increases in aggregate demand due to increased private and
government spending, etc. Demand inflation is constructive to a faster rate of
economic growth since the excess demand and favourable market conditions
will stimulate investment and expansion.
Cost-push inflation / supply shock inflation caused by a drop in aggregate supply (potential output). This may be due to
natural disasters, or increased prices of inputs. For example, a sudden
decrease in the supply of oil, leading to increased oil prices, can cause cost-
push inflation. Producers for whom oil is a part of their costs could then passthis on to consumers in the form of increased prices.
Built-in inflation It involves workers trying to keep their wages up with prices (above
the rate of inflation), and firms passing these higher labor costs on totheir customers as higher prices, leading to a 'vicious circle'.
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Negative Effect of Inflation Cost-push inflation
High inflation can prompt employees to demand rapid wage increases,
to keep up with consumer prices. Wage growth will be set as afunction of inflationary expectations, which will be higher when
inflation is high. This can cause a wage spiral. In a sense, inflation
begets further inflationary expectations, which beget further inflation.
Hoarding People buy durable and/or non-perishable commodities and other
goods as stores of wealth, to avoid the losses expected from the
declining purchasing power of money, creating shortages of the
hoarded goods.
Hyperinflation If inflation gets totally out of control (in the upward direction), it can
grossly interfere with the normal workings of the economy, hurting its
ability to supply goods. Hyperinflation can lead to the abandonment of
the use of the country's currency, leading to the inefficiencies of
barter.
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Allocative efficiency A change in the supply or demand for a good will normally cause its
relative price to change, signaling to buyers and sellers that they
should re-allocate resources in response to the new marketconditions. But when prices are constantly changing due to inflation,
price changes due to genuine relative price signals are difficult to
distinguish from price changes due to general inflation, so agents are
slow to respond to them. The result is a loss of allocative efficiency.
Shoe leather cost High inflation increases the opportunity cost of holding cash balances
and can induce people to hold a greater portion of their assets in
interest paying accounts. However, since cash is still needed in order
to carry out transactions this means that more "trips to the bank" are
necessary in order to make withdrawals, proverbially wearing out the"shoe leather" with each trip.
Menu costs With high inflation, firms must change their prices often in order to
keep up with economy-wide changes. But often changing prices is
itself a costly activity whether explicitly, as with the need to print newmenus, or implicitly.
Negative Effect of Inflation
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Positive Effect of Inflation
Labor-market adjustments
Inflation would lower the real wage if nominal wages are kept constant,
Economists argue that some inflation is good for the economy, as it would
allow labor markets to reach equilibrium faster.
Room to maneuver The primary tools for controlling the money supply are the ability to set the
discount rate, the rate at which banks can borrow from the central bank, and
open market operations which are the central bank's interventions into the
bonds market with the aim of affecting the nominal interest rate. If an
economy finds itself in a recession with already low, or even zero, nominal
interest rates, then the bank cannot cut these rates further (since negativenominal interest rates are impossible) in order to stimulate the economy - this
situation is known as a liquidity trap. A moderate level of inflation tends to
ensure that nominal interest rates stay sufficiently above zero so that if the
need arises the bank can cut the nominal interest rate.
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Avoiding the Financial Market Inefficiency
Mundell-Tobin effect
Moderate inflation would induce savers to substitute lending for some
money holding as a means to finance future spending. That
substitution would cause market clearing real interest rates to fall. Thelower real rate of interest would induce more borrowing to finance
investment. In a similar vein, noted that such inflation would cause
businesses to substitute investment in physical capital (plant,
equipment, and inventories) for money balances in their asset
portfolios. That substitution would mean choosing the making ofinvestments with lower rates of real return. (The rates of return are
lower because the investments with higher rates of return were
already being made before). The two related effects are known as the
Mundell-Tobin Effect.
Positive Effect of Inflation
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Controlling Inflation
There many ways to control the inflation. There
are:
Monetary Policy
Fiscal Policy
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Monetary Policy Government uses monetary approach to stabilize the
economy by controlling the inflation.
How? By using monetary tools, which are usually
related to interest rate or money supply
Monetary Policy: Target Market Variable: Long Term Objective:
Inflation Targeting Interest rate on overnight debt A given rate of change in the CPI
Price Level Targeting Interest rate on overnight debt A specific CPI number
Monetary Aggregates The growth in money supply A given rate of change in the CPI
Fixed Exchange Rate The spot price of the currency The spot price of the currency
Gold Standard The spot price of goldLow inflation as measured by the
gold price
Mixed Policy Usually interest rates Usually unemployment + CPI change
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Fiscal Policy
Government uses the Government
Expenditure or Revenue to influence the
economy
The methods are:
Tax
Seigniorage (Printing Money)
Borrowing Money
National Reserve Consumption
Selling of Assets (Land for example)