Part 1: An Overview Part 2: Measures and Calculations Inflation Part 1: An Overview Part 2: Measures and Calculations

Part 1: Inflation—An Overview

The level of prices doesn’t matter… …but the rate of change of price does If wages and price level increase at the same time, then the real value of your money has stayed the same! Nominal wage: dollar amount of any given wage paid Real wage: the wage rate divided by the price level INFLATION RATE (overall percentage increase of prices) makes people poorer (because it outpaces wage increases). Inflation rate= Price level in Year 2 – Price level in base year X 100 Price level in base year Economists often toss around little phrases like “there is no such thing as a free lunch.” Another phrase that is pertinent to this material is “only relative prices matter.” If you cut a worker’s wage to half its previous value, but also cut all prices one half of their previous level, the worker’s real wage doesn’t change. The inflation rate is based on a price index, which measures the changes in price of a particular selection of goods.

Three Main Economic Costs High rates of inflation impose significant economic cost Shoe-Leather Costs: increased costs of transactions caused by inflation Ex. German Hyperinflation of 1921-1923 Menu Costs: the real cost of changing list prices Ex. Brazil Supermarket workers Unit-of-Account Costs: costs arising from the way inflation makes money a less reliable unit of measurement All of these costs are felt more severely when the inflation rate is severe Shoe-leather Costs We might expect the student in the example above to be pretty upset about the doubling prices of two goods she really enjoys consuming. What would she do? She might spend a lot of time looking for less expensive substitutes. She might drive around town looking for a coffee shop with prices that haven’t doubled. She might decide that she needs to get her $20 of income out of her wallet (where it is quickly becoming worthless) and into something else that might hold value better. All this extra time and effort comes at a cost to the consumer. Shoe leather cost is an allusion to the wear and tear caused by the extra running around that takes place when people are trying to avoid holding money. OR increased cost of transactions caused by inflation. A historical example of this would be the German hyperinflation of 1921-23. Merchants employed runners to take their cash to the bank many times a day to convert it into something that would hold its value, such as a stable foreign currency. This used up valuable resources—the time and labor of runners—that could have been used productively elsewhere. Menu Cost What would the sellers of gas and café lattes need to do? Change their menus or signs. This might not be very expensive for the gas station, they would just need to have the paid employee go outside and change the sign. But the restaurant or coffee shop might need to literally print new menus and this is pretty costly. And what if the price inflation persists? Maybe prices are rising 10% every few months and menus need to be constantly changed as a result. A historical example: During Brazilian inflation in the 1990s, supermarket workers reportedly spent half their time replacing old price stickers with new ones. Unit-of-Account Cost These costs can emerge from the way in which we tax certain assets. Suppose you owned a house that was worth $100,000 and your state levied a property tax of 1% on that house. Each year you expected to pay $1000 in property taxes. Over the course of a short period of time, maybe two years, real estate prices go way, WAY up. Now your house, on paper, is worth $200,000 but it’s the very same house. It’s not a better house. Your state reassesses property taxes and now claims that you owe $2000 every year. Assuming your income didn’t double as your house was doubling in value, you are worse off because the property tax system didn’t take into account that it was inflation that caused your house to increase in value.

Winners and Losers from Inflation Economic transactions, such as loans, often involve contracts that extend over a period of time and these contracts are normally specified in nominal term. Nominal interest rate – the interest rate as stated in the contract (i.e., a car loan with 7% interest) Real interest rate – interest rate after adjustment for inflation Nominal interest rate – Inflation rate = Real interest rate Most contracts lock people into paying a fixed interest rate, regardless of future trends in purchasing power. The interest rate is the extra percentage that borrowers must pay to the lender for the use of the money. Suppose you lend a buddy $100 and he promises to pay you back in a year. There are two reasons why it makes sense to charge him interest. By providing this service to your friend, you won’t have that $100 over the next year to buy things that you enjoy. Your service, and delayed consumption, should entitle you to compensation. When he pays you back, inflation will have eroded the purchasing power of the original $100. Knowing this, you should be entitled to enough interest so that inflation doesn’t hurt your purchasing power. So the interest rate should have two parts: the part to compensate you for the service you are providing, and the part that offsets the inflation that is expected to occur. Economists call the sum of these two parts the nominal interest rate. Suppose you and your friend agree that inflation next year will be 5% and you agree that your lending services are worth another 3%. You charge your friend: 8% = 3% + 5% After a year’s time, three scenarios could have happened. Scenario 1: you expected 5% inflation and you experienced exactly 5% inflation. The purchasing power of the $100 you lent was unchanged when your friend paid you back exactly 5% inflation. The purchasing power of the $100 you lent was unchanged when your friend paid you back exactly enough to compensate for the inflation. Scenario 2: you expected 5% inflation and you experienced only 1% inflation. Your purchasing power has actually increased because your friend paid you back more than enough to compensate for the inflation. Note: When actual inflation is below expected inflation, the lender (in this case you) gains and the borrower loses. Scenario 3: you expected 5% inflation and you experienced 8% inflation. Your purchasing power has actually decreased because your friend paid you back less than enough to compensate for the inflation. Note: When actual inflation is above expected inflation, the lender (in this case you) loses and the borrower gains.

Winners and Losers from Inflation If the inflation rate is higher than expected, borrowers win! The money they pay back has lower real value (less purchasing power) than the money they borrowed. For this reason, long-term contracts are rare in regions with high inflation. If lenders attempt to battle this by setting higher nominal interest rates, borrowers lose! If the inflation rate is lower, lenders win! The money they receive back from the borrower is worth more than the money they lent. Inflation reduces the real interest rate of savings. Money in the bank/invested is earning interest, but inflation cuts into the value of the money saved and earned in interest (“real interest rate”), so savers lose!

Inflationary Spirals Inflation reduces incentive to save, so consumers spend This cause demand-pull inflation Higher prices cause workers to demand higher wages, which increases cost of production This increases inflation If there is inflation in an economy, firms and households will prefer to spend their money now rather than save. High unanticipated inflation reduces the incentive to save, since it lowers the real interest rate. More spending in the economy contributes to more inflation. Over time, workers will begin t demand higher wages, which further contributes to inflation. An inflationary spiral is when higher prices lead to more spending, which leads to even higher prices and demands among workers for higher wages, contributing to even more inflation. (Demand-pull inflation occurs when aggregate demand is greater than aggregate supply. People have money to spend and there simply isn’t enough for consumers to buy. )

Disinflation Recessions/depressions bring down inflation. Government actions to deflate (bring down the inflation rate) can create a decrease in GDP, so the government responds early (2% or so) in order to minimize the impact of these policies. Disinflation is NOT deflation. Deflation is a decrease in price levels. Disinflation is a decrease in the inflation rate. To read more on the distinction between them: http://www.nbcnews.com/id/7149156/ns/business- answer_desk/#.UR58QR2ceSo Inflation is the overall rise in prices. Deflation is the overall decline in prices. Disinflation is the process of reducing rapid inflation to a smaller, less damaging, amount of inflation. What is problematic about disinflation? Often a high rate of inflation is caused by “too much” money being circulated and spent in the economy. The obvious way to reduce the inflation is to act in ways to reduce the amount of money being circulated and spent. This can be painful because this will often reduce demand for goods and services and put some workers out of work. Most central banks and governments target inflation at around two to three percent. Anything less than that may cause the fear of deflation. Anything greater than that may lead producers and consumers to act in ways that increase the odds of the inflationary spiral shown above. Policy makers in the US have, since the 1980s, tried to maintain a very low and stable amount of inflation so that painful corrections like this are unnecessary.

Cost-Push Inflation Cost-push inflation occurs when certain inputs that are universally important to business operations rise in price (i.e., oil). For all businesses, this creates a situation in which the cost of producing has gone up – so many will choose to produce less. The result of this leftward shift of the supply curve is higher prices for consumers and a rise in the aggregate price level.

Demand-Pull Inflation Demand-pull inflation occurs when aggregate demand is greater than aggregate supply. People have money to spend and there simply isn’t enough for consumers to buy. An example of this would be the market for consumer goods during World War II. More people had a steady paycheck, but so many factories had been converted to wartime production that luxury goods were in short supply. When the war ended, this was one of the causes of rapid inflation.

Part 2: The Measurement and Calculations of Inflation

Price Indexes and the Aggregate Price Level Aggregate Price Level: measures the overall level of prices in the economy. To measure the average price changes for consumer goods and services, economists track changes in the cost of a typical consumer’s consumption bundle Market Basket: a hypothetical set of consumer purchases of goods and services There is a need to have a single number summarizing what is happening to consumer prices. Just as Macroeconomists find it useful to have a single number to represent the overall level of output, they also find it useful to have a single number to represent the overall level of prices: the Aggregate Price Level. With millions of products being purchased throughout the day and across America, how can we tell if overall prices are rising or falling? And if they are rising quickly or slowly? We need to first figure out what Americans are buying in their “market basket,” and then we determine the prices of those goods, and then compile this information into one statistic: A Price Index. Market baskets include food, clothing, transportation, and housing costs.

What goes into the US Market Basket?

Market Baskets and Price Indexes Economists track changes in the cost of buying a given market basket. Working with a market basket and a base year, we obtain a price index, a measure of the overall price level. Price Index: measures the cost of purchasing a given market basket in a given year. The index value is normalized so that it is equal to 100 in the selected base year. A Price index is a weighted average of prices. It tracks changes in the prices of a selection of goods produced in a nation from one time to another. When price rises, the index number increases, when prices fall, the index number decreases.

Trend of CPI since 1913

Formulas Price index = Cost of basket for that year X 100 Cost of market basket in base year Price index for the base year is always 100 This is the method for calculating both Consumer Price Index and Producer Price Index Inflation rate = PI in Year 2 – PI in Year 1 X 100 PI in Year 1 The base year is a benchmark year. All other years, past and future, are compared to the base year to see if the market basket was more or less expensive than it was in that year.

Consumer Price Index Consumer Price Index (CPI): measures the cost of the market basket of a typical urban American family CPI is used to accomplish two things: Simplify the way we notice the changes in prices Measure inflation rates When we talk about inflation, we are usually taking about rising prices for things that we all consume. The Consumer Price Index (CPI) is the most widely used measure of price inflation. It is computed every month and uses prices for a market basket of about 80,000 goods and services that a typical urban family of four consumes.

Other Price Indices Producer Price Index (PPI): measures the cost of a typical basket of goods and services—containing raw commodities such as steel, electricity, coal, and so on—purchased by producers GDP Deflator: to measure change in nominal vs real GDP; measures aggregate price level GDP Deflator is technically not a price index, but it is used in the same way. Since real GDP is currently expressed in 2000 dollars, the GDP deflator for 2000 is equal to 100. If nominal GDP were to increase by 5%, but real GDP does not change, the GDP deflator indicates that the aggregate price level increased by 5% and is 105.

All social security payments are adjusted each year to offset any increase in consumer prices over the previous year. The CPI is used to calculate the official estimate of the inflation rate used to adjust these payments yearly. Why is it important to index Social Security payments? So retirees can maintain the purchasing power. Indexing also extends to the private sector, where many private contracts, including some wage settlements, contain cost-of-living allowances (called COLAs) that adjust payments in proportion to changes in CPI.

Key Concepts (Part 1) Rapid inflation imposes costs on society in the form of: shoe-leather, menu, and unit-of-account costs Nominal interest rate = real interest rate + expected inflation Unexpectedly high rates on inflation benefit borrowers and hurt lenders. Unexpectedly low rates of inflation hurt borrowers and benefit lenders. If the inflation rate gets too high, the process of reducing (disinflation) can be painful for the economy

Key Concepts (Part 2) Inflation is a broad measure of how fast overall prices in the economy are rising. It’s important to understand that some goods may actually be falling in price, yet overall the economy is experiencing inflation. Creation of a price index allows economists to track changes to overall price of a market basket of items. Consumer inflation is the rate of increase in the CPI