7 Inflation LO7-1 LO7-2 LO7-3 LO7-4 How inflation is measured. Why inflation is a socioeconomic problem. The meaning of “price stability.” The broad causes of inflation.

Inflation We recognize inflation as the second of the two major macroeconomic problems we can face. The core problems: What kind of price increases are referred to as “inflation”? Who is hurt and who is helped by inflation? What is an appropriate goal for “price stability”? Sometimes it is necessary to distinguish the increase in the price of a few goods from an increase in inflation.

Runaway Inflation In 1923, prices in Germany more than doubled every day. No one saved, invested, or made long-run plans. Production came to a halt; unemployment increased by a factor of 10. The economy collapsed. Ultimately Hitler came to power. Zimbabwe experienced a similar economic disaster between 2007 and 2010. In 1923 in Germany, the purchasing power of money disintegrated. Workers demanded to be paid twice a day. They would run out and spend it all quickly before its value decreased further. A bundle of paper money was better to burn in a wood stove than the piece of wood it could buy.

Exercise The current price of a good is $1. If its price doubles every day, what will its price be in 10 days? 20 days? In 10 days, $512. In 20 days, $524,288. This exercise is designed to bring home the idea of hyperinflation. The answer to the first one is found by doubling 1 2 4 8 16 32 64 128 256 512. Then continue for the second one.

What Is Inflation? Inflation: an increase in the average level of prices, not a change in any specific price of a good. The prices of specific basket of goods are collected and computed into an average price level for that basket in a year. A rise in that average price level is inflation. A decrease in that average price level is deflation. You might wish to add disinflation, the situation where inflation is still occurring but at a slower pace than before. The basket of goods is a list of typical things an urban family would buy. It is assumed to not change from year to year. However, some modifications are made to keep it up to date. 5

Relative Prices The market mechanism causes the prices of individual goods and services to rise or fall – an essential market function. Relative price: the price of one good compared to the price of other goods. Buyers switch from one good to another when their relative prices diverge. Inflation is a rise in the average price of all goods. It is not a market function. It might be useful to ask students to identify some goods whose prices have dropped in the past year and some that have risen. These movements can be shown to be market driven – that is, the result of changes in supply and demand.

Effects of Inflation Some prices rise and some fall. If prices rise, you must reallocate your purchasing power to ensure that you get the most satisfaction per dollar spent. You might reduce buying goods with higher prices and increase buying goods with lower prices. This can be seen by the difference between nominal income and real income. It might be time to stress the difference between nominal and real data. Nominal means as measured (inflation included). Real means after the effects of inflation have been removed.

Effects of Inflation Nominal income: the amount of money income received in a given time period, measured in current dollars. Real income: income in constant dollars; nominal income adjusted for inflation. You may get a raise (nominal income increases) – but if it does not rise as fast as inflation, your purchasing power decreases (real income falls). Nominal vs. real will come up several times during this course. 8

Redistributive Effects of Inflation There is a redistribution of income and wealth due to inflation. Inflation makes some people worse off and others better off. There are price effects, income effects, and wealth effects. Introduces the next set of slides.

Redistribution of Income and Wealth by Inflation Price effects. Those who buy products that are increasing in price the fastest end up worse off. Those who sell products that are increasing in price the fastest end up better off. Those who buy products that are increasing in price the slowest end up better off. Those who sell products that are increasing in price the slowest end up worse off. We look at goods with different price changes here. 10

Redistribution of Income and Wealth by Inflation Income effects. People with nominal incomes rising more slowly than inflation end up worse off. People with nominal incomes rising faster than inflation end up better off. We look at people with different income changes. Someone on a fixed income suffers the worst. 11

Redistribution of Income and Wealth by Inflation Wealth effects. Those who own assets that are declining in real value end up worse off. Those who own assets that are increasing in real value end up better off. Many assets, like real estate and gold, increase their nominal value right along with inflation. A fixed payout bond does not. 12

Money Illusion Money illusion: using nominal dollars rather than real dollars to gauge changes in one’s income or wealth. Exercise: In the “good old days” a movie ticket was 50 cents and the minimum wage was $1.00. Compare the purchasing power of the minimum wage today to the “good old days.” You could buy two movie tickets with one hour’s work before, but not now. How many hours you need to work depends on what the price of a movie ticket is in your area. If it is $10, you need to work 1.38 hours. If it is $7.50, you need to work just over one hour. House values skyrocketed (in nominal dollars) in the 1970s. Owners felt really wealthy – until they sold and turned the house into purchasing power, which had not increased (real dollars).

Exercise in Money Illusion The inflation rate in 1980 was 13.5%. In 1979 your income was $10,000. In 1980 your income was $11,000. Did your purchasing power increase? Decrease? Stay the same? Decrease! Your income went up 10% while prices went up 13.5%. Students might be surprised at the very high 13.5% inflation rate in 1980. Inflation was wrung out of the system in the Fed-induced recession of 1982 and has stayed low (2 to 5%) since.

Macro Consequences of Inflation Uncertainty – not knowing the prices of goods in the future makes purchasing and production decision making much more difficult. Speculation – decisions will shift from standard economic activity to betting on the future prices of goods. Bracket creep – in a progressive tax system, when nominal incomes rise, the taxpayer gets pushed into a higher tax bracket. Reluctance to decide, committing time and resources to speculative or inflation-protected activities, and paying more tax with no increase in purchasing power all contribute to a much less effective or productive economy.

Hyperinflation Hyperinflation: inflation rate in excess of 200 percent, lasting at least 1 year. Spending accelerates and production declines. This has occurred (Germany and other European countries post-WW1, and Zimbabwe recently).

Deflation Deflation: a general decrease in average prices. This has redistribution effects that are the opposite of those for inflation. This has macro consequences also. Sellers are reluctant to stock inventory. Buyers are reluctant to buy now. Businesses are reluctant to borrow funds or invest. Incomes fall, and asset values decrease. The opposite of inflation. It is not so good, either. You could spend some time stressing the consequences.

Measuring Inflation Measuring inflation serves two purposes. Gauging the average rate of inflation. Identifying its principal victims. Intro for the next set of slides.

Consumer Price Index (CPI) Consumer price index (CPI): a measure (index) of the average price of consumer goods and services. Used to calculate the inflation rate. Inflation rate: the annual percentage rate of increase in the average price level. You might wish to identify other price indexes here. Use the percentage change formula to get the inflation rate: Inflation rate = (CPI year 2 – CPI year 1) X 100 /CPI year 1 19

Creating a Price Index Select a “market basket” of goods: a standardized list of goods and services customers usually buy. Select a base year: the reference year whose dollar value will be used. Set the price index in the base year always equal to 100. Measure the prices for the basket of goods in both the current year and in the base year. It is a good idea to walk through this process step by step. The government measures the collective (nominal) price of the basket each year.

Computing a Price Index Basket price in the base year = $12,000. Basket price in the current year = $13,200. Compute the price index (CPI) for the current year: X/100 = $13,200/$12,000 X = (13,200 x 100)/12,000 = 110 CPI in the current year is 110. A CPI of 110 indicates that prices in the current year are 10% higher than prices in the base year. This is a handy exercise to introduce the ratio equation. Price index in current year Basket price in current year Price index base year = Basket price in base year

Exercise In 2006, CPI was about 200. In 1983, the base year, CPI was 100. These two CPI figures tell us that prices doubled between 1983 and 2006. In 1974 CPI was about 50. So prices doubled between 1974 and 1983. If a good was priced at $10 in 1974, what would you expect the price to be in 2006? This is designed to give students a feel for how prices in general have changed over the last 30 years or so. Price in 2006 = $10 X 200/50 = $40.

Other Measures of Inflation Core inflation: changes in CPI, excluding food and energy prices, which are volatile. Producer price index (PPI): changes in the average prices at intermediate steps of production. GDP deflator: changes in prices of all goods and services included in GDP. Used to adjust nominal GDP to real GDP. The Fed likes the core inflation number because it is more stable than the CPI. Food and energy prices are more volatile and, when included (as they are in the CPI), it doesn’t look as good. The PPI is essentially a wholesale price index. Some use it as an indicator for the CPI’s change in the following month.

Computing Inflation Rate from CPI CPI in 2006 was 201.6. CPI in 2005 was 195.3. Compute the inflation rate for 2006: Inflation rate = (201.6-195.3)x100/195.3 = 3.23% CPI year 2 – CPI year 1 Inflation rate = X 100 CPI year 1 A straightforward use of the percentage change formula.

The Goal: Price Stability Price stability: the absence of significant changes in the average price level. Officially defined as a rate of inflation of less than 3 percent. Established by Full Employment and Balanced Growth Act of 1978. This measure passed by Congress provides a target or goal for macro policy. 25

The Goal: Price Stability Measurement concerns: We are seeking price stability at the lowest rate of unemployment. From year to year, there are quality improvements in the basket of goods. New products change the content of the basket of goods we buy. No macro measurement is precise. The policy of 3 percent may not coincide with the unemployment goal. The basket of goods used to compare prices may change radically.

The Historical Record highest The increase in inflation in the second half of the 1960s resulted from rapid increases in government spending as two “wars” were accelerated: in Vietnam and on poverty. The inflation spikes in the 1970s were caused by the rapid increase in oil prices. Since 1984 the inflation rate has hovered in the 2 to 5 percent range. lowest The highest and lowest annual inflation rates since WW2 are identified.

Causes of Inflation Demand-pull inflation: results from excessive pressure to buy on the demand side of the economy. A booming economy creates shortages. Too much money pumped into the economy by the Federal Reserve. Cost-push inflation: results from higher production costs putting pressure on suppliers to push up prices. The late 1960s inflation was demand-pull. The two episodes in the 1970s were cost-push. 28

Protective Mechanisms Cost of living allowances (COLA): nominal incomes are indexed to automatically rise at the same rate as inflation. Adjustable-rate mortgage (ARM): interest rate on a mortgage rises along with inflation so that lenders do not lose money. COLAs are supposed to help those on fixed incomes, such as Social Security recipients. ARMs are designed to protect the lender, not the mortgagee.

The Real Interest Rate Real interest rate: the nominal interest rate minus the anticipated inflation rate. The borrower pays the nominal rate. The inflation-adjusted (real) rate of interest: Protects the lenders. Hurts the borrowers. Borrowers will pay back loan using more lower- valued dollars, but lenders receive the same purchasing power. A lender will add anticipated inflation to the interest rate to protect itself. Example: Lend $100 to be paid back in 1 year at 3% interest. When paid back, the lender gets $103. If inflation of 5% occurs during that year, the purchasing power received is $103-$5 = $98. To protect itself, the lender, expecting 5% inflation, charges 8% interest, so it gets $108 nominal dollars. In real terms, the lender gets $108 - $5 = $103 in purchasing power. Real interest rate = Nominal interest rate – Anticipated rate of inflation 30

Application: The Economy Tomorrow The virtues of inflation. A little inflation might be a good thing. The challenge for tomorrow is to find the optimal rate of inflation. High enough to encourage more spending. Low enough not to raise the specter of an inflationary flashpoint. Inflationary flashpoint: the rate of output at which inflationary pressures intensify. As the economy approaches maximum capacity to produce, it becomes more costly to hire people and to acquire resources. Costs rise, and prices are pushed up to cover those costs. At some point prices begin to accelerate upward. That’s the inflationary flashpoint.

Revisiting the Learning Objectives LO7-1 Know how inflation is measured Inflation is measured by changes in a price index such as the consumer price index (CPI). Here begins the summary of the chapter.

Revisiting the Learning Objectives LO7-2 Know why inflation is a socioeconomic problem Inflation redistributes income by altering relative prices, income, and wealth. Some people actually gain from inflation, whereas others suffer a loss of real income or wealth. Inflation creates uncertainty and speculation and detracts from productive activity. COLAs and ARMs help protect some people from inflation.

Revisiting the Learning Objectives LO7-3 Know the meaning of “price stability” The U.S. goal is an inflation rate of less than 3 percent per year. This goal must be integrated with a potentially conflicting goal of full employment.

Revisiting the Learning Objectives LO7-4 Know the broad causes of inflation Inflation is caused either by excessive demand (“demand-pull” inflation) or by structural changes in supply (“cost-push” inflation).

Looking Ahead: Chapter 8 The Business Cycle After learning about this chapter, you should know The major macro outcomes and their determinants. Why the debate over macro stability is important. The nature of aggregate demand (AD) and aggregate supply (AS). How changes in AD and AS affect macro outcomes.