Module Inflation: An Overview 14 Module Inflation: An Overview KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

Reading Modules 14-15 – Inflation GDP is really a P*Q measure. You take the quantity of output (Q) and multiply by the price of the output (P). If prices rise, and Q stays the same, GDP will increase. This is misleading because the true size of the economy hasn’t increased, it has just gotten more expensive. To adjust for changing prices, we create Real GDP, which calculates the value of current production, but using prices from a fixed point in time. This fixed point in time is called the base year. Valuing 2009 production at 2008 prices creates real GDP in 2009 and allows us to compare it back to 2008 (the base year). This is also known as constant-dollar GDP.   Note: The instructor can now show the real GDP numbers for the same years from the table of nominal GDP numbers. Explain which year is the base year. Then show how the real size of the economy has changed from the 1980s to recent years.

What you will learn in this Module: What is inflation How it is measured How it affects the economy and specific groups within the economy.

Definitions Inflation is the increase in the overall price level. Deflation is the decrease in the overall price level. Price level = overall prices, not just a few items. When we talk about inflation, we are usually talking about rising prices for things that we all consume.   This 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. Note: If the instructor is pressed for time, it is my advice to not dwell on the statistical weaknesses of the CPI. I don’t believe it is likely testable on the AP exam, and the CPI has recently been improved to address most of the criticisms.

Short History of Inflation Price Indexes and the Aggregate Price Level Aggregate Price Level Note: it is a good idea to use an example similar to the one below to demonstrate how economists construct a price index for the purpose of tracking inflation.   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, are they rising quickly or slowly? We first need to 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. Short History of Inflation

Market Baskets and Price Indexes Consumers buy all sorts of different goods and services in a typical year. This typical basket of goods and services purchased is called the market basket. Market Basket

Activity – Price Your Basket Work thru example 14.42.4 Try Cheese, Skates and Aspirin When we talk about inflation, we are usually talking about rising prices for things that we all consume.   This 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. Note: If the instructor is pressed for time, it is my advice to not dwell on the statistical weaknesses of the CPI. I don’t believe it is likely testable on the AP exam, and the CPI has recently been improved to address most of the criticisms.

Market Baskets and Price Indexes Price Index in given year = Cost of market basket in a given year Cost of market basket in base year X 100 In general, a price index is computed by constructing this ratio:   Price Index in year t = 100*(Cost of the market basket in year t)/(Cost of the market basket in the base year) The base year is the 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. Use 2008 as the base year. DPI2008 = 100*($3900)/($3900) = 100 NOTE: any price index is always 100 in the base year. DPI2009 = 100*($4600/($3900) = 117.9 Calculating the inflation rate is just calculating the percentage change between any two values of the price index. Inflation from 2009 to 2008 = 100*(DPI2009 – DPI2008)/(DPI2008) = 100*(117.9-100/100) = 17.9% Inflation Rate = Price index in year 2 - Price index in year 1 Price index in year 1 X 100 What is inflation rate in 2014? 2012 2013 2014 100 110 130

The Consumer Price Index Consumer Price Index (CPI) What is it? Basket for a urban family of four. 80,000 goods and services When we talk about inflation, we are usually talking about rising prices for things that we all consume.   This 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. Note: If the instructor is pressed for time, it is my advice to not dwell on the statistical weaknesses of the CPI. I don’t believe it is likely testable on the AP exam, and the CPI has recently been improved to address most of the criticisms.

Other Price Measures Producer Price Index (PPI) - typical basket of goods and services—containing raw commodities such as steel, electricity, coal, and so on—purchased by producers. GDP deflator- 100 times the ratio of nominal GDP for that year to real GDP for that year expressed in prices of a selected base year. Coincidence of inflation measures As we showed with the DPI, a price index can be created for anything. Two are commonly used, with the CPI, to gauge changes in the aggregate price level.   The 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. The GDP deflator is technically not a price index, but it is used in the same way. For a given year the GDP deflator is equal to 100 times the ratio of nominal GDP for that year to real GDP for that year expressed in prices of a selected base year. 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%.

Figure 15.3 The CPI, the PPI, and the GDP Deflator Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

The Level of Prices Doesn’t Matter... Misconception It’s all relative Real Wage Real Income NOTE: Economists often toss around little phrases like “there’s no such thing as a free lunch”. Another phrase that is pertinent to this material is “only relative prices matter”. Create an example to illustrate this point.   Example: A student in the class has income of $20 per week to spend on gasoline ($2 per gallon) or venti  mochachino café lattes (at $4 per cup). We can see her purchasing possibilities in a table below. The most gas she could buy: The most lattes she could buy: To buy one more latte, she must give up: 10 gallons of gas 5 cups 2 gallons of gas One gallon of gas uses up 10% of her income. One cup of mochachino uses up 20% of her income. What would happen if her income doubled and so did the price of gasoline and the price of a café latte? Absolutely nothing! The prices of gas and café lattes, relative to her income is unchanged. The price of a cup of latte, relative to the price of a gallon of gas is unchanged. Nothing REAL has changed. Short History of Inflation

...But the Rate of Change of Prices Does Inflation Rate Inflation rate = “Real” interest rate = nominal rate – inflation rate, Hyperinflation (think Evita) No specific level. +25-50% Monetary causes. Price level in year 2 - Price level in year 1 Price level in year 1 X 100 Note: refer back to the previous example.   But what if the price of gas and café lattes doubles, while the student’s income stays the same? The most gas she could buy: The most lattes she could buy: To buy one more latte, she must give up: 5 gallons of gas 2.5 cups 2 gallons of gas One gallon of gas uses up 20% of her income. One cup of mochachino uses up 40% of her income. The price of a cup of latte, relative to the price of a gallon of gas is unchanged. But! Relative to her income, these items are now twice as costly. Obviously, this price inflation has radically decreased her purchasing power because her income did not rise to keep pace. In a very REAL sense, she is worse off. What would she do? What would the sellers of gas and café lattes do? Inflation creates costs for both groups of people. 1. 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 become worthless) and into something else that might hold value better. All of 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 costs of transactions caused by inflation. 2. Menu Costs 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 a paid employee go outside and change the sign. But a restaurant or coffee shop might need to literally print new menus and this is pretty costly. And what if this price inflation persists? Maybe prices are rising 10% every few months and menus neeed to be constantly changed as a result. These are costs incurred by the sellers just to update the posted prices. 3. Unit-of-Account Costs The costs arising from the way inflation makes money a less reliable unit of measurement. 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.

“Costs” of Inflation Shoe-Leather Costs: time spent looking for substitutes. Menu Costs: Change menus or signs Unit-of-Account Costs: costs arising from the way inflation makes money a less reliable unit of measurement. Note: Stress to students that inflation can often just redistribute money from one person to another. A good example of this can be seen when we look at borrowers and lenders.   Suppose you lend a buddy $100 and he promises you pay you back in a year. There are two reasons why it makes sense to charge him interest. 1. 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. 2. 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: Nominal interest rate = real interest rate + expected inflation 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 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 Unexpected inflation activity Answer questions and develop rules for winners and losers. Note: Stress to students that inflation can often just redistribute money from one person to another. A good example of this can be seen when we look at borrowers and lenders.   Suppose you lend a buddy $100 and he promises you pay you back in a year. There are two reasons why it makes sense to charge him interest. 1. 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. 2. 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: Nominal interest rate = real interest rate + expected inflation 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 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.

Deflation and Disinflation Disinflation = reducing inflation Deflation = falling price level Who are winners / losers from deflation ? Note: the instructor can use this section to briefly preview future discussions on monetary and fiscal policy, or can skip over it for now.   A quick review of terms: 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. Disinflation would be necessary if inflation was 10% and policy makers acted to bring it down to 3%. 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. Policymakers 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.

Summary Change in price level Measured by basket (CPI, PPI, GDP deflator) Unexpected change in rate is biggest threat. Inflation penalizes savers. Risk hyperinflation or stagflation. Deflation penalizes borrowers. Downward spiral. Note: Stress to students that inflation can often just redistribute money from one person to another. A good example of this can be seen when we look at borrowers and lenders.   Suppose you lend a buddy $100 and he promises you pay you back in a year. There are two reasons why it makes sense to charge him interest. 1. 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. 2. 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: Nominal interest rate = real interest rate + expected inflation 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 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.