© The McGraw-Hill Companies, 2008 Chapter 26 Inflation, expectations and credibility David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill Education, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

© The McGraw-Hill Companies, 2008 Inflation is... Inflation is a rise in the price level. Pure inflation is when goods and input prices rise at the same rate. One of the first acts of the Labour government in 1997 was to make the Bank of England independent with a mandate to achieve low inflation. The rental contracts and the civil servant wages are indexed to inflation in Turkey.

© The McGraw-Hill Companies, 2008 Some questions about inflation What are the causes of inflation? What are the effects and hence costs of inflation? What can be done about it? These are the questions we seek to answer in what follows.

© The McGraw-Hill Companies, 2008 Calculating Inflation We use price indices to measure inflation. Consumer Price Index (CPI) Producer Price Index (PPI) Gross Domestic Product deflator (GDP deflator)

© The McGraw-Hill Companies, 2008 Inflation in the UK, Source: Economic Trends Annual Supplement, Labour Market Trends

© The McGraw-Hill Companies, 2008 Inflation in Turkey Source: TEPAV

© The McGraw-Hill Companies, 2008 THE CONSUMER PRICE INDEX The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. The Bureau of Labor Statistics reports the CPI each month. It is used to monitor changes in the cost of living over time.

© The McGraw-Hill Companies, 2008 THE CONSUMER PRICE INDEX When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

© The McGraw-Hill Companies, 2008 How the Consumer Price Index Is Calculated Fix the Basket: Determine what prices are most important to the typical consumer. –The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. –The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services.

© The McGraw-Hill Companies, 2008 How the Consumer Price Index Is Calculated Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.

© The McGraw-Hill Companies, 2008 How the Consumer Price Index Is Calculated Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.

© The McGraw-Hill Companies, 2008 How the Consumer Price Index Is Calculated Choose a Base Year and Compute the Index:Choose a Base Year and Compute the Index: –Designate one year as the base year, making it the benchmark against which other years are compared. –Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

© The McGraw-Hill Companies, 2008 How the Consumer Price Index Is Calculated Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.

© The McGraw-Hill Companies, 2008 How the Consumer Price Index Is Calculated The Inflation Rate –The inflation rate is calculated as follows:

© The McGraw-Hill Companies, 2008 Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

© The McGraw-Hill Companies, 2008 Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

© The McGraw-Hill Companies, 2008 Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

© The McGraw-Hill Companies, 2008 Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

© The McGraw-Hill Companies, 2008 Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

© The McGraw-Hill Companies, CPI 851 goods and services included in 12 main categories. CPI-Turkey 2012 (%) 1.Food and nonalcoholic beverages 26,22 2.Alcoholic beverages and tobacco 5,21 3.Clothing and shoes 6,87 4.Housing 16,44 5.House appliances 7,45 6.Health 2,29 7.Education 2,18 8.Communication 4,6 9.Transportation 16,73 10.Recreation and culture 2,98 11.Restaurants and Hotels 5,63 12.Other 3,4 TOTAL 100 Source: TÜİK

© The McGraw-Hill Companies, 2008 The GDP Deflator The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.

© The McGraw-Hill Companies, 2008 The GDP Deflator The GDP deflator is calculated as follows:

© The McGraw-Hill Companies, 2008 The Causes of Inflation Demand-Pull Inflation: Increases when the demand increases. Example: Good economic conditions cause demand to increase. Cost-Push Inflation: The increase in costs can push the prices up.

© The McGraw-Hill Companies, 2008 Hyperinflation Hyperinflations are periods when inflation rates are very large During such periods there tends to be a ‘flight from cash’, i.e. people hold as little cash as possible –e.g. Germany in , Hungary , Brazil in the late 1980s. Large government budget deficits help to explain such periods –persistent inflation must be accompanied by continuing money supply growth

© The McGraw-Hill Companies, 2008 German Hyperinflation, (January 1922=1) DateMoney Supply PricesReal MoneyMonthly inflation(%) Jan Jan July Sept Oct

© The McGraw-Hill Companies, 2008 Seigniorage and Inflation Tax Seigniorage: The real income that the government gets by printing money Inflation Tax: The decrease in real national debt because of the increase in inflation.

© The McGraw-Hill Companies, 2008 Inflation illusion People have inflation illusion when they confuse nominal and real changes. Welfare depends upon real variables, not nominal variables. If all nominal variables (prices and incomes) increase at the same rate, real income does not change.

© The McGraw-Hill Companies, 2008 The costs of inflation (1) Fully anticipated inflation: Institutions adapt to known inflation: –nominal interest rates –tax rates –transfer payments there is no inflation illusion Some costs remain: –shoe-leather people economise on money holdings –menu costs firms need to alter price lists etc.

© The McGraw-Hill Companies, 2008 The costs of inflation (2) Even if inflation is fully anticipated, the economy may not fully adapt –interest rates may not fully reflect inflation –taxes may become distorted fiscal drag may have unintended effects on tax liabilities capital and profits taxes may be distorted

© The McGraw-Hill Companies, 2008 The costs of unanticipated inflation Unintended redistribution of income –from lenders to borrowers –from private to public sector –from old to young Uncertainty –firms find planning more difficult under inflation, which may discourage investment This has been seen as the most important cost of inflation

© The McGraw-Hill Companies, 2008 Defeating inflation Monetary policy: Inflation will be lower if the rate of money growth is lower. Fiscal Policy: If the government spends less, then it needs to print less money to cover its debt. Price policy: The government tries to control the prices. (e.g. Limit the raise in rental contracts).