Ch. 14: Inflation CIE3M1-01

What Is Inflation? Inflation is the increase in the prices of goods & services over a period of time Figure 14.1 pg. 290  comments?

How To Increase Your Income Without Doing More Work Cost of living allowances can be calculated in the following manner: (Costs Today / Past Costs) x 100% Gas = $1.25 / $0.50 x 100% = 250%

The Consumer Price Index CPI is a measure of the general changes in market prices of a selected group of goods & services ( 30,000) family Products are weighted according their proportion of total household expenditures with seven components (food 18.1, housing 36.3, clothing 8.7, transportation 18.3, health 4.2, recreation and education 8.8, tobacco / alcohol 5.6)

The Consumer Price Index Current base year 1986 given the number 100 whereas 1990 is 117, which means there was 17 % inflation (Current Year CPI / Base Year CPI x 100%) CPI, GDP and unemployment rate are the three most commonly used indicators of how the Canadian economy is doing

Inflation Since – 42 prices rose rapidly because of WW – 45 government controlled prices 1946 – 49 rapid price increase with end of war 1951 Korean War drove up prices

Inflation Since – 65 (low inflation of 1.5%) – 72 (higher inflation of 4.8%) – 82 (9% inflation) – 91 (< 5% inflation) (low inflation of < 2%) 6. Figure 14.5 pg. 293 #1 - 3

Inflation: The Winner & Losers Those who owe money (borrowers) win and those who are owed money (lenders) lose Inflation Race – expanding businesses, workers in powerful bargaining positions, and those who borrowed money are the winners Declining industries, workers in weak bargaining positions, and those on fixed incomes lose

Inflation: The Winner & Losers Inflation shifts benefits from creditors to debtors Hyperinflation or extremely high rates of inflation devastates an economy causing money to become worthless  people turn to barter destroying benefits specialization (higher quality, cheaper products and more leisure time)

Inflation: The Winner & Losers Deflation – decrease in the general level of prices over time (Depression 1930s) Pgs. 301 – 302 #1 - 2

What Causes Inflation? Full employment and no inflation is the ideal situation (i.e. full bucket) Bucket shows real output which is adjusted for inflation so that different year’s outputs can be compared

What Causes Inflation?

Demand-Pull Inflation If full employment exists (full bucket) and injections (X + I + G) > leakages M + S + T) then no more goods & services can be produced, only prices will rise (inflation, water spilling out of the bucket) Demand for goods & services > quantity of goods & services pulls up prices

Demand-Pull Inflation

Government Policies to Control Demand-Pull Inflation 1. Contractionary Fiscal Policy – G ↓ and T ↑  ↑ gov’t revenue for use during a recession 2. Contractionary / Tight Money Policy – Sell bonds, ↑ the bank rate and use moral suasion to discourage bank loans 3. Pg. 303 #3 - 5

Applying Fiscal & Monetary Policy To Demand-Pull Inflation 1. Unemployment – the biggest negative consequence of controlling inflation with contractionary policies 2. Delays in applying the policy – recognition lag; decision lag; implementation lag

Cost-Push / Sellers’ Inflation resource costs (e.g.,wages) increase  producers pass on the increased costs to consumers in the form of higher priced products The worst situation is the twin evils of inflation & unemployment existing at the same time  stagflation

Cost-Push / Sellers’ Inflation Stagflation - occurred in the 1970s when OPEC raised the price of oil which was an essential source of energy for the Canadian economy (e.g. bucket has holes on the side that leak)

Cost-Push / Sellers’ Inflation

Income vs. Expenditure Method Of Measuring The Economy C + I + G + (X – M) = GDP  Expenditure Method M (supply of money) x V (velocity of circulation of money) = GDP GDP = P x Q  MV = PQ Recession – M ↑ x V = P x Q ↑ Full Employment – M ↑ x V = P ↑ x Q

Income vs. Expenditure Method Of Measuring The Economy Monetary Rule – economist Milton Friedman believed that the money supply (M) should only be increased by the same amount as the increase in the amount of GDP which would solve the problem of inflation ∆% GDP ↑ = ∆% M ↑

Income vs. Expenditure Method Of Measuring The Economy Keynesians believe in using G and T to solve the problems of the economy Monetarists believe G and T cause more problems than they solve and the economy would be healthiest if money supply grows proportionally with GDP

Wage & Price Controls Policies aimed at restraining inflation by holding wages and prices below a specific level Successful controls during WW 2 but unsuccessful controls in the 1960s and 70s.

Wage & Price Controls 1. lack of united support 2. large bureaucracy needed 3. interference with the operation of the market 4. import prices  all contributed to the lack of success