©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 15: Inflation and the Price Level

©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives 1.Explain how the Consumer Price Index (CPI) is constructed and use it to calculate the inflation rate 2.Show how the CPI is used to adjust economic data to eliminate the effects of inflation 3.Discuss the two most important biases in the CPI 4.Distinguish between inflation and relative price changes to find the true cost of inflation 5.Understand the connections among inflation, nominal interest rates, and real interest rates

©2012 The McGraw-Hill Companies, All Rights Reserved 3 Keeping up with Grandpa It may come as a surprise to most people to know that: Inflation can make a comparison of economic conditions at different points in time quite difficult Inflation increases uncertainty when planning for the future (for people and policy makers)  Consider costs of inflation EgyptMoroccoTurkey Prices of Goods and Services between 1965 and times higher 7 times higher 800,000 times higher

©2012 The McGraw-Hill Companies, All Rights Reserved 4 Measuring the Price Level Consumer Price Index (CPI) is a measure of changes in prices CPI measures  The cost of a standard basket of goods and services in a given year  Relative to the cost of the same basket of goods and services in the base year  Base year changes periodically

©2012 The McGraw-Hill Companies, All Rights Reserved 5 Calculating the CPI 2000 Spending Monthly Cost in 2000 Rent (2 bedroom apartment) $500 Sandwiches (60 at $2 each) 120 Taxi rides (10 at $6 each) 60 Monthly expenditures $ Spending Monthly Cost in 2005 Rent (2 bedroom apartment) $630 Sandwiches (60 at $2.50 each) 150 Taxi rides (10 at $7 each) 70 Monthly expenditures $850

©2012 The McGraw-Hill Companies, All Rights Reserved 6 Calculating the CPI CPI is the ratio of the cost of the basket of goods in current year to the cost in the base year

©2012 The McGraw-Hill Companies, All Rights Reserved 7 Calculating the CPI Base year (2000) cost $680 and 2005 cost $850 CPI = (850 / 680) (100) = 1.25 Cost of living in 2005 is 25% higher than in 2000  CPI for the base year is always 1  In that year the numerator and the denominator of the CPI formula are the same  CPI for a given period is the cost of living in that period relative to what it was in the base year

©2012 The McGraw-Hill Companies, All Rights Reserved 8 Cost of Living 2000 Spending Monthly Cost in 2000 Rent (2 bedroom apartment) $500 Sandwiches (60 at $2 each) 120 Taxi rides (10 at $6 each) 60 Shirts (4 at $30) 120 Monthly expenditures $ Spending Monthly Cost in 2005 Rent (2 bedroom apartment) $630 Sandwiches (60 at $2.50 each) 150 Taxi rides (10 at $7 each) 70 Shirts (4 at $50) 200 Monthly expenditures $1,050 CPI = 1050 / 850 = 1.31

©2012 The McGraw-Hill Companies, All Rights Reserved 9 Price Index A price index measures the average price of a given class of good or services relative to the price of the same goods and services in a base year The CPI is an especially well-known price index CPI measures the change in consumer prices Other indices  Producer price index  Import / export price index

©2012 The McGraw-Hill Companies, All Rights Reserved 10 Inflation The rate of inflation is the annual percentage change in the price level Inflation in 2004 (1.889 – 1.840) / = = 2.7% How is inflation in the 1930s different since 2003?  Inflation rates are negative  Negative inflation = Deflation YearCPIInflation % % % % YearCPIInflation –2.3% –9.0% –9.9% –5.1%

©2012 The McGraw-Hill Companies, All Rights Reserved 11 Deflation Around the World Deflation represents a situation in which the prices of most goods and services are falling over time so that inflation is negative Japan experienced mild deflation during the past decade. Qatar experienced a 4.86 decrease in prices between 2008 and 2009 mainly due to the global financial crisis. Jordan experienced a 0.68 decrease in prices over the same period.

©2012 The McGraw-Hill Companies, All Rights Reserved 12 Inflation in Egypt

©2012 The McGraw-Hill Companies, All Rights Reserved 13 Inflation in Morocco

©2012 The McGraw-Hill Companies, All Rights Reserved 14 Inflation in Qatar

©2012 The McGraw-Hill Companies, All Rights Reserved 15 Adjusting for Inflation A nominal quantity is measured in terms of its current dollar value A real quantity is measured in physical terms  Quantities of goods and services To compare values over time, use real quantities  Deflating a nominal quantity converts it to a real quantity  Divide a nominal quantity by its price index to express the quantity in real terms

©2012 The McGraw-Hill Companies, All Rights Reserved 16 Family Income in 2000 and 2008 Can a family buy more with $20,000 in income in 2000 or with $22,000 in 2008?  2000 is the base year for the CPI  Deflate nominal income in both years to get real income  Compare real income  $20,000 in 2000 has the greater purchasing power

©2012 The McGraw-Hill Companies, All Rights Reserved 17 Jamal vs. Kamal: who earned more? Compare Jamal’s salary with Kamal’s  Requires a CPI series that includes 1930  CPI using 1982 as base year  Kamal had higher real salary  Adjusting for inflation brings the two figures closer together but in real terms Kamal still earned more than 12 times Jamal’s salary Player YearNominal Salary Jamal 1930$80,000 Kamal 2001$10,300,000 Real Salary $479,042 $5,786,515 CPI

©2012 The McGraw-Hill Companies, All Rights Reserved 18 Real Wages Real wage is the purchasing power of worker's nominal wages  The real wage for any given period is calculated by dividing the nominal wage by the CPI for that period The purchasing power in 1999 was bigger than in 2009 Year Minimum Wage 1999 MAD MAD10.64 CPI Real Average Wage MAD10 / = MAD10.92 MAD10.64 / = MAD 9.64

©2012 The McGraw-Hill Companies, All Rights Reserved 19 Indexing Indexing increases a nominal quantity each period by the percentage increase in a specified price index  Indexing prevents the purchasing power of the nominal quantity from being eroded by inflation Indexing automatically adjusts certain values, such as Social Security payments, by the amount of inflation  If prices increase 3% in a given year, the Social Security recipients receive 3% more  Indexing is sometimes included in labor contracts

©2012 The McGraw-Hill Companies, All Rights Reserved 20 Adjusting for Inflation An indexed labor contract  First year wage is $12 per hour  Real wages rise by 2% in the second year of the contract and by another 2 percent in the third year  CPI is 1.00 in 1 st year, 1.05 in the 2 nd, and 1.10 in the 3 rd  Nominal wage = real wage * CPI Year Real Wage 1 $ $ $12.48 CPI Nominal Wage $12.00 $12.85 $13.73

©2012 The McGraw-Hill Companies, All Rights Reserved 21 Minimum Wage Because the minimum wage is not indexed to inflation, its purchasing power falls as prices rise Governments must therefore raise the nominal minimum wage periodically to keep the real value of the minimum wage from eroding  Ironically, despite such government intervention, it is common knowledge that such schemes have not contributed sufficiently to maintaining the public’s purchasing power and alleviating poverty

©2012 The McGraw-Hill Companies, All Rights Reserved 22 CPI and Inflation CPI and other indexes influence policy decisions and wage increases If CPI overstates inflation by 1 to 2 percentage points a year then  Unnecessary increases government spending  Underestimates increase in the standard of living Suppose now that CPI indicates 3% inflation when cost of living actually increases 2%  Real income increases 1%

©2012 The McGraw-Hill Companies, All Rights Reserved 23 CPI and Inflation There are two important reasons why the official inflation rate, based on the CPI, may overstate the true rate of inflation  Quality adjustment bias  Substitution bias

©2012 The McGraw-Hill Companies, All Rights Reserved 24 CPI Quality Adjustment Bias One important bias in the CPI is its measurement of price changes but not quality changes  PC with 20% more memory has 20% higher price  Not the same PC as the one with less memory  If not adjustment is made for quality, PC's contribution to the CPI will be 20% Adjusting for quality is difficult  Large numbers of goods  Subjective differences Incorporating new goods is difficult  No base year price for this year's new goods

©2012 The McGraw-Hill Companies, All Rights Reserved 25 CPI Substitution Bias CPI uses a fixed basket of goods and services  When the price of a good increases, consumers buy less and substitute other goods  Failing to account for substitution overstates inflation Example: base year cost of market basket Item 2000 price2000 Spending Coffee (50 cups) $1.00$50.00 Tea (50 cups) $1.00$50.00 Cake (100 slices) $1.00$ Total $200.00

©2012 The McGraw-Hill Companies, All Rights Reserved 26 CPI Substitution Bias In 2008, coffee and scones are more expensive  Buying exactly the same basket of goods costs $300, compared to $200 in 2000  CPI = 300 / 200 = 1.50 Item 2008 price2008 Spending Coffee (50 cups) $2.00$ Tea (50 cups) $1.00$50.00 Cake (100 slices) $1.50$ Total $300.00

©2012 The McGraw-Hill Companies, All Rights Reserved 27 CPI Substitution Bias Actually, consumer substitutes tea for coffee  Cake purchases constant True CPI for consumer is 250 / 200 = 1.25 CPI estimate of 1.50 is 20% higher than the consumer's experience Item 2008 price2008 Spending Coffee (00 cups) $2.00$0.00 Tea (100 cups) $1.00$ Scones (100) $1.50$ Total $250.00

©2012 The McGraw-Hill Companies, All Rights Reserved 28 The Cost of Inflation: Not What You Think Since the oil shocks of the 1970s, MENA countries have been plagued with relatively high inflation When people complain about inflation, they are often concerned primarily about relative price changes  Before describing the true economic costs of inflation, let us examine this confusion people experience about inflation and its costs  Need to distinguish between the price level and the relative price InflationEgyptJordanKuwaitQatarKSA %14.9%10.5%15.0%9.8%

©2012 The McGraw-Hill Companies, All Rights Reserved 29 Relative Prices Price level is the overall level of prices at a particular point in time  Measured by a price index such as the CPI Relative price of a specific good is a comparison to the prices of other goods and services  Calculated as a ratio  Example: if the price of oil were to rise by 10 percent while the prices of other goods and services were rising on average by 3 percent, the relative price of oil would increase

©2012 The McGraw-Hill Companies, All Rights Reserved 30 Relative Prices Public opinion surveys suggest that many people are confused about the distinction between inflation, which is an increase in the overall price level, and an increase in a specific relative price  Changes in relative prices do not necessarily imply a significant amount of inflation  Imagine, for instance, that all prices in the economy, including wages and salaries, go up exactly 10 percent each year  The inflation rate is 10 percent, but relative prices are not changing

©2012 The McGraw-Hill Companies, All Rights Reserved 31 Inflation and Relative Prices YearCPIInflation % % Oil Price Change 8% Relative Price Change -2% 2%  Inflation between 2006 and 2007 is 10 percent  Price of oil increased by 8%  the relative price of oil—that is, its price relative to all other goods and services—falls by about 2 percent

©2012 The McGraw-Hill Companies, All Rights Reserved 32 The True Cost of Inflation: Noise in the Price System Prices transmit information about  The cost of production and  The value buyers place on buying an additional unit Inflation creates static in the communication  Buyers and sellers can't easily tell whether  The relative price of this good is increasing OR  Inflation is increasing the price of this good and all others  Deciding these issues requires market participants gather information – at a cost  Response to changing prices is tentative and slow

©2012 The McGraw-Hill Companies, All Rights Reserved 33 The True Cost of Inflation: Distortions of the Tax System Most economies in MENA operate a progressive income tax system that raises the tax burden of individuals on their higher earnings  Example: the Moroccan tax code of 2008 imposed a tax rate of 42 percent on the highest income bracket Suppose Hicham earns $30,000  The following represents a simplified look at Hicham’s tax liability under the 2008 tax code

©2012 The McGraw-Hill Companies, All Rights Reserved 34 The True Cost of Inflation: Distortions of the Tax System

©2012 The McGraw-Hill Companies, All Rights Reserved 35 The True Cost of Inflation: Distortions of the Tax System Following the previous table, the tax liability increases with higher income brackets Hicham’s total tax liability is $10,607 which represents about 35 percent of his pre-tax income of $30,000 Hicham’s after-tax income is therefore $19,393 In 2009, the Moroccan government introduced a new tax code that was designed to reduce the tax liability of people like Hicham  Assume also that inflation rate in 2009 in Morocco was 1 percent

©2012 The McGraw-Hill Companies, All Rights Reserved 36 The True Cost of Inflation: Distortions of the Tax System

©2012 The McGraw-Hill Companies, All Rights Reserved 37 The True Cost of Inflation: Distortions of the Tax System As the previous table shows, Hicham’s tax liability is reduced to $8,455, representing 28 percent of his pre-tax income of $30,000 Hicham’s after-tax income is, therefore, $21,545, which is 11 percent higher than his previous year’s after-tax income Hence, the net gain to Hicham resulting from the new tax code is 10 percent (11 percent minus 1 percent inflation)

©2012 The McGraw-Hill Companies, All Rights Reserved 38 The True Cost of Inflation: Distortions of the Tax System It is important to note that the Moroccan case may be an exception for various reasons: 1. The years 2008 and 2009 mark the global financial crisis and such a change in the tax code does not necessarily signal further future adjustments 2. An inflation rate of 1 percent may be too unreasonable for Morocco where about half of the population is illiterate and is not likely to participate in detailed consumer surveys or to maintain a particular budget 3. Changes in the tax codes in countries like Morocco are generally not designed to alleviate poverty or to maintain purchasing power, but rather to fight tax evasion and to increase the country’s tax base

©2012 The McGraw-Hill Companies, All Rights Reserved 39 The True Cost of Inflation: Shoe-Leather Costs As all shoppers know, cash is convenient  Cash can be used in almost any routine transaction Inflation raises the cost of holding cash to consumers and businesses  If there is no inflation, cash holds its value over time  When inflation is high, cash loses value over time More frequent, smaller withdrawals cost consumers and businesses time, travel – a real cost of inflation  Banks process more transactions, increasing costs  Costs of managing cash holding are called "shoe leather" costs

©2012 The McGraw-Hill Companies, All Rights Reserved 40 Shoe-Leather Costs: Example Bassam’s Hardware needs $5,000 cash per day Bassam has a choice:  Go to the bank first thing on Monday morning to withdraw $25,000—enough cash for the whole week  Go to the bank first thing every morning for $5,000 each time The cost of going to the bank, in terms of inconvenience and lost time, at $4 per trip Funds left in the bank earn precisely enough interest to keep their purchasing power unaffected by inflation  How often will Bassam go to the bank?

©2012 The McGraw-Hill Companies, All Rights Reserved 41 Shoe-Leather Costs: Example If inflation is zero, there is no cost to holding cash  Bassam will go to the bank only once a week, incurring a shoe-leather cost of $4 per week At the beginning of each day, his cash holding will be represented by the following table:  Bassam’s average cash holding at the beginning of each day is $75,000/5 = $15,000  If inflation is 10 percent, the cost to Bassam is $1,500 per year

©2012 The McGraw-Hill Companies, All Rights Reserved 42 Shoe-Leather Costs: Example If Bassam goes to the bank every day, his average cash holding at the beginning of the day will be only $5,000  In that case, his losses from inflation will be $500 (10 percent of $5,000) a year The benefit of changing his banking behavior is a loss of only $500 per year to inflation (or $1,000 saved) The cost of going to the bank every day is $4 per trip  Assuming Bassam’s store is open 50 weeks a year, going to the bank 5 days a week adds 200 trips per year (total cost of $800)  Bassam will begin going to the bank more often

©2012 The McGraw-Hill Companies, All Rights Reserved 43 The True Cost of Inflation: Unexpected Redistribution of Wealth Unexpected inflation redistributes wealth Suppose workers' salaries are not indexed and inflation is higher than anticipated  Salaries lose purchasing power  Employers gain at the expense of workers  The effect of the inflation is not to destroy purchasing power but to redistribute it Similarly, unexpectedly high inflation benefits borrowers at the expense of lenders  Borrowers repay with dollars worth less than anticipated

©2012 The McGraw-Hill Companies, All Rights Reserved 44 The True Cost of Inflation: Long-Run Planning Some decisions have a long time horizon  Erratic inflation makes planning risky Retirement planning requires an estimated cost for your desired life-style  Save too little and you live less well in the future  Save too much and you live less well now Given the costs of inflation, most economists agree that low and stable inflation promotes a healthy economy

©2012 The McGraw-Hill Companies, All Rights Reserved 45 Hyperinflation Hyperinflation is an extremely high rate of inflation  There is no official threshold above which inflation becomes hyperinflation  Example: Turkey: 110 percent in 1980 and 106 percent in 1994 Nicaragua: 33,000 percent in 1988 Germany: 1932 most well known episode of hyperinflation: inflation was 102,000,000 percent

©2012 The McGraw-Hill Companies, All Rights Reserved 46 Hyperinflation

©2012 The McGraw-Hill Companies, All Rights Reserved 47 Inflation and Interest Rates Another important aspect of inflation is its close relationship to other key macroeconomic variables  Economists have long realized that during periods of high inflation, interest rates tend to be high as well Suppose that there are two neighboring countries, Alpha and Beta  In Alpha: currency is alphan  Inflation rate is zero and is expected to stay zero  In Beta: currency is betan  Inflation rate is 10 percent and is expected to remain at that level

©2012 The McGraw-Hill Companies, All Rights Reserved 48 Inflation and Interest Rates Bank deposits pay 2 percent annual interest in Alpha and 10 percent annual interest in Beta  In which countries are bank depositors getting a better deal? Alpha, not Beta, offers the better deal to depositors  In Alpha, someone who deposits 100 alphans in the bank will have 102 alphans representing a 2 percent increase in buying power  In Beta, the depositor who deposits 100 betans on 110 betans by the end of the year representing no increase in buying power

©2012 The McGraw-Hill Companies, All Rights Reserved 49 Inflation and Interest Rates Unanticipated inflation helps borrowers and hurts lenders Real interest rate is the annual percentage increase in the purchasing power of financial assets  Real interest rate = nominal interest rate – inflation r = i -  Nominal interest rate is the annual percentage increase in the dollar value of an asset  Nominal interest rates are the most commonly stated rates

©2012 The McGraw-Hill Companies, All Rights Reserved 50 Real Interest Rates in Egypt

©2012 The McGraw-Hill Companies, All Rights Reserved 51 Egypt Real Interest Rates,

©2012 The McGraw-Hill Companies, All Rights Reserved 52 Inflation and Interest Rates Unexpected inflation benefits borrowers and hurts lenders  For a given nominal interest rate, the higher the inflation rate, the lower the real interest rate Expected inflation may not hurt lenders if they can adjust the nominal interest rates  Inflation-protected bonds pay a real rate of interest plus the inflation rate

©2012 The McGraw-Hill Companies, All Rights Reserved 53 Fisher Effect Fisher effect is the tendency for nominal interest rates to be high when inflation is high and low when inflation is low Why do interest rates tend to be high when inflation is high?  Example: Suppose inflation has recently been high, so borrowers and lenders anticipate that it will be high in the near future  Expect lenders to raise their nominal interest rate so that their real rate of return will be unaffected  Borrowers are willing to pay higher nominal interest rates when inflation is high

©2012 The McGraw-Hill Companies, All Rights Reserved 54 Egypt Inflation (red line) and Interest Rates (blue line),