1. C HAPTER 14 I NFLATION Impact and Measurement Causes and Cures

2. Inflation: Impact and Measurement Proverbs 23:5 and Revelation 6:5-6 Inflation: is the term economists use to describe a sustained rise in the average price level. The existence of inflation does not necessarily mean that the price of every good is rising. Inflation: Losers and Winners: Losers: persons living on a fixed income, creditors, savers, consumers. Winners: for almost every loser there is a corresponding winner: (pension-holder vs. former employer) (Creditors vs. borrowers) and (Savers vs. investors- banks). Cost of Living Adjustment: Currently many employers take future inflation into consideration when developing pension plans. These plans include a COLA, which adjusts payments upward as inflation causes prices to rise. The Social Security Administration annually adjusts its payments according to changes in the cost of living. Hyperinflation: reading pg 284

3. Measuring Inflation: GDP Deflator and Consumer Price Index (CPI) GDP Deflator: Calculated by comparing the prices of ALL goods and services from year to year, the GDP deflator is able to measure the changes in prices of everything from hot dogs to battleships. The problem with using the GDP deflator as a COLA factor is that is measures changes in the prices of all goods in the nation. If the price of military hardware rises while prices on everything else remain level, the GDP deflator will still rise. Consumer Price Index (CPI): Governmental economists us the CPI to measure the changes in the prices that affect a selected market basket of goods and services. To calculate the CPI, economists repeatedly measure the prices of approximately four hundred goods and services that an average urban household purchases over a base period (initial period of the survey). See Figure 14-1 the base period is that of the years 1982-1984.

4. Inflation: CPI Uses of the CPI: One of the major uses of the CPI is for determining inflation rates. (Figure 14-1). The CPI also allows economists to determine an individual’s purchasing power. Many individuals and business firms have recognized the eroding influence of inflation and have accepted the CPI as the primary tool to index or adjust wages, prices and interest rates. Indexing: a process of tying present wages and prices to some adjustment figure to maintain a balance between real wages and real prices. Ex/ the federal government indexes social security payments using a cost of living index based in the CPI.

5. Inflation: CPI Limitations of the CPI: 3 main reasons. A. first the CPI assumes that all urban households consistently purchase, month after month, the same market basket of goods and service, while in reality buying preferences change. B. the problem of adjusting price changes to quality changes (pg 287: Ex/ the washing machine of 1970 vs. 2012 washing machine). C. it tends to ignore the law of demand. As the price of a good rises, ceteris parabus, people will tend to demand less of the good and will purchase a less expensive substitute. Ex/ Buying a home vs. Renting

6. Inflation: Causes and Cures Causes of Inflation: Figure 14-3 illustrates the intersection of a good’s supply and demand curves determines its price. Only TWO situations can cause a price increase. 1) a shift of the supply curve to the left (Fig. 14-4a: producer is producing less) or 2) a shift of the demand curve to the right (Fig. 14-4b: buyers are demanding more). Total Supply and Total Demand Curves: Fig. 14-5. The GDP is used for the Total Demand Curve. Since the intersection of the total supply and the total demand curves determines the nation’s price level, there can be only two possible explanations for inflation: 1) a decrease in the nation’s supply of goods and services (leftward shift in the total supply curve) or 2) an increase in the nation’s demand for goods and services (rightward shift in the demand curve) #1 is called cost-push inflation and #2 is called demand-pull inflation.

7. Inflation: Causes and Cures Cost-Push Inflation: business firms begin the inflationary process by charging higher prices, an action that shifts the total supply curve to the left (Fig. 14-6 and 14-7 pg 289: Read and Understand). Demand pull Inflation: inflation begins with an increase in demand by consumers (whatever the reasons for the increase in demand) and the demand curve shifts to the right. Money Growth: The root cause of inflation: a continual increase in the money supply keeps the price level going up. Price increases are but a logical result of the infusion of more $$$ into the economy. If new money is not injected in to the economy, business firms would be unable to pay higher wages and consumers would be unable to pay higher prices. Ex/ Car and filling the tires with air pg. 290.

8. Inflation: Causes and Cures Cures for Inflation: People try to stem inflation by implementing wage-price controls or limiting the creation of money. Wage-Price Controls: Those who view inflation as a price phenomenon have a simple solution: mike it illegal for business firms to raise the prices of their products or the wages of their workers. They advocate freezing in place the total supply and total demand curves. The problem with wage and prices controls is that they cannot work if the government continues inflating the money supply. Imagine inflating a car’s tires but putting a barrier above the car that will not allow it to rise (pg 291). Price controls creates an artificial shortage for a product.

9. Inflation: Causes and Cures Limitation of Money Creation: If one believes that increases in the money supply create an excessive demand for goods and services that causes inflation, then the obvious solution is to limit the quantity of money being created. Christians should want to support policies that curb inflation but verification of the result of those policies is also important. 1 Tim. 6:6 “godliness with contentment is great gain”. A.W. Phillips: The Phillips Curve: discovered an extremely significant statistical relationship between changes in wages and the prevailing rate of unemployment. There is a tradeoff between the rate of inflation and the level of unemployment.

10. Q UESTIONS ?