CHAPTER 7 - INFLATION

INFLATION is an increase in the average level of prices of goods and services.

• It is not a SHORT-TERM increase.

• Prices are rising over a prolonged period of time

Measurement: Inflation is measured by the percentage change in price level.

• In the U.S. in 2002, inflation was 1.6 percent

• The level of prices increased by 1.6 percent over the year

DEFLATION is a decrease in the average level of prices of goods and services.

AVERAGE VERSUS RELATIVE PRICE CHANGES

Some prices rise faster than others. Economists need to know what is happening to average prices.

Example using fish and beef:

	Year 1	Year 2
1 pound of fish	$1	$2
1 pound of beef	$2	$4

 In Year 1, beef is twice as expensive as fish. This is the price of beef RELATIVE to fish.

In year 2, beef is still twice as expensive as fish. The relative prices have not changed between years 1 and 2.

What has changed?
The prices of both beef and fish have doubled.
The ABSOLUTE levels of all prices have gone up, but because they have increased by the same percentage, the RELATIVE PRICES are unchanged.

Inflation measures the changes in absolute prices.
So all prices have doubled, the inflation rate is 100 percent. There was a 100 percent increase in the prices of beef and fish.

In reality some prices rise faster than others which means that relative prices are changing as the absolute prices are rising.

The measured inflation rate records the AVERAGE change in absolute prices, AN INCREASE IN THE AVERAGE PRICE LEVEL.

REDISTRIBUTIVE EFFECTS OF INFLATION

Inflation results in redistributions of income and wealth because people buy different combinations of goods/services, own different assets and sell distinct goods or services (including labor). The impact of inflation on the individual depends on how prices change for the goods and services each person actually buys or sells.

PRICE EFFECTS
Price changes are the most visible consequence of inflation. As prices increases, the amount of a good that you can purchase may decrease (or your purchasing power decreases).

NOMINAL INCOME – is the amount of money income received in a given time period, measured in current dollars.

REAL INCOME – is the purchasing power of that money income, as measured by the amount of goods and services your dollars will buy. Your real income changes with price changes.

**Not all prices rise at the same rate during an inflation.

**Not everyone suffers equally from inflation

• People who consume goods and services whose prices are rising faster than others bear a greater burden of inflation: their real incomes fall more.

INCOME EFFECTS
Not all incomes rise at the same rate of inflation, some people’s incomes rise faster and some rise slower.

FIXED-INCOME GROUPS like retired people who depend solely on social security or private pensions and workers with multi-year contracts at fixed wage rates also suffer real income losses when price levels rise.

LENDERS, like banks, that have lent funds at fixed interest rates also suffer real income losses when price levels rise. They continue to receive interest payments fixed in nominal dollars that have increasingly less real value.

**Both of these groups experience a declining share of real income (and output) in inflationary periods.

Others may experience a rise in their nominal incomes and may end up with a larger share of total income.

WEALTH EFFECTS
Some gain and lose as a result of the assets they hold.

When the average price level is increasing, the real value of savings may be reduced if inflation is rising faster than the interest rate. Those who hold assets that increase in value faster than the inflation rate (stocks, houses, diamonds, etc.) will have an increase in the real value of those assets.

SOCIAL TENSIONS
Inflation may increase social and political tensions, between labor and management, government and the people, businesses and consumers.

MONEY ILLUSION
Even those whose nominal incomes keep up with inflation feel oppressed by rising prices. They may use their nominal income (nominal dollars) to gauge changes in their income and wealth. When they discover that their additional dollars don’t buy additional goods/services, they feel worse off.

CONSEQUENCES OF INFLATION

Inflation results in uncertainty, changing consumption, work, saving, investment and trade behavior. It makes economic decisions more difficult. It also affects production decisions of firms since they are uncertain about what prices will be in the future.

SHORTENED TIME HORIZONS
Consumers and producers postpone or cancel their expenditure plans and the demand for goods and services falls.

Hyperinflation – or an inflation rate in excess of 200%, lasting at least one year greatly shortens time horizons. Often workers must spend their income immediately to prevent the loss in value.

SPECULATION
If speculative profits become too easy, few people will engage in production; instead everyone will be buying and selling existing goods. Think about what is happening in the real estate market (especially in Southern California) right now. As a result of speculation, production declines and unemployment rises.

BRACKET CREEP
Tax rates are higher for higher incomes. Inflation increases everyone’s income so people are pushed into higher tax brackets and higher tax rates.

Inflation stress tends to create political backlash. Voters tend to blame the government for inflation.

DEFLATION DANGERS
A falling price level can do the same harm as a rising price level. Lenders win and borrowers lose. Deflation reverses the kinds of redistributions caused by inflation. Time horizons get shorter. Businesses are reluctant to borrow or invest.

MEASURING INFLATION

Two purposes:

1. to gauge the average rate of inflation

2. to identify its principal victims

CONSUMER PRICE INDEX is the most common measure of inflation.
CPI measures changes in the average price of consumer goods and services.

• CPI is calculated using a “market basket of goods and services the typical consumer buys.”

• Price changes of those goods/services are compared from year to year.

BASE PERIOD
In order to calculate changes in prices, the CPI is usually expressed in terms of what the market basket cost in a specific time period. This time period is arbitrarily designated as 100.

ITEM WEIGHT
The percentage of total expenditure spent on a specific product; used to compute inflation indexes. It is the relative importance of a product in a consumer’s budget.

PRODUCER PRICE INDEX
Keeps track of average prices received by producers. PPIs include crude materials, intermediate goods, and finished goods.

Over time, the PPIs and CPI generally reflect the same rate of inflation. In the short run, the PPIs increase before CPI because it takes time for producers price increases to be reflected in the prices that consumers pay.

GDP DEFLATOR
The GDP deflator covers all output including consumer goods, investment goods, and government services. It is NOT based on a fixed basket of goods/services. It changes with people’s consumption and investment. Generally reflects a lower inflation rate than CPI.

REAL VS. NOMINAL GDP
The GDP deflator is used to adjust nominal output values for changing price levels.

• NOMINAL GDP – current-dollar value of output

• REAL GDP – inflation-adjusted value of output.

REAL GDP =	NOMINAL GDP
	GDP deflator

**Changes in Real GDP are a goods measure of how output and living standards are changing. Nominal GDP statistics, by contrast, mix up output and price changes.

THE GOAL: PRICE STABILITY

PRICE STABILITY is a major goal of economic policy. In 1978 a goal was set to keep inflation below 3%.

There is a tradeoff between inflation and unemployment. To keep prices from rising, the government may have to restrain spending in the economy. Such restraint could lead to cutbacks in production and ultimately, unemployment.

The goal of “full employment” is defined as the lowest rate of unemployment consistent with stable prices.

QUALITY CHANGES

The CPI does not account for changes in the quality of products which may lead to higher prices, thus, sometimes the CPI may overstate the true rate of inflation.

NEW PRODUCTS

Over the course of time, new products are introduced (e.g., computers and word processors). New products not included in the CPI may cause the CPI to overstate inflation.

CAUSES OF INFLATION

There are two types of inflation: demand-pull and cost-push.

DEMAND-PULL inflation results from excessive pressure on the demand side of the economy. If the economy is producing at capacity, but consumers want more goods there may be “too much money chasing too few goods.” In which case producers may begin increasing prices.

COST-PUSH inflation is a result of supply side issues. If the cost of inputs (e.g., oil) increases, producers may increase prices to cover these higher costs. Also, higher wages increase costs of production which may put upward pressure on product prices. (That’s one of the reasons why unionized grocery stores can’t compete with Wal-Mart Super Stores).

PROTECTIVE MECHANISMS

COLAs are cost of living adjustments where nominal incomes are indexed to the inflation rate. For example, if inflation rates increase by more than 3% in a given year, Social Security benefits go up automatically by the same percentage as the inflation rate. This protects those people on salaries and fixed incomes.

ARMs
In loan agreements, debtors win and creditors lose when the price level rises.

REAL INTEREST RATE – the inflation-adjusted rate of interest or the nominal interest rate minus the anticipated inflation rate.

Example: If the real interest ate is 5% and inflation is 7%, the real interest rate is –2%.

ARMs are adjustable rate mortgages. A mortgage (home loan) adjusts the nominal interest rate to the changing rates of inflation. So the interest rate the borrower pays will change during the term of the loan according to inflation.

ADDITIONAL INFORMATION

To understand the effects of inflation, you have to understand what happens to the value of money in an inflationary period.

The real value of money is what it can buy – PURCHASING POWER.

Real value of $1 = $1/price level.

The higher the price level, the lower the real value or purchasing power of the dollar.

Example: An economy has only one good - MILK. If price of milk is $.50, then $1 would buy 2 glasses of milk. If price of milk rises to $1, then a dollar would buy one glass of milk.

Thus, purchasing power, or the real value of money falls as prices rise.

If prices and nominal income rise by the same percentage, then inflation is not a problem. (If a good costs twice as many dollars, and we have twice the income then inflation is not a problem).

Inflation is a problem when inflation rises faster than nominal income. It hurts those households whose income does not keep up with the prices of the goods they buy.

In the 1970s in the US, the rate of inflation rose to near record levels. Workers negotiated cost-of-living raises in their wage contracts. The typical cost of living raise ties salary to the consumer price index (CPI).

If CPI rises by 8%, incomes rise by 8%.

Unexpected inflation redistributes income away from those on fixed incomes (like creditors that receive debt repayments in a fixed amount of dollars per month).

Fixed expenditures = debtors who make fixed repayments per month benefit from inflation.

Think of a loan for one year at %10 ($100). If inflation increases by 15%, the lender has lost purchasing power because it will now cost him/her $115 to buy what the $100 would have purchased a year ago.

NOMINAL VS. REAL INTEREST RATE

NOMINAL INTEREST RATE is the observed interest rate in the market and includes the effect of inflation.

REAL INTEREST RATE is the nominal interest rate minus the rate of inflation:

Real Interest rate = Nominal interest rate – rate of inflation

Lending money, if nominal interest is 10% and inflation rate is 5%, lender gets positive return of loan of 5% (10%-5% = 5%).

If the inflation rate is 10%, the real return from a nominal interest rate is ZERO (%10-%10 = 0). No increase in purchasing power.

Unexpected inflation redistributes income. Borrowers and lenders agree to loan terms based on what they EXPECT the rate of inflation to be over the period of the loan.

Unexpected inflation hurts more than borrowers and lenders. Any contract requiring FIXED PAYMENTS over some long-term period changes in value as the rate of inflation changes.

• If vendor and buyer have fixed prices over a two-year period and there are unexpected price increases, vendor is hurt by rising prices.

This is the reason for COLAs, variable interest rates on home mortgages, etc. They adjust with the rate of inflation.

THE INFLATIONARY RECORD

Inflation is a relatively new problem for the U.S. From 1789 (when the U.S. Constitution was ratified) to 1940, there was no particular trend in the general price level. At times they rose and at times they fell.

Since 1940, prices in the U.S. have gone up markedly. Today it is 8 times what it was in 1940 but the rate of growth has varied.

Inflation rates vary widely in other countries. In the 1990s it was 0% in Japan but 328% in Turkmenistan.

HYPERINFLATION is an extremely high rate of inflation.

In most cases it makes a country’s currency worthless and leads to an introduction of a new currency.

In Argentina in the 1980s, people had to carry around large stacks of currency for small purchases.

The most dramatic inflation occurred in Europe after WWI. In Germany prices rose from 1914 to 1924, by 1924 prices were more than 100 trillion times higher than they had been in 1914.

Hyperinflation often leads to crises that lead to new governments, new economic policies and new monies. Hyperinflation is generally associated with rapid growth of the money supply.

RECAP:

1. Inflation is a sustained rise in the average level of prices.

2. The higher the price level, the lower the real value (purchasing power) of money.

3. Unexpectedly high inflation redistributes income away from those who receive fixed dollar payments (like creditors) toward those who make fixed dollar payments (like debtors).

4. The real interest rate is the nominal interest rate minus the rate of inflation.

5. Demand-pull inflation is a product of increased spending; cost-push inflation reflects increased production costs.

6. Hyperinflation is a very high rate of inflation that often results in the introduction of a new currency.