Topic 5- Inflation

Inflation

• sustained increase in general price level (average prices of goods/services)

• the value of money decreases

• purchasing power falls

Deflation

• sustained decrease in the average level of prices

• you can buy MORE with the same money

• purchasing power rises

Inflation Causes (2)

• long-run continuous increase in the money supply

• short-run demand-pull or cost-push factors

Increase in Money Supply

• when the money supply grows faster than real output, more money chases the same amount of goods

• this leads to higher and persistent inflation (ongoing higher prices)

Demand-Pull Factors

• when aggregate demand increases faster than supply

• firms charge more because there’s high demand and limited supply

• associated with booming economies

• easier to control

Cost-Push Factors

• increases in the costs of production (fuel, labor, raw materials)

• firms must pay more to produce, and pass those higher costs onto consumers

• more dangerous than demand-pull factors (associated with stagflation/recessions)

Why Inflation isn’t Inherently Bad

• inflation is only “bad” if it decreases purchasing power due to unanticipated increases in price

• increases in price is NOT BAD on its own- as long as wages increase proportionately

Anticipated Inflation

inflation that’s accurately forecasted and is expected/prepared for

Unanticipated Inflation

inflation that’s NOT accurately forecasted and is not expected or prepared for

Problems with Unanticipated Inflation

• it redistributes income and wealth, effecting those with fixed incomes

• it makes borrowing and lending more risky

Those Affected by Unanticipated Inflation (4)

• pensioners

• minimum wage earners

• savers

• sticky wages

Pensioners

• fixed income not indexed for inflation (some states make cost-of-living adjustments)

• payments don’t keep up with increasing prices, which reduces purchasing power

Minimum Wage Earners

• same pay with higher prices

• real income falls when prices increase faster than wages

• indexed/adjusted infrequently

Savers

• people’s savings now buy less

• the real value of their deposits fall

• fixed nominal interest rate on savings is not adjusted

Sticky Wages

• wages tend to adjust slowly

• this means earnings are disproportional when prices rise unexpectedly

• due to negotiated contracts and efficiency wages, some wages fall behind even anticipated inflation

• wages can be sticky downwards OR upwards

The Risk of Lending/Borrowing

• unanticipated inflation creates uncertainty about future interest rates and the real value of money

• it’s harder for lenders/borrowers to plan

What Happens When Inflation is Higher than Expected

• borrowers GAIN and lenders LOSE

• real interest is lower than anticipated, so it reduces the value lenders expected to get back

• borrowers repay fixed-rate debt with money that has lower purchasing power

Nominal Interest Rate

the stated/quoted interest rate (market interest rate)

Real Interest Rate

interest rate adjusted for inflation (use Fisher Equation)

Fisher Equation

Real Interest = Nominal Interest - Expected Inflation

Problems with Anticipated Inflation (3)

• some wages still stick

• inflation still causes inefficiencies in the economy

• even if wages increase proportionally, we see added costs

Added Costs of Inflation (3)

• Menu Costs- administrative costs associated with changing prices

• Shoe Leather Cost- wasted time and effort from holding less cash during high inflation (leads to more frequent trips to withdraw funds)

• Misallocation of Resources- higher prices lead to firms producing more because they mistake the inflated prices for increased demand

  • OR firms waste time on price management instead of actual production

Measuring Inflation

we can use the GDP Deflator and/or the Consumer Price Index (CPI)

Consumer Price Index

ratio showing the cost of a basket of goods/services in a given year in relation to the cost of the same basket of goods/services in the base year

(Current Cost of Market Basket / Base Year Cost of Market Basket) x 100

Basket of Goods

BLS determines the basket using a survey of 14,000 households

Basket Distribution

• Housing ~ 30%

• Transportation ~ 17%

• Food ~ 14%

• Insurance ~ 11%

• Healthcare ~ 9%

• Entertainment ~ 5%

• Clothing and Cash Contributions ~ 3% (each)

• Education and Other Goods ~ 2% (each)

CPI as a Measure

• CPI in the Base Year = 100

• CPI is an index (no units)

• assumes households buy the same market basket every month

GDP Deflator

• compares price of current goods/services (domestically produced) to the price of the same goods in the base year

• (Nominal GDP / Real GDP) x 100

• Nominal uses current prices, Real uses base-year prices

• Inflation is the percentage change in the deflator from year to year

Producer Price Index (PPI)

compares price received by producers of goods and services at all stages of production

Calculating Inflation (using Deflator or CPI)

Inflation Rate = (index in current year - index in previous year) / index in previous year x 100

Calculating CPI Steps

• pick a basket

• collect prices (statisticians do this monthly)

• calculate index (current cost of basket divided by base year cost of basket)

• find inflation (% change in CPI from year to year)

Benefits of CPI

• tells us how much more (or less) it costs to live today compared to before

• helps businesses set wages/prices

• helps government adjust programs/taxes

• helps people make better financial decisions

Limitations of CPI

• doesn’t account for everything

• baskets are based on averages

• basket and its prices must be adjusted frequently

Core vs. Headline CPI

• Headline- includes process of ALL goods/services in the CPI basket (more volatile)

• Core- excludes food and energy prices (paints a clearer picture of price trends)

Current Value of Products (equation)

using CPI, we can compare values from different years:

Current Value = Original Value x (Current CPI / CPI in the Past)

*original value could be a salary, the price of a good, etc.

4 Biases of CPI

• substitution bias- consumers switch to cheaper substitutes when prices change, but CPI assumes the same basket

• increase in quality bias- CPI doesn’t adjust for higher quality, just higher price, so it overstates inflation

• new product bias- new goods take time to be added to CPI, and chances are by the time they’re added the price has fallen since then, so CPI overstates price

• outlet bias- big supermarket prices are used for CPI calculations, which overstates actual consumer prices (ignores bulk/discount shopping)

Impact of Biases on CPI

the 4 biases combined can overstate the true inflation rate by 0.5-1%