ECON Lecture 8.1: Impact of Policy Decisions on Inflation: Definitions, Measurements, and the Equation of Exchange

Defining and Measuring Inflation

• Definition of Inflation: Inflation is defined as the overall increase in the level of prices prevalent in an economy over time.

  • Scope of Measurement: The term refers to the average of all prices going up, rather than the increase of one specific price. For example, if the price of gasoline rises while most other prices decrease such that the overall level remains unchanged, that is not considered inflation.

• Key Related Concepts:

  • Inflation: Occurs when prices of most goods result in higher levels over time.

  • Disinflation: This is a decrease in the rate of inflation. Prices are still rising, but at a slower rate than previously.

    • Example: If inflation was $10\%$ in 2014, $8\%$ in 2015, and $6\%$ in 2016, this transition is disinflation. Even at $6\%$, prices are increasing, just more slowly than when they were increasing at $10\%$.

  • Deflation: A situation where prices, on average, are actually falling.

    • Frequency: While inflation and disinflation occur regularly, deflation is significantly more rare across an entire economy.

    • Historical Context: Gasoline prices dropped from approx. $\$3.50$ to $\$2.15$ (a reduction of about $\$1.00$) between certain periods (e.g., around 2017). However, because the prices of other goods like food and cars did not fall, this was a reduction in specific prices, not general deflation for the economy.

The Consumer Price Index (CPI)

• Definition: The Consumer Price Index (CPI) provides a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

• Bureau of Labor Statistics (BLS):

  • Organization: The CPI is produced by the BLS, a federal government bureau under the Department of Labor within the executive branch of the United States.

  • Function: The BLS calculates various data points, including unemployment and inflation rates, making them publicly available via the internet.

• The Market Basket:

  • Concept: A metaphorical "basket" representing all the goods and services an average person purchases monthly (including electricity, water, clothes, dining, gasoline, etc.).

  • Market Basket Survey: Conducted roughly every $10\,$ years to update what Americans are buying.

  • Urban Areas: The survey focuses on urban areas, defined as metropolitan areas and their surrounding suburbs (e.g., Atlanta), rather than rural farming areas.

  • Process of Collection: A "huge army of secret shoppers" from the BLS visits stores (Target, Walmart, Macy’s, car dealerships, hospitals) every month to record the current prices of items in the Market Basket.

  • Updating Necessity: The basket must be updated to reflect technological shifts. For instance, items like iPhones or Samsung Galaxy phones were not in the basket ten years ago, while older technology like Motorola Motos might have been more prevalent then.

The Nature and Origin of Money

• Definition of Money: Money is any good that serves as a medium of exchange or is accepted as a means of payment for goods and services.

• Historical Mediums of Exchange:

  • Colonial Frontier: Nails were often used as money because they were valuable and scarce. People would trade a "purse full of nails" for bullets or flour. Merchants accepted nails because they knew others (such as people building cabins) would accept them.

  • Ancient Civilizations: Gold and silver have been used as standardized money for thousands of years, as recorded in biblical texts and discovered in archaeological sites (China, Israel, Egypt).

• The Problem of Barter:

  • Barter Exchange: Swapping one good directly for another.

  • Dual Coincidence of Wants: A requirement for barter where each person must want exactly what the other person has to trade.

  • Constraint Example: If one person has an iPhone and wants a Sony laptop, but the person with the Sony laptop doesn't want an iPhone, a trade cannot occur.

• The Advantage of Money: Money eliminates the need for a dual coincidence of wants. It acts as a medium of exchange that everyone accepts, allowing an individual to sell a good for money and then use that money to purchase what they truly want from a third party.

The Equation of Exchange

• The Formula: $M \times V = P \times Q$

• Variables Defined:

  • $M$ (Money Supply): The physical and electronic amount of money available in society (currency, checking accounts, savings accounts).

  • $V$ (Velocity): The average number of times money changes hands or "turns over" in a transaction per year.

  • $P$ (Price Level): The average level of all prices, typically measured by the CPI.

  • $Q$ (Quantity of Output): An index of physical output (all goods and services added together).

• Conceptual Balance:

  • The left side ($M \times V$) represents the total spending power of society.

  • The right side ($P \times Q$) represents the total nominal GDP (the value of all goods and services sold).

  • In a balanced circular flow, the money side must equal the physical side of the economy.

The Mechanism Triggering Inflation

• Equilibrium Scenario:

  • Assume $M = \$6\text{ billion}$, $V = 5$, and $Q = 3\text{ billion items}$.

  • Left side: $\$6\text{ billion} \times 5 = \$30\text{ billion}$ (Total spending power).

  • Right side logic: To match spending power, merchants will price the $3\text{ billion}$ items such that they total $\$30\text{ billion}$. Therefore, $P = \$10\, (\$10 \times 3\text{ billion} = \$30\text{ billion})$.

  • If merchants tried to set prices at $\$20$, the total value ($\$60\text{ billion}$) would exceed purchasing power ($\$30\text{ billion}$), creating a surplus and forcing prices back down to $\$10$.

• Inflation Scenario (Printing Money):

  • If the government doubles the money supply ($M$) to $\$12\text{ billion}$ while $V$ stays at $5$, spending power becomes $\$60\text{ billion}$.

  • If production ($Q$) remains fixed at $3\text{ billion items}$, there will be a shortage at old prices. Prices ($P$) must rise to $\$20$ to balance the equation ($\$20 \times 3\text{ billion} = \$60\text{ billion}$).

  • Conclusion: Doubling the money supply doubles the price level. This increases Nominal GDP (from $\$30\text{ billion}$ to $\$60\text{ billion}$) but does not change the Real GDP (the actual physical ability to consume).

Hyperinflation

• Definition: A very high rate of inflation, generally defined for this course as over $100\%$ per year.

  • Alternative definitions from other economists include any month with inflation over $50\%$.

• Cause: Hyperinflation is caused by the government printing massive amounts of money far in excess of the goods produced.

• Societal Impacts:

  1. Destruction of Savings: If a student has saved or inherited $\$100,000$, that money is only valuable for what it can buy. At $100\%$ annual inflation, a car costing $\$30,000$ would cost $\$60,000$ in year one and $\$120,000$ in year two. The purchasing power of the savings rapidly diminishes until they are destroyed.

  2. Economic Instability: Prices serve as signals for rational decision-making. When prices change constantly, consumers and businesses cannot determine if they are getting a good deal, making rational economic planning impossible.

  3. Political Instability: When the population sees their savings destroyed and can no longer afford goods, they become upset with political leaders. This leads to social unrest and instability.

• Case Study: Venezuela:

  • In 2016, inflation in Venezuela hit $800\%$ (an eight-fold increase).

  • Price Shift: A car costing $\$30,000$ on January 1st would cost $\$240,000$ by December 31st.

  • Outcome: The government attempted to implement price controls, which exacerbated the problem, leading to political crises and a predicted economic meltdown.