Transcript Inflation - McGraw Hill Higher Education

13e
Chapter 07:
Inflation
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
• 07-01. Know how inflation is measured.
• 07-02. Know why inflation is a
socioeconomic problem.
• 07-03. Know the meaning of “price stability.”
• 07-04. Know the broad causes of inflation.
7-2
What Is Inflation?
• Inflation: an increase in the average level of
prices, not a change in any specific price of a
good.
• The prices of specific basket of goods are
collected and computed into an average
price level for that basket in a year.
– A rise in that average price level is inflation.
– A decrease in that average price level is
deflation.
7-3
Relative Prices
• The market mechanism causes the prices of
individual goods and services to rise or fall –
an essential market function.
– Relative price: the price of one good compared
to the price of other goods.
– Buyers switch from one good to another when
their relative prices diverge.
• Inflation is a rise in the average price of all
goods.
– It is not a market function.
7-4
Effects of Inflation
• Some prices rise and some fall.
• Rising prices require you to reallocate your
purchasing power to ensure that you get the
most satisfaction per dollar spent.
– You might reduce buying goods with higher prices
and increase buying goods with lower prices.
• This can be seen by the difference between
nominal income and real income.
7-5
Effects of Inflation
• Nominal income: the amount of money
income received in a given time period,
measured in current dollars.
• Real income: income in constant dollars;
nominal income adjusted for inflation.
• You may get a raise (nominal income
increases) – but if it does not rise as fast as
inflation, your purchasing power decreases
(real income falls).
7-6
Redistribution of Income and Wealth
by Inflation
• Price effects.
– Those who buy products that are increasing in
price the fastest end up worse off.
– Those who sell products that are increasing in
price the fastest end up better off.
– Those who buy products that are increasing in
price the slowest end up better off.
– Those who sell products that are increasing in
price the slowest end up worse off.
7-7
Redistribution of Income and Wealth
by Inflation
• Income effects.
– People with nominal incomes rising more
slowly than inflation end up worse off.
– People with nominal incomes rising faster than
inflation end up better off.
7-8
Redistribution of Income and Wealth
by Inflation
• Wealth effects.
– Those who own assets that are declining in real
value end up worse off.
– Those who own assets that are increasing in
real value end up better off.
7-9
Money Illusion
• Money illusion: using nominal dollars rather
than real dollars to gauge changes in one’s
income or wealth.
• Exercise:
– In the “good old days” a movie ticket was 50 cents
and the minimum wage was $1.00.
– Compare the purchasing power of the minimum
wage today to the “good old days.”
– You could buy two movie tickets with one hour’s
work before, but not now.
7-10
Macro Consequences of Inflation
• Uncertainty: not knowing the prices of
goods in the future makes purchasing and
production decision making much more
difficult.
• Speculation: decisions will shift from
standard economic activity to betting on the
future prices of goods.
• Bracket creep: in a progressive tax system,
when nominal incomes rise, the taxpayer
gets pushed into a higher tax bracket.
7-11
Deflation
• Deflation: a general decrease in average
prices.
• This has redistribution effects that are just the
opposite of those for inflation.
• This has macro consequences also.
–
–
–
–
Sellers are reluctant to stock inventory.
Buyers are reluctant to buy now.
Businesses are reluctant to borrow funds or invest.
Incomes fall, and asset values decrease.
7-12
Consumer Price Index (CPI)
• Consumer price index (CPI): a measure
(index) of the average price of consumer
goods and services.
– Used to calculate the inflation rate.
• Inflation rate: the annual percentage rate
of increase in the average price level.
7-13
Creating a Price Index
• Select a “market basket” of goods: a
standardized list of goods and services
customers usually buy.
• Select a base year: the reference year whose
dollar value will be used.
• Set the price index in the base year always
equal to 100.
• Measure the prices for the basket of goods
in both the current year and in the base
year.
7-14
Computing a Price Index
Price index in current year
Price index base year
=
Basket price in current year
Basket price in base year
• Basket price in the base year = $6,000.
• Basket price in the current year = $6,600.
• Compute the price index (CPI) for the current year:
– X/100 = $6,600/$6,000
– X = (6,600 x 100)/6,000
– X = 110
• CPI in the current year is 110.
• A CPI of 110 indicates that prices in the current year are
10% higher than prices in the base year.
7-15
Other Measures of Inflation
• Core inflation: changes in CPI, excluding
food and energy prices.
• Producer price index (PPI): changes in the
average prices at intermediate steps of
production.
• GDP deflator: changes in prices of all goods
and services included in GDP.
– Used to correct nominal GDP to real GDP.
7-16
Computing Inflation Rate from CPI
Inflation rate =
•
•
•
•
CPI
year 2
– CPI
CPI
year 1
X 100
year 1
CPI in 2006 was 201.6.
CPI in 2005 was 195.3.
Compute the inflation rate for 2006:
Inflation rate = (201.6-195.3)x100/195.3
= 3.23%
7-17
The Goal: Price Stability
• Price stability: the absence of significant
changes in the average price level.
– Officially defined as a rate of inflation of less
than 3 percent.
– Established by Full Employment and Balanced
Growth Act of 1978.
7-18
The Goal: Price Stability
• Measurement concerns.
– We are seeking price stability at the lowest rate
of unemployment.
– From year to year, there are quality
improvements in the basket of goods.
– New products change the content of the basket
of goods we buy.
7-19
Causes of Inflation
• Demand-pull inflation: results from
excessive pressure to buy on the demand
side of the economy.
– A booming economy creates shortages.
– Too much money pumped into the economy by
the Federal Reserve.
• Cost-push inflation: due to higher
production costs putting pressure on
suppliers to push up prices.
7-20
Protective Mechanisms
• Cost of living allowances (COLA): nominal
incomes are indexed to automatically rise at
the same rate as inflation.
• Adjustable-rate mortgage (ARM): interest
rate on a mortgage rises along with inflation
so that lenders do not lose money.
7-21
The Real Interest Rate
• Real interest rate: the nominal interest rate
minus the anticipated inflation rate.
– The borrower pays the nominal rate.
– The inflation-adjusted (real) rate of interest:
Real interest rate = Nominal interest rate – Anticipated rate of inflation
– Protects the lenders. Hurts the borrowers.
– Borrowers will pay back loan using more lowervalued dollars, but lenders receive the same
purchasing power.
7-22