Transcript Chapter 13 - The Monetary System, Prices, and Inflation

Chapter 13
The Monetary System,
Prices, and Inflation
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 13 / THE MONETARY SYSTEM, PRICES, AND INFLATION
©2005, South-Western/Thomson Learning
Slides by John F. Hall
Animations by Anthony Zambelli
The Monetary System

Establishes two different types of standardization in
the economy
 Unit of value—a common unit for measuring how much


something is worth
• Refers to the way we think about and record transactions
Means of payment—things we can use as payment when
we buy goods and services
• Refers to how payment is actually made
In United States, the dollar is centerpiece of our
monetary system
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History of the Dollar


How did the dollar come to play such an important role in
the economy?
Prior to 1790, each colony had its own currency
 Called the “pound” in every colony, but it had a different purchasing
power in each of them
 In 1790 Congress created a new unit of value called the dollar


Primary means of payment in United States until Civil War
was paper currency issued by private banks
However, during Civil War government issued first federal
paper currency—greenback
 Functioned as both unit of value and major means of payment until
1879

In 1913, a new institution was created to be the national
monetary authority in United States
 Federal Reserve System
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Why Paper Currency is Accepted as A
Means of Payment


Paper currency is a relatively recent development in the history of the
means of payment
Earliest means of payment were precious metals and other valuable
commodities such as furs or jewels
 Called commodity money because they had important uses other than as a
means of payment


Commodity money eventually gave way to paper currency
Today paper currency is no longer backed by gold or any other physical
commodity
 This type of currency is called fiat money
• Fiat, in Latin, means “Let there be,” and fiat money serves as a means of
payment by government declaration


While government can declare that paper currency is to be accepted as
a means of payment, it cannot declare the terms
Value of the dollar—its purchasing power—does change from year to
year
 Reflected in changing prices of things we buy
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Measuring the Price Level and Inflation

Microeconomic causes—changes in
individual markets—can explain only a tiny
fraction of price change
 For the most part, price rises came about
because of a continually rising price level
• Average level of dollar prices in the economy
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Index Numbers


Most measures of the price level are reported in the form
of an index
 Series of numbers, each one representing a different period
In general, an index number for any measure is calculated
as
Value of measure in currentperiod
x 100
Value of measure in base period

Compress and simplify information so that we can
see how things are changing at a glance
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The Consumer Price Index


Most widely used measure of the price level in United States
 Designed to track price paid by typical consumer
 Compiled and reported by Bureau of Labor Statistics (BLS)
Two problems must be solved before we even begin
 Must decide which goods and services should be included in
average
 How to combine all the different prices into a average price level

CPI’s approach is to track cost of CPI market basket
 Collection of goods and services typical consumer bought in some
base period
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From Price Index to Inflation Rate

Consumer Price Index is a measure of the
price level in the economy
 Inflation rate measures how fast price level is
changing, as a percentage rate
 When price level is rising, as it almost always is,
inflation rate is positive
 When price level is falling, as it did during Great
Depression, we have a negative inflation rate
• Called deflation
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How the CPI is Used


CPI is one of the most important measures of performance
of the economy
Used in three major ways
 As a policy target
• Measure most often used to gauge our success in achieving low inflation
 To index payments
• A payment is indexed when it is set by a formula so that it rises and falls
proportionately with a price index
 To translate from nominal to real values
• In order to compare economic values from different periods, we must


Translate nominal variables
 Measured in the number of dollars
Into real variables
 Adjusted for the change in dollar’s purchasing power
• CPI is often used for this translation
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Figure 1: The Rate of Inflation Using the
Consumer Price Index, 1950-2001
Annual Inflation Rate (%)
14
12
10
8
6
4
2
0
-2
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Real Variables and Adjustment for
Inflation

Suppose that from December 2004 to December
2005, your nominal wage rises from $15 to $30
per hour
 Are you better off?


• That depends
To track your real wage, need to look at number of
dollars you earn relative to price level
Real wage formula is as follows
Real w agein any year 
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Nominal w agein that year
x 100
CPI in that year
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Real Variables and Adjustment for
Inflation

Important point
 When we measure changes in macroeconomy, we usually care
about purchasing power those dollars represent
• Not about the number of dollars we are counting

Translate nominal values into real values using the formula
nominal value
real value 
x 100
price index

How most real values in the economy are calculated
 One important exception
• To calculate real GDP, government uses a different
procedure
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Inflation and the Measurement of Real
GDP



A special price index called GDP price index is
calculated for GDP
Most important differences between CPI and GDP
price index
 Types of goods and services covered by each index
Can summarize chief difference between CPI and
GDP price index
 GDP price index measures prices of all goods and

services that are included in U.S. GDP
While CPI measures prices of all goods and services
bought by U.S. households
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The Inflation Myth
Most people think inflation erodes average
purchasing power of income
 By making goods and services more expensive
 However, this statement is mostly wrong
 Inflation can redistribute purchasing power
from one group to another
 But it does not directly decrease average real

income

Often blame inflation for lowering our
purchasing power when the real cause lies
elsewhere
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The Redistributive Cost of Inflation


One cost of inflation is that it often redistributes purchasing
power within society
How does inflation sometimes redistribute real income?
 An increase in price level reduces purchasing power of any payment
that is specified in nominal terms


Inflation can shift purchasing power away from those who
are awaiting future payments specified in dollars
 Toward those who are obligated to make such payments
Does inflation always redistribute income from one party in a
contract to another?
 No—if inflation is expected by both parties, it should not redistribute
income
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Expected Inflation Need Not Shift
Purchasing Power

Over any period, percentage change in a real value (%Δ Real) is
approximately equal to percentage change in associated nominal value
(%Δ Nominal) minus the rate of inflation
 %ΔReal = %ΔNominal – Rate of Inflation



If inflation is fully anticipated, and if both parties take it into account, then
inflation will not redistribute purchasing power
When inflation is not correctly anticipated, however, our conclusion is
very different
Nominal interest rate
 Annual percent increase in a lender’s dollars from making a loan

Real interest rate
 Annual percent increase in a lender’s purchasing power from making a loan
• In absence of inflation, real and nominal interest rates would always be equal
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Unexpected Inflation Does Shift
Purchasing Power

When inflationary expectations are
inaccurate
 Purchasing power is shifted between those
obliged to make future payments and those
waiting to be paid
 An inflation rate higher than expected harms
those awaiting payment and benefits the payers
 An inflation rate lower than expected harms the
payers and benefits those awaiting payment
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The Resource Cost of Inflation

Inflation imposes an opportunity cost on society as
a whole and on each of its members
 When people must spend time and other resources
coping with inflation they pay an opportunity cost
• Sacrifice goods and services those resources could have
produced instead

Resources used by consumers to cope with
inflation
 Time you could have spent earning income or enjoying
leisure activities
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The Resource Cost of Inflation

Inflation also forces sellers to use up resources
 Sellers of goods and services are also buyers of resources and
intermediate goods
 Each time sellers raise prices, labor is needed to
•
•
•
•


Put new price tags on merchandise
Enter new prices into a computer scanning system
Update HTML code on a Web page
Change prices on advertising brochures, menus, and so on
Inflation makes us all use up resources managing our
financial affairs
All these additional activities—use up time and resources
 From society’s point of view, these resources could have been used
to produce other goods and services that we’d enjoy
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Is the CPI Accurate?


Bureau of Labor Statistics spends millions of dollars
gathering data to ensure measure of inflation is accurate
BLS is a highly professional agency, typically headed by an
economist
 Billions of dollars are at stake for each 1% change in CPI
 BLS deserves high praise for keeping its measurement honest and
free of political manipulation
 Economists widely agree CPI overstates U.S. inflation rate
• Even those who work at BLS

BLS has been working hard to reduce this upward bias,
and—especially in the late 1990s—it made some progress
 But significant bias remains
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Sources of Bias in the CPI

Several reasons for upward bias in CPI
 Substitution bias
 New technologies
 Changes in quality
 Growth in discounting
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Substitution Bias

Until recently, CPI almost completely ignored a
general principle of consumer behavior
 People tend to substitute goods that have become
relatively cheaper in place of those that have become
relatively more expensive

Although BLS has partially fixed the problem, CPI
still suffers from substitution bias
 Categories of goods whose prices are rising most rapidly

tend to be given exaggerated importance in CPI
Categories of goods whose prices are rising most slowly
tend to be given too little importance in CPI
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New Technologies
 CPI
excludes new products that
tend to drop in price when they first
come on the market
 Result is an overestimate of the
inflation rate
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Changes in Quality
Many products are improving over time
 BLS struggles to deal with these changes
 In recent years, BLS has adopted some
routine statistical procedures to automatically
adjust price changes for quality
improvements

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Using the Theory: The Use and Misuse
of an Imperfect CPI

Inaccuracies in measuring CPI suggest that CPI should be used and
interpreted with great care
 Unfortunately, CPI is often used for purposes which—by its nature—it cannot
handle accurately

Indexing
 Justification for indexing is to protect these people from any deterioration in
living standards caused by inflation
• But because changes in CPI overstate inflation, these beneficiaries are
•
overindexed
Nominal benefit rises by a greater percentage than a more accurately measured
price index would rise
 When a payment is indexed and price index overstates inflation, real
payment increases over time
• Purchasing power is automatically shifted toward those who are indexed, and
away from rest of society

General principle applies whether the economy is growing rapidly or
slowly, and it applies to anyone who is indexed
 Social security recipients, government pensioners, union workers with
indexed wage contracts, or anyone else
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Using the Theory: Long-Run
Comparisons

Because BLS does not correct previously-reported
CPI numbers to reflect later methodological
improvements
 Long-term comparisons of real variables based on official
CPI will remain inaccurate, even as CPI measurement
improves

Using or viewing CPI as an index of the cost of
living creates an added source of inaccuracy
 Because CPI ignores impact of new goods on living


standards
Raises a further objection to CPI-based indexing for
maintaining (rather than increasing) living standards
Ad to CPI-based inferences about changes in economic
well-being over time
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Using the Theory: What the CPI Does
Well

CPI has another purpose besides indexing and making inferences about
living standards
 To measure inflationary tendencies in economy
 CPI is one of several useful tools to help achieve this goal

Other measures not based on the CPI are available for tracking
consumer prices
 Including a special index calculated by commerce department’s Bureau of


Economic Analysis (BEA) to track prices of consumer goods in GDP
Called chain-type consumer expenditures price index
While the two measures of inflation tend to rise and fall together, they
often give different results
 Inflation based on the BEA’s index is generally lower than inflation based on

CPI
Still, because the CPI is based on a different set of data, and because it
includes some goods ignored by other indices, it provides policy makers with
valuable information about price changes
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