Transcript Document

The Monetary System,
Prices, and Inflation
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
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
4
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
5
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 current period
x 100
Value of measure in base period
• Compress and simplify information so that we can
see how things are changing at a glance
6
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
8
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
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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
Nominal wage in that year
Real wage in any 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
• GDP price index includes some prices that CPI ignores
– GDP price index excludes some prices that are part of
CPI
• 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 not only time, but
other resources as well
– 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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A Preliminary Word About Deflation
• In early 2000s, as annual inflation rate
approached 2%, a new worry appeared on
the American political and economic scene
– That disinflation ( a decreasing inflation rate)
might lead to deflation (a negative inflation rate)
– In some respects, deflation creates costs for
society similar to those of inflation
• However, deflation has some special costs
and risks of its own, entirely different from
those of inflation
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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
– When included, CPI regards them as entirely
separate from existing goods and services
• Instead of recognizing that they lower cost of
achieving a given standard of living
– Result is an overestimate of the inflation rate
24
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
25
Growth in Discounting
• CPI treats toothpaste bought at a high-priced
drugstore and toothpaste bought at Wal-Mart or
Drugstore.com as different products
– Assumes we continue to buy from high- and low-priced
stores in unchanged proportions
• But that is not what has been happening
– In fact, Americans are buying more and more of their
toothpaste and other products from discounters
• CPI omits reductions in the prices people pay
from more frequent shopping at discount stores
– Overstates inflation rate
26
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 previouslyreported 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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