Transcript Unit 7 - Inflation - Inflate Your Mind

Unit 7 - Inflation

Inflation Measures
Common inflation measures are:
Consumer Price Index
Producer Price Index
GDP deflator
Macroeconomics
Unit 7 - Inflation

The Consumer Price Index (CPI)
 is the most common inflation measure.
 measures consumer goods only.
 is a weighted index (an increase
in the price of eggs is
more important than an
increase in the price of
black-and-white televisions).
Macroeconomics
Unit 7 - Inflation
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The Producer Price Index (PPI)
measures business goods only.
is a weighted index.
Macroeconomics
Unit 7 - Inflation
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The GDP Deflator
measures price increases of all goods and
services based on real and nominal GDP
calculations
Equals nominal GDP divided by real GDP.
Example: nominal GDP=$120, and real
GDP=$100.
GDP deflator = $120/$100=1.2.
Macroeconomics
Unit 7 - Inflation

United States CPI-U History for selected years (average
percentage change)
1914
1
2000
3.4
1918
18
2001
2.8
1942
1946
10.9
8.3
2006
2007
3.2
2.8
1980
1985
13.5
3.6
2008
2009
3.8
-.4
1990
5.4
2010
1.6
Source:
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
Macroeconomics
For a United States consumer, $100 in
1990 bought the same as _____ in 2010.
1.
2.
3.
4.
5.
6.
$93
$100
$142
$166
$196
$223
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Unit 7 - Inflation

For an inflation calculator, visit:
http://www.bls.gov/data/inflation_calculator.htm
Macroeconomics
What causes steady price
increases in the long run:
1.
2.
3.
4.
5.
0 of 5
Too much demand
Too little demand
Too much
government
spending
Steady increases in
the money supply
Trade deficits
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Unit 7 - Inflation
●The Cause of Inflation
In the long run, a steady increase in
the nation’s money supply is the only
cause of constantly rising prices.
Macroeconomics
Unit 7 - Inflation

The Cause of Inflation
Let’s look at a very simplified
economy with only two products to
understand the cause of price changes.
Macroeconomics
Unit 7 - Inflation
Assume, for simplicity, that in year 1,
an economy produces only 2 products:
oranges and hammers.
Macroeconomics
Unit 7 - Inflation
Assume that there are 10 orange
producers.
Each producer makes 2 oranges, so
total production of oranges is 20.
Macroeconomics
Unit 7 - Inflation
Assume that there are 5 hammer
producers.
Each producer makes 1 hammer, so
total production of hammers is 5.
Macroeconomics
Unit 7 - Inflation
Assume that the country’s money
supply is $100.
Macroeconomics
Unit 7 - Inflation
Assume that the price of an orange is the
same as the price of a hammer and that
consumers spend their entire income (no
savings) on oranges and hammers.
Then what is the average equilibrium price
per product?
Macroeconomics
Unit 7 - Inflation
Answer:
Money supply is $100.
Total production is 25 (20 oranges and 5 hammers).
The equilibrium price is $100 / 25, or $4.
If the price is less than $4, there is a surplus of
money.
If the price is more than $4, there is a surplus of
products.
Macroeconomics
Unit 7 - Inflation
Assume that in year 2, the money
supply increases to $200.
Now what is the equilibrium price per
product?
Macroeconomics
Unit 7 - Inflation
Year 2 money supply is $200.
Total production is 25.
Equilibrium price is $200 / 25, or $ 8.
If the price is less than $8, there is a surplus
of money.
If the price is more than $8, there is a
surplus of products.
Macroeconomics
Unit 7 - Inflation
Without an increase in production,
an increase in the money supply
causes average prices to increase.
Macroeconomics
Unit 7 - Inflation
What does it take for production to
increase?
Is it necessary to increase the money
supply in order to experience economic
growth and make incomes increase?
Macroeconomics
Unit 7 - Inflation
Let’s assume a constant money supply.
Will technological progress occur?
What will happen to profits and
average incomes?
Macroeconomics
Unit 7 - Inflation
Consider the orange and hammer
example.
One orange and one hammer producer
improve their technology and double
their production.
Macroeconomics
Unit 7 - Inflation
What is total production now?
What is the average equilibrium price
of an orange and a hammer?
Macroeconomics
Unit 7 - Inflation
Total production is 28 products:
22 oranges (9 times 2, plus 4) + 6 (4
times 1, plus 2) hammers.
Average price per product = $100/28 =
$3.57.
Macroeconomics
Unit 7 - Inflation
Revenue of the orange producer that
doubled its production is 4 times $3.57, or
$14.28 (compared to $ 8 in year 1).
Revenue of the hammer producer that
doubled its production is 2 times $3.57, or
$7.15 (compared to $ 4 in year 1).
Macroeconomics
Unit 7 - Inflation
Both innovative producers are better
off.
Innovation pays.
Macroeconomics
Unit 7 - Inflation
But what happens if the technology is
shared and all producers adopt the
improved technology?
What is total production and what will
be the average equilibrium price?
Macroeconomics
Unit 7 - Inflation
Total orange production is 40 (10 times 4).
Total hammer production is 10 (5 times 2).
Equilibrium price per product is $2 ($100
divided by 50).
What is the revenue per producer?
Macroeconomics
Unit 7 - Inflation
Revenue per orange producer = $8 (4 times
$2).
Revenue per hammer maker = $4 (2 times
$2).
This is the same revenue as in year 1, before
the technology improvements. Is anyone
better off? Does innovation really pay in a
constant money supply economy?
Macroeconomics
Unit 7 - Inflation
How many oranges does $8 buy in year 1?
How many hammers does $8 buy in year 1?
How many oranges does $8 buy after the
technology improvements?
How many oranges does $8 buy after the
technology improvements?
Lower prices means greater purchasing power and
increased real incomes.
Macroeconomics
Unit 7 - Inflation
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Falling Prices
Are falling prices
harmful to
the economy?
Macroeconomics
Unit 7 - Inflation
 Falling Prices
Why are some people
concerned about
falling prices?
Large pizza: $2.50
Macroeconomics
Unit 7 - Inflation
Average Price Level
S
$30
$20
D1
D2
496
578
Quantity Demanded/
Quantity Supplied
Unit 7 - Inflation
 Falling Prices
Falling prices due to
a decrease in demand
is harmful.
Jacket: $20
Macroeconomics
Unit 7 - Inflation
S1
Average Price Level
S2
$35
$25
D
296
379
Quantity Demanded/
Quantity Supplied
Unit 7 - Inflation
 Falling Prices
Falling prices due to
an increase in supply
is beneficial.
Ipod: $25
Macroeconomics
Unit 7 - Inflation
Understanding economics: priceless
Macroeconomics
Unit 7 - Inflation
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Harmful Consequences of Inflation
Inflation leads to:
 Increases in long-term interest rates
 Decreases in exports
 Decreases in savings
 Mal-investments (people buy houses instead of investing in
new businesses)
 Higher taxes (COLAS increase nominal, not real income)
 Inefficient government spending (government is not
accountable for printed money)
Macroeconomics
Unit 7 - Inflation
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Short-run versus Long-run Consequences of
Inflation
In the short run, an increase in the money supply
decreases interest rates and stimulates spending.
In the long run, an increase in the money supply
increases prices, increases long-term interest rates,
and slows down the economy.
Macroeconomics
Unit 7 - Inflation
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A Constant Money Supply System
In a constant money supply system:
 The quantity of money in circulation is
constant or nearly constant.
 Average prices decrease with increases in
production.
 Purchasing power, profits, wealth and incomes
increase.
Macroeconomics
Unit 7 - Inflation
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The Gold Standard
The Gold Standard is an example of a system with
an constant (or nearly constant) money supply.
In a gold standard, the supply of money is only
allowed to grow as much as the supply of gold
grows each year. Historically this has been
between 1 and 2 % per year.
Macroeconomics
Unit 7 - Inflation
 The
Gold Standard
An appropriately applied gold standard forces the
Federal Reserve System to keep the money supply limited
to the growth of the gold supply.
In a growing economy and an appropriately applied gold
standard, prices will fall.
The Gold Standard failed in the 1960s, because the Fed
was not disciplined enough to limit the money supply.
Macroeconomics
Unit 7 - Inflation
 The
Gold Standard
If the Fed is disciplined to keep the money supply
constant without a gold standard, then we would
not need a gold standard. This is actually
preferable, because the supply of gold in some
years fluctuates more than 1-2%.
Macroeconomics