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Inflation

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					   Inflation is an increase in the average level of
    prices, not a change in any specific price.
   The average price is determined by finding
    the average price of all output.
    ◦ A rise in the average price is called inflation.
    ◦ A fall in the average price is called deflation.
   Changes in relative prices may occur in a
    period of stable average price, or in periods
    of inflation or deflation.


   A relative price is the price of one good in
    comparison with the price of other goods.
   By reallocating resources in the economy,
    relative price changes are an essential
    ingredient of the market mechanism.


   A general inflation doesn’t perform this
    market function.
   Although inflation makes some people worse
    off, it makes some people better off.
   The three major methods inflation
    redistributes money by are:
    ◦ The Price Effect
    ◦ The Income Effect
    ◦ The Wealth Effect
   Nominal income is the amount of money
    income received in a given time period,
    measured in current dollars.


   Real income is income in constant dollars:
    nominal income adjusted for inflation.
   Two basic lessons about inflation:
    ◦ Not all prices rise at the same rate during inflation.
    ◦ Not everyone suffers equally from inflation.
     Not all prices rise at the same rate during
      inflation.
     Not everyone suffers equally from inflation.
   People who prefer goods and services that
    are increasing in price least quickly end up
    with a larger share of income.
   Even if all prices rose at the same rate,
    inflation would still redistribute income.
   Redistributive effects originate both in
    expenditure and income patterns.
   What looks like a price to a buyer looks like
    an income to a seller.


 If prices are rising, incomes must be rising
  too.
 People whose nominal income rise faster
  than inflation end up with a larger share of
  total income.
200

180

160                    Prices
                                Wages
140

120

100
  1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
                         YEAR
   People hold wealth in different forms
    (accounts, stocks, commodities).
   When the value of these changes due to
    inflation, some people will get wealthier and
    some will lose wealth.
   One of the most immediate consequences of
    inflation is uncertainty.
   Uncertainties created by changing price levels
    affect consumption and production decisions.
   People tend to shorten their time horizons in
    the face of inflation uncertainties.
   Time horizons are shortened as people
    attempt to spend money before it loses
    further value.
   During the German hyperinflation, workers
    were paid two or three times a day so that
    they could buy goods in the morning before
    prices increased in the afternoon.


       Hyperinflation is an inflation rate in excess of
        200 percent, lasting at least one year.
   If you expect prices to rise, it makes sense to
    buy things now for resale later.
   Few people will engage in production if it is
    easy to make speculative profits.
   People may be encouraged to withhold
    resources from the production process,
    hoping to sell them later at higher prices.
   As such behavior becomes widespread,
    production declines and unemployment rises.
   Bracket creep is the movement of taxpayers
    into higher tax brackets (rates) as nominal
    incomes grow.
   As prices rise, incomes rise, and then taxes
    rise.
   Deflation — a falling price level — might not
    make people happy either.
   Deflation reverses the redistributions caused
    by inflation.
   Lenders win and creditors lose.
   When prices are falling, people on fixed
    incomes and long-term contracts gain more
    real income.
   Falling price levels have similar macro
    consequences.


 Time horizons get shorter.
 Businesses are more reluctant to borrow
  money or to invest.
   People lose confidence in themselves and
    public institutions when declining price levels
    deflate their incomes and assets.
   Measuring inflation serves two purposes:
    ◦ Gauges the average rate of inflation.
    ◦ Identifies its principal victims.
   The CPI is the most common measure of
    inflation.
   The consumer price index (CPI) is a measure
    (index) of changes in the average price of
    consumer goods and services.
   By observing the extent of price increases, we
    can calculate the inflation rate.


   The inflation rate is the annual
    percentage rate of increase in the average
    price level.
   The Bureau of Labor Statistics constructs a
    market basket of goods and services that
    consumers usually buy.
   Specific goods and services are itemized
    within the broad categories of expenditures.
   The relative importance of a product in the
    CPI is reflected in its item weight.


   Item weight is the percentage of total
    expenditure spent on a specific product;
    used to compute inflation indexes.
   The impact on the CPI of a price change for a
    specific good is calculated as follows:



        percentage change in CPI =
    item weight X percentage change in
                price of item
                                         Transportation
                                             19.0%
                          Housing
                           32.6%                Food
                                                13.6%




Insurance and pensions 9.3%                        Clothing 4.7%
                                            Miscellaneous 10.5%
                    Entertainment 5.1%
                                Health care 5.3%
   There are three producer price indexes (PPI)
    which keep track of average prices received
    by producers.
   One includes crude materials, another
    intermediate goods, and the last covers
    finished goods.
   PPIs are watched as a clue to potential
    changes in consumer prices.


 In the short run, the PPIs usually increase
  before the CPI.
 The PPIs and the CPI generally reflect the
  same inflation rate over long periods.
   The GDP deflator is a price index that refers
    to all goods and services included in GDP.
    ◦ It is the broadest price index is the GDP deflator.
    ◦ It covers all output including consumer goods,
      investment goods, and government services.
   The GDP deflator usually registers a lower
    inflation rate than the CPI.


 Unlike the CPI and PPI, the GDP deflator
  is not limited to a fixed basket.
 Its value reflects both price changes and
  market responses to those changes.
   The GDP deflator is used to adjust nominal
    output values for changing price levels.
    ◦ Nominal GDP is the value of final output produced
      in a given period, measured in the prices of that
      period (current prices).
    ◦ Real GDP is the value of final output produced in a
      given period, adjusted for changing prices.
   Nominal and Real GDP are connected by the
    GDP deflator:
   Price stability is the absence of significant
    changes in the average price level; officially
    defined as an inflation rate of less than 3
    percent.
   A little bit of inflation might be the “price” the
    economy has to pay to keep unemployment
    rates from rising.


   Some unemployment may be the “price”
    society has to pay for price stability.
   In the long view of history, the U.S. has done
    a good job in maintaining price stability.
   Upon closer inspection, however, our inflation
    performance is very uneven.
20
                                                      Inflation
16
                                               A
12
8
4
0                                                             B
4
8
12                                                    Deflation
     1920   1930   1940   1950   1960   1970   1980    1990   2000
   Inflation is rooted in supply and demand.
   The most common types of inflation come
    from demand-pull and cost-push.
   Demand-pull inflation results from excessive
    pressure on the demand side of the economy.
   “Too much money chases too few goods”
    enabling producers to raise prices.
   The pressure on price could also originate on
    the supply side.
   Higher production costs put upward pressure
    on product prices.
   Low rates of inflation don’t have the drama of
    hyperinflation, but they still redistribute real
    wealth and income.
    ◦ For example, if prices rise by an average of just 4
      percent a year, the real value of $1,000 drops to
      $822 in five years and to only $676 in ten years.
   Cost-of-living adjustments (COLAs) are
    automatic adjustments of nominal income to
    the rate of inflation.
   COLAs are commonly used by landlords as
    well as in labor agreements and government
    transfer programs.
   An adjustable-rate mortgage (ARM) is a
    mortgage (home loan) that adjusts the
    nominal interest rate to changing rates of
    inflation.
   ARMs were developed to protect lenders
    against losses during long term rises in
    inflation.
   The real interest rate is the nominal interest
    rate minus the anticipated inflation rate.


Real interest rate = nominal interest rate
        – anticipated interest rate
   If prices rise faster than interest accumulates,
    the real interest rate will be negative.
End of Chapter 7

				
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