Download Chapter 8 - BCCBUSINESSSTUDIES

Chapter 8
8.1
Macroeconomic Performance
• Since each economy has several different
markets usually people will focus on the
macroeconomic aggregates. (total
unemployment)
• Two really important indicators in recent
economics are inflation and unemployment.
Importance of Information
• There is not one source of information for the
economy.
• The information comes from multiple sources
like the IMF, World Bank and United Nations.
• This is why it is important to be up to date
with data because it is always changing.
Real and Nominal Measurements
• Nominal value: the value of an economic
variable based on current prices, taking no
account of changing prices through time.
• Real value: the value of an economic variable
taking account of changing prices through
time.
Example
• Suppose last year you bought a tub of ice
cream for 100 baht, but inflation has been
10%, so this year you have to pay 110 baht.
Your REAL consumption has not changed, but
your spending has increased.
• Real consumption has not changed at all,
although nominal value has increased to 110
baht.
Index Numbers
• Index numbers are a device for comparing the
value of a variable in one period of time or
location with base observation. (Example the
retail price index measures the average level
of prices relative to a base period)
• Cost of living represents the households cost
of goods over time relative to the base year.
Inflation vs Price Level
• The phenomenon of inflation refers to a
continual rise of the price-level. When
inflation occurs, the purchasing power of a
unit of money (the dollar in the United States)
is declining. The inflation rate is calculated by
comparing the price level in one time period
to the price level of a previous period.
Measuring the Price Level
8.2
The Consumer Price Index
– The price level is the “average” level of prices and
is measured by using a price index.
– The consumer price index, or CPI, measures the
average level of the prices of goods and services
consumed by an urban family.
The Consumer Price Index
• Constructing the CPI
– Constructing the CPI involves three stages:
 Selecting the CPI basket
 Conducting a monthly price survey
 Using the prices and the basket to calculate the
CPI
The Consumer Price Index
– Housing is the largest component.
– Transportation and food and beverages are the
next largest components.
– The remaining components account for only 26
percent of the basket.
The Consumer Price Index
– The CPI basket is based on a Consumer
Expenditure Survey.
– The current CPI is based on a 1993-95 survey,
although the reference base period is still 198284.
– Every month, BLS employees check the prices of
80,000 goods and services in 30 metropolitan
areas.
– The CPI is calculated using the prices and the
contents of the basket.
The Consumer Price Index
– For a simple economy that consumes only
oranges and haircuts, we can calculate the CPI.
– The CPI basket is 10 oranges and 5 haircuts.
Item
Quantity
Price
Cost of CPI
basket
Oranges
10
$1.00
$10
Haircuts
5
$8.00
$40
Cost of CPI basket at base period prices
$50
The Consumer Price Index
– This table shows the prices in the base period.
– The cost of the CPI basket in the base period
was $50.
Item
Quantity
Price
Cost of CPI
basket
Oranges
10
$1.00
$10
Haircuts
5
$8.00
$40
Cost of CPI basket at base period prices
$50
The Consumer Price Index
– This table shows the prices in the current period.
– The cost of the CPI basket in the current period is
$70.
Item
Quantity
Price
Cost of CPI
basket
Oranges
10
$2.00
$20
Haircuts
5
$10.00
$50
Cost of CPI basket at base period prices
$70
The Consumer Price Index
– The CPI is calculated using the formula:
– CPI = (Cost of basket in current period/Cost of
basket in base period)  100.
– Using the numbers for the simple example, the
CPI is
– CPI = ($70/$50)  100 = 140.
– The CPI is 40 percent higher in the current period
than in the base period.
The Consumer Price Index
• Measuring Inflation
– The main purpose of the CPI is to measure
inflation.
– The inflation rate is the percentage change in the
price level from one year to the next.
– The inflation formula is:
– Inflation rate = [(CPI this year – CPI last year)/CPI
last year]  100.
The Consumer Price Index
– Figure 6.13 shows the CPI and the inflation rate,
1973–2003.
The Consumer Price Index
• The Biased CPI
– The CPI may overstate the true inflation for four
reasons
 New goods bias
 Quality change bias
 Commodity substitution bias
 Outlet substitution bias.
The Consumer Price Index
• The Biased CPI
– New goods bias New goods that were not available in
the base year appear and, if they are more expensive
than the goods they replace, the price level may be
biased higher.
– Similarly, if they are cheaper than the goods they
replace, but not yet in the CPI basket, they bias the
CPI upward.
– Quality change bias Quality improvements generally
are neglected, so quality improvements that lead to
price hikes are considered purely inflationary.
The Consumer Price
Index
• The Biased CPI
– Commodity substitution bias The market basket
of goods used in calculating the CPI is fixed and
does not take into account consumers’
substitutions away from goods whose relative
prices increase.
– Outlet substitution bias As the structure of
retailing changes, people switch to buying from
cheaper sources, but the CPI, as measured, does
not take account of this outlet substitution.
The Consumer Price Index
• The Biased CPI
– A Congressional Advisory Commission estimated that
the CPI overstates inflation by 1.1 percentage points a
year.
– The bias in the CPI distorts private contracts, increases
government outlays (close to a third of government
outlays are linked to the CPI), and biases estimates of
real earnings.
– To reduce the bias in the CPI, the BLS will undertake
consumer expenditure surveys more frequently and
revise the CPI basket every two years.
Retail Price Index
• CPI and RPI are nearly calculated the same.
Both want to measure price levels at a certain
time.
• RPIX does not take into account household
goods and excludes retired people and the
super rich.
RPIX, RPI and CPI
• The RPI (Retail price index) includes mortgage interest
payments. Thus changes in the interest rates effect the RPI.
If interest rates are cut, it will reduce mortgage interest
payments. Thus the RPI will fall but not the CPI.
• The RPI also includes council tax and some other housing
costs not included in CPI
• The CPI includes some financial services not included in the
RPI
• The CPI is based on a wider sample of the population for
working out weights.
• RPIX is the same as RPI minus mortgage interest payments.
• RPIX is closer to CPI but not exactly same.
The Experience of Inflation
8.3
What is inflation?
Inflation is a general and sustained rise in
the level of prices of goods and services
i.e. prices of the vast majority of goods and
services keep on rising
Some countries have experienced
hyperinflation in the past: runaway
inflation during which prices rise at
phenomenal rates and money becomes
almost worthless
How to measure inflation
There are many millions of different goods and
services exchanged in an economy, so most
countries track the prices of a selection of goods
and services to construct a price index
Year 0 (base year)
•Identify the basket of goods and services
purchased by the ‘typical’ family
•Monitor the ‘average’ price of each item in the
basket at a sample of different retail outlets
•Monitor how much the ‘typical’ family spends on
each item in the basket
•Weight the average price of each item by the
proportion of household expenditure spent on it
•Add up all the weighted average prices
•Set the total weighted average price of the basket
equal to 100
Year 1 onwards
•
Repeat the monitoring of household spending
patterns and prices
•
Compare the total weighted average price of the
basket to base year to calculate the change in
the price index
Calculating a consumer price index
Price of basket was $25 in base year, so annual inflation has been 8%, i.e.
Note: The basket of goods and services bought and the weights applied to each item in
the basket may change from year to year as products and spending patterns change
Uses of price indices
As an economic indicator
A consumer or retail price index is a widely used
measure of price inflation and therefore a measure of
changes in the cost of living
As a price deflator
Rising prices reduce the purchasing power of wages,
profits, pensions, savings, tax revenues, and a host of
other economic variables of importance to different
groups of people and decision makers. A price index is
therefore used to calculate changes in their real values
over time
For indexation
Indexation involves increasing certain payments and
values, such as state pensions and income tax
thresholds, by the annual rate of increase in price
inflation in order to keep their real value constant
The costs of inflation
Low and stable price inflation can be beneficial for an economy:
 It encourages consumers to buy goods and services sooner rather than later
 It reduces the real cost of loan repayments (think nominal and real values)
But high or rising inflation can be bad for an economy:
x Inflation erodes the value or purchasing power of money. People, especially those on
low and fixed incomes, cannot buy as much as they did before with their incomes.
Demand for many products will fall if real incomes continue to be squeezed
x It increases the costs of production and reduces profits margins
x It reduces the price competitiveness of exports
x It creates economic uncertainty. Consumers, firms and governments will be uncertain
about their future costs and the impact rising inflation could have on their incomes and
revenues. Firms may cut their investment and consumers their spending
Stagflation: an economic situation when unemployment and inflation are both high and/or rising
What is deflation?
▼ Japanese inflation, 1970–2010 (% annual change in CPI)
Disinflation refers to a slowdown in the rate
at which prices are rising in general
but
deflation involves a continuous decline in
the general level of prices in an economy
So what’s so bad about falling prices?
Increasing supply, competition, productivity and technological advance are good things for
an economy and consumers, and have reduced the prices of many products over time,
such as mobile phones, televisions, cars, holidays and clothing, in many countries
However, when falling product prices become widespread and prolonged due to a slump
in aggregate demand, the result is malign deflation
In addition, the real cost of
borrowing and public spending
rises. Firms cut investment and the
government must cut spending or
raise taxes.
Consumers delay
spending waiting for
prices to fall further
Stocks of unsold goods
accumulate so firms cut
their prices. Profits fall
Household incomes fall as
unemployment rises,
reducing demand further
Firms cut their production
and reduce the size of
their workforces
Eventually the economy goes into a
deep recession as demand, output,
the demand for labour, and incomes
continue to fall. Many firms may go
out of business because they are
unable to make any profit no matter
how much they cut their prices.
8.4
Theory of Money
• Money Stock: the quantity of money in the
economy.
• Velocity of circulation: the rate at which
money changes hands: the volume of
transactions divided by the money stock.
Supply Shock
• A supply shock is an event that suddenly
increases or decreases the supply of a
commodity or service, or of commodities and
services in general. This sudden change affects
the equilibrium price of the good or service or
the economy's general price level.
Demand-pull or cost-push inflation?
A demand-pull inflation is caused by aggregate demand rising faster than
the aggregate supply of goods and services
A cost-push inflation is caused by rising wages and other production costs.
Firms will raise their prices to cover these additional costs
A rise in import prices may cause an imported inflation. Import prices may
rise following a fall in the exchange rate of the importing country
What causes inflation?
Economists today tend to agree that the main cause of inflation is ‘too
much money chasing too few goods’
i.e. if the money supply increases at a faster rate than the aggregate supply
of goods and services then the general level of prices will rise
The money supply may expand to meet demand and cost pressures ►
Consequences of Inflation
8.5
Consequences of Inflation
• Many governments have set their central
banks a target for a low but positive rate of
inflation. They believe that persistently high
inflation can have damaging economic and
social consequences.
Consequences of Inflation
• Income redistribution: One risk of higher
inflation is that it has a regressive effect on
lower-income families and older people in
society. This happen when prices for food and
domestic utilities such as water and heating rises
at a rapid rate
• Falling real incomes: With millions of people
facing a cut in their wages or at best a pay freeze,
rising inflation leads to a fall in real incomes.
Consequences of Inflation
• Negative real interest rates: If interest rates
on savings accounts are lower than the rate of
inflation, then people who rely on interest
from their savings will be poorer. Real interest
rates for millions of savers in the UK and many
other countries have been negative for at least
four years
Consequences of Inflation
• Cost of borrowing: High inflation may also
lead to higher borrowing costs for businesses
and people needing loans and mortgages as
financial markets protect themselves against
rising prices and increase the cost of
borrowing on short and longer-term debt.
There is also pressure on the government to
increase the value of the state pension and
unemployment benefits and other welfare
payments as the cost of living climbs higher.
Consequences of Inflation
• Risks of wage inflation: High inflation can lead
to an increase in pay claims as people look to
protect their real incomes. This can lead to a
rise in unit labour costs and lower profits for
businesses
Consequences of Inflation
• Business competitiveness: If one country has
a much higher rate of inflation than others for
a considerable period of time, this will make
its exports less price competitive in world
markets. Eventually this may show through in
reduced export orders, lower profits and
fewer jobs, and also in a worsening of a
country’s trade balance. A fall in exports can
trigger negative multiplier and accelerator
effects on national income and employment.
Consequences of Inflation
• Business uncertainty: High and volatile
inflation is not good for business confidence
partly because they cannot be sure of what
their costs and prices are likely to be. This
uncertainty might lead to a lower level of
capital investment spending.