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Chapter IV: Prices and Inflation
A. Measuring prices and inflation
B. The AS-AD Model and inflation
C. Cost-push and demand-pull inflation
D. Inflation as a monetary phenomenon
E. Effects of inflation and inflation hedging
F. Controlling inflation
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Distinguishing real
and nominal values




Keynes had reasons to treat
the aggregate price level as given,
but in many instances the price level
will change over time
In this case we need to know more about
the price deflator for GDP
It allows to distinguish between real GDP
growth and nominal values of GDP
First we look at how prices are measured
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Measuring prices:
Two approaches



Prices are often given with reference
to a standard product for raw materials
Other prices are given as a compound measure
for a basket of goods and services
Example:
 When newspapers write about oil prices, they usually
mean one of two reference crudes: Brent from the
North Sea, or West Texas Intermediate (WTI)
 When ministers from the Organization of the
Petroleum Exporting Countries (OPEC) discuss
prices, they usually refer to a basket of heavier cartel
crudes, which trade at a discount to WTI and Brent
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Consumer price index (CPI)



An important indicator is the
consumer price index (CPI)
It attempts to measure the evolution,
over time, of the cost of living
of a typical household
It implies definition of
 A typical household
 A typical basket of goods and services
of that household
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Constructing the CPI
What do we need to construct a CPI?
 A base year t0 (in Germany 2000)
 A “typical household” (in Germany various types)
 A “basket” with “typical” of goods and services
of the household (xi,0 ) for t0
(in Germany about 750)
 Prices of the base year pi,0
and current prices pi,t for that basket
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Two types of price indices


If the weights xi,0 of the base period remain
fixed, it will give us a “Laspeyres index”
If the weights are updated every period (flexible
basket), xi,t, we obtain a “Paasche index”
n
PI tLaspeyres 
p
i ,t
i 1
n
p
i 1
i ,0
n
x i ,0
 x i ,0
PIt
Paasche

p
i ,t
 x i ,t
p
i ,0
 x i ,t
i 1
n
i 1
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Problems
of the Laspeyres index
The CPI according to Laspeyres overstates the
cost of living

Reasons: The following is not measured
 Shoppers revise shopping plan in response to
changes in price relativities (substitution bias)
 There are new products that are not incorporated
in the original basket
 There are improvements in the quality of products
and services (quality bias)
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Problems
of the Paasche index

The Paasche index
 Is more difficult to administer
(the denominator has to be re-calculated every year)
 Requires quantity data for each year,
which may be difficult to obtain
 Could be misleading, because each time
different quantities are used, and therefore
changes may not solely be attributable
to price changes
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Impact of CPI on
public and private agents

In the U.S., the CPI affects the income of almost
80 million people as a result of statutory action
 Social Security beneficiaries,
 Military and Federal civil service retirees,
 Food stamp recipients


Changes in the CPI also affect the cost of
lunches for children who eat lunch at school
Some private firms and individuals use the CPI
to keep rents, royalties, alimony payments and
child support payments in line with prices
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“Chain-linked” indices
n
p
i,t
PI
Laspeyres

t
x i,t j
i1
n
p
i,t j
,where j = 2
 x i,t j
i1


To alleviate the burden of the traditional CPI
on the federal budget, the US Bureau of Labor
Statistics publishes chain-weighted indexes using
a rolling base year since 1995
Other countries followed
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Real GDP
Real GDP is measured
in prices of a base year
For instance:
Real GDP of 2005 (in prices of 2000):
n
real
GDP2005


i1
n
output
output
pi,2000
 x i,2005


input
input
pi,2000
 x i,2005
i1
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Real GDP
and the GDP deflator
The GDP deflator is defined as follows:
GDP deflator =
Nominal GDP
Real GDP
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Reading
Reading 4-1
“Fighting America’s inflation flab”,
The Economist, October 5, 2000
(on methodological tricks with indices)
Abel, Bernanke and Croushore,
Chapter 2
(only 2.4 and 2.5)
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CPI and GDP deflator:
Differences


The CPI is a Laspeyres index, whereas
the GDP deflator is a Paasche index
The difference depends on what basket
of goods we use to calculate the index
 Is it best to use the same one
(of the reference year)?
 Or should we use the one at time t,
which changes period by period?

The answer is not obvious!
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Example: Oil shock (1)


Suppose we choose the Laspeyres index
and take the time-zero basket fixed
There is an oil shock at time 0,
the oil price skyrockets:
 households reduce the demand for gasoline
and cars
 increase the use of substitute means
of transportation (for instance subways)
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Example: Oil shock (2)


At time t the actual basket of goods includes
much less gasoline than at time zero, but the
Laspeyres formula does not take it into account,
so it will overstate inflation
The Paasche tends to understate inflation
instead, because it gives a smaller weight to
gasoline (the share of gasoline expenditures
at time t)
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Reading:
Oil shock and prices
Reading 4-2
“Pistol pointed at the heart”,
The Economist, May 29th, 2008
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Differences between CPI
and GDP deflator: summary
Price index
GDP deflator
Goods and
services
Only private goods
and services are
included
All private and
public goods are
included
International
trade
No distinction
between national or
international goods
and services
Only national
goods and
services are
summarized
Basket
Fixed
composition
Flexible
composition
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The inflation rate
and the growth rate

The annual inflation rate is calculated as
Pt 1 
 t 1  
 1 100
 Pt


The annual growth rate is calculated as
GDP real 
t 1
g t 1  
1100
real
GDPt

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International GDP deflators
1971-2005: North and South America
GDP Deflators: South America
GDP Deflators: North America
160
180
United States
160
120
Canada
140
Argentina
Mexico
120
100
Brazil
100
Other South America
140
80
80
60
60
40
40
20
20
0
1
7
9
0
1
1
7
9
3
1
7
9
5
1
7
9
7
1
7
9
9
1
8
9
1
1
8
9
3
1
8
9
5
1
8
9
7
1
8
9
9
1
9
9
1
1
9
9
3
1
9
9
5
1
9
9
7
1
9
9
9
2
0
0
1
2
0
0
3
2
0
0
5
1
7
9
1
1
7
9
3
1
7
9
5
1
7
9
7
1
7
9
9
1
8
9
1
1
8
9
3
1
8
9
5
1
8
9
7
1
8
9
9
1
9
9
1
1
9
9
3
1
9
9
5
1
9
9
7
1
9
9
9
2
0
0
1
2
0
0
3
2
0
0
5
Source: Worldbank; own calculations
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International GDP deflators
1971-2005: Europe and Asia
GDP Deflators: Europe
GDP Deflators: Asia
120
160
140
100
EU 25
120
EU 15
100
80
Other Europe
60
80
60
China
40
Japan
40
Korea
20
20
20
05
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
19
77
19
75
19
73
20
05
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
19
77
19
75
19
73
19
71
19
71
0
0
Source: Worldbank; own calculations
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Percentage increase p.a.
World inflation
Consumer price inflation, median for developingand GDP weighted mean for high-income
25
20
15
Developing
economies
10
5
0
Jan
91
High revenue economies
Jan
92
Jan
93
Jan
94
Jan
95
Jan
96
Jan
97
Jan
98
Jan
99
Jan
00
Jan
01
Jan
02
Jan
03
Jan
04
Source: Worldbank
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Inflation history
of the United States
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A useful link

http://www.bls.gov/data/inflation_calculator
.htm
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Inflation in the Euro area,
recent trends (HICP)
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World inflation
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Inflation in transition
economies
Inflation rates of transition economies even
dwarf those of Latin America in the early
1990s
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The AS-AD model
and inflation
If the AS curve is
steeper, a
variation of the
AD changes
GDP at constant
prices and
triggers an
increase of the
price deflator
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Output and employment



This seems to suggest that there is a positive
relationship between the price level and output
for varying AD functions
Given the production function:
Is there a tradeoff between unemployment and
price stability? I.e. If we want more employment,
we have to accept higher prices?
This hypothesis is expressed in the so-called
“Phillips curve”
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Inflation
Phillips curve
8
Source:
Economic Report to the President,
1985
7
6
5
Phillips curve
4
3
2
1
2
3
4
5
6
7
Unemployment
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Phillips curve




The discussion about the Phillips curve is
very much related to Keynesian demand
management
Unfortunately there is no trade off between
unemployment and inflation
The Phillips curve simply overlooks long
term reactions on the supply side
Let’s see what happens if the economy
is constrained by its potential
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The AS-AD model
and inflation
In the long run the
AS curve is vertical,
the expansion of
output is only
temporary
 In the long run we
return to potential
output at point C
 All we have
achieved is an
increase of the price
level

C
B
A
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Long run Phillips curve




In the long run employment is to remain at
its “natural” level (“natural employment”)
So the Phillips curve tradeoff works
only in the short term
(We shall come back to this when we
discuss demand pull inflation)
Let us come back to the price increase
induced by shifting along the AS curve
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Price level increase
and inflation




Is this price increase called inflation?
For most people it is, but economists
speak of inflation only if it is reoccurring
and persistent
So the case discussed here is a one-time
price adjustment only, not necessarily
inflation
How then is inflation generated?
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Why is there inflation?


Inflation could result from activist
economic policies
There are two types of mechanisms:
 Cost push
 Demand pull


Each on its own will provoke price
increases, but not necessarily inflation
However both mechanisms in tandem
could cause inflation indeed
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Oil shock
and policy reactions




Let’s assume there is an oil price shock as
in the example discussed
It would shift the supply curve to the left
creating a price increase and reducing
production
Reduced production entails unemployment
The government reacts with expansionary
fiscal policies
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Cost-push inflation
Price level
Each time the price

increase feeds
 back into wages

and costs
Inflation is due
to accommodating
fiscal policy
GDPpotential
Aggregate output
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Government demand as
a driving force of inflation



Let’s assume that the “natural rate of
employment” is reached, but there is
residual structural unemployment
The government does not tolerate this and
expands government outlays to inflate
aggregate demand
It must drive prices up, which then feed
back into wages and costs shifting the AS
curve to the left
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Demand-pull inflation
Price level



GDPpot GDPtarget
Fiscal policy drives
prices up,
and each time
the price increase
feeds back
into wages
and costs
Aggregate output
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The role of monetary policy
But neither cost push nor
demand pull could provoke
inflation without monetary
expansion
Milton Friedman
1912-2006, Nobel prize in 1976
“Inflation is always and everywhere
a monetary phenomenon”
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Views on inflation:
the monetarists
Price level
3: restoration of
“natural output” level
2’: expansion of money
supply and of AD
4
3
2
3’
2’
2: restoration of
“natural output” level
1’
1’: expansion of money
supply and of AD
1: initial
equilibrium
1
GDPnatural
Aggregate output
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Inflation
and the supply of money
Increase in Inflation and money supply in the USA
(10 years annual average)
Growth rate of the Inflation
1970
1960
1950
1980
1910
1940
1900
1890
1930
1920
1870
1880
Growth rate of the money supply in percent
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Reading
Reading 4-3
“An old enemy rears its head”,
The Economist, May 22nd, 2008
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Once more:
the Phillips curve


Activist fiscal or monetary policies
trying to push employment beyond
the “natural employment rate” should show
up in the Phillips curve
Let’s have a look at the Phillips curve for
Germany
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Phillips curve for Germany
Years
1961 to 1996
Inflation rate in %
Inflation rate in %
Years
1961 to 1973
Unemployment rate in %
Unemployment rate in %
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“Natural unemployment”
and hysteresis




As the short-term tradeoff between
unemployment and inflation is exploited,
there are “irreversible” structural effects
People thrown out of job loose their
qualification and become “structurally
unemployed”
This process is called “hysteresis”
It is exacerbated by structural changes
in the economy (the production function)
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Inflation and hysteresis
of unemployment
Inflation rate in %
Phillips curve for Germany
1961 to 1996
un 1
un 2
un 3
Unemployment rate in %
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The dynamics
of the Phillips curve
Turning clock-wise does in fact support the thesis
that expansionary policy is followed by inflation

u
The shift toward the right supports hysteresis
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Reading
Abel, Bernanke and Croushore, Chapter
12.1 and 12.2
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Creeping progression
and “inflation tax”





As the income tax is progressive, inflation will
automatically increase the tax burden relative
to GDP in real terms (“bracket creep”)
There is an “inflation tax” on money holdings
The counterpart is “seignorage”
It could diminish welfare by reducing cash
holdings below the optimum for transactions
The “inflation tax” hits the poor more than the
rich, because the latter can hedge assets
against inflation
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Inflation
and distortions of allocation

Inflation can cause serious distortions on
the allocation of capital because
 the tax system ignores inflationary gains
(losses), and it charges certain activities
too heavily (lightly)
 profits could be inflated by deficient
accounting which (inter alia)
 fixes
depreciation at historical costs
 leads to difficulties in evaluating inventory flows
 treats dividends and debt charges differently
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Inflation
and distortions of allocation



If inflation is expected, consumers could reduce
savings to spend more on consumption,
which would increase the costs of investment,
and reduce growth
Inflation entails uncertainty, which could affect
consumers’ and investors’ behavior negatively
Accounting techniques could be improved
to adjust for inflation, but this leads to higher
information costs
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Inflation and redistribution

There are distributional arguments against
inflation. It is alleged
 to let profit income earners benefit more
than wage earners
 to penalize nominal income earners
 Pensioners?
 Fixed-income
earners (from securities etc.)?
 to benefit debtors at the expense of creditors
 to make the the government
win at the expense of the private sector
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Hedging against inflation





The distributional effects largely depend on
whether inflation is expected, or not
If inflation is expected, it could be built into
contracts
One way of incorporating unforeseeable inflation
is to use indexing
Indexing is also an incentive for governments
to control the price level
It is crucial to distinguish between “passive”
contract from self-referencing contracts
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“Scala mobile” in Italy






An example for a self-referencing indexing
scheme is the “scala mobile” in Italy
From 1946 until 1992, Italy had linked wage
increases to the CPI
This lead to continuous inflationary pressures
that were hard to resist by monetary policies
Moreover the Banca d’Italia was dependent on
the government
In 1992 the “scala mobile” was repealed
The central bank became more independent
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Prohibition of indexation
in Germany





In 1948 indexation was prohibited in Germany
It was only permitted by Bundesbank
authorization, and permissions were rare
The introduction of the euro in 1999 changed
this policy, but the indexation of wages and
leasing fees is still forbidden
The central government has heralded an
inflation-indexed bond with a volume of 10 billion
€ for the year of 2005
Nowadays more than 26 countries worldwide
offer inflation-indexed bonds
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Reading
Abel, Bernanke and Croushore,
Chapter 12.3
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Different “types”
of inflation



There are different types of inflation:
creeping, rapid, and hyperinflation
The German hyperinflation is a striking example
of money expansion driving the inflation rate
This experience qualifies as a “controlled
experiment” and support Friedman’s thesis that
“inflation is always and everywhere
a monetary phenomenon”
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Example:
Germany after WW I
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The German hyperinflation
1922-23
Whole sale price index
1,E+12
1,E+11
1,E+10
1,E+09
1,E+08
1,E+07
1,E+06
1,E+05
1,E+04
1,E+03
1,E+02
1,E+01
23
19
19
23
No
v
23
19
Ju
ly
19
22
Ja
n
22
19
Ju
ly
19
21
Ja
n
21
19
Ju
ly
20
19
Ja
n
19
19
Ja
n
19
19
Ju
ly
Ja
n
Ju
ly
19
14
1,E+00
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Is inflation under control now?




Today, both the Fed and the European
Central Bank are independent institutions
with conservative monetary policies
The two world currencies, the dollar and
the euro, show little signs of inflation
Many countries have “anchored” their
currencies in one of the world currencies
Sometimes anchoring even entails
deflation (e.g. Argentina)
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Discussion 4:
Inflationary risks and corporate management



Why should firms be concerned about
inflation?
What strategies can be adopted to hedge
inflationary risks at the firm level?
Do firms need inflationary risk
management where currency boards
appear to guarantee price stability?
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