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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 Goethe Business School 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 2 Goethe Business School 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 3 Goethe Business School 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 4 Goethe Business School 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 5 Goethe Business School 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 6 Goethe Business School 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) 8 Goethe Business School 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 9 Goethe Business School 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 10 Goethe Business School “Chain-linked” indices n p i,t PI Laspeyres t x i,t j i1 n p i,t j ,where j = 2 x i,t j i1 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 11 Goethe Business School 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 i1 n output output pi,2000 x i,2005 input input pi,2000 x i,2005 i1 12 Goethe Business School Real GDP and the GDP deflator The GDP deflator is defined as follows: GDP deflator = Nominal GDP Real GDP 13 Goethe Business School 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) 14 Goethe Business School 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! 15 Goethe Business School 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) 16 Goethe Business School 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) 17 Goethe Business School Reading: Oil shock and prices Reading 4-2 “Pistol pointed at the heart”, The Economist, May 29th, 2008 18 Goethe Business School 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 19 Goethe Business School 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 1100 real GDPt 20 Goethe Business School 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 21 Goethe Business School 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 22 Goethe Business School 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 23 Goethe Business School Inflation history of the United States 24 Goethe Business School A useful link http://www.bls.gov/data/inflation_calculator .htm 25 Goethe Business School Inflation in the Euro area, recent trends (HICP) 26 Goethe Business School World inflation 27 Goethe Business School Inflation in transition economies Inflation rates of transition economies even dwarf those of Latin America in the early 1990s 28 Goethe Business School 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 29 Goethe Business School 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” 30 Goethe Business School 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 31 Goethe Business School 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 32 Goethe Business School 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 33 Goethe Business School 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 34 Goethe Business School 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? 35 Goethe Business School 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 36 Goethe Business School 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 37 Goethe Business School 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 38 Goethe Business School 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 39 Goethe Business School 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 40 Goethe Business School 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” 41 Goethe Business School 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 42 Goethe Business School 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 43 Goethe Business School Reading Reading 4-3 “An old enemy rears its head”, The Economist, May 22nd, 2008 44 Goethe Business School 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 45 Goethe Business School Phillips curve for Germany Years 1961 to 1996 Inflation rate in % Inflation rate in % Years 1961 to 1973 Unemployment rate in % Unemployment rate in % 46 Goethe Business School “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) 47 Goethe Business School Inflation and hysteresis of unemployment Inflation rate in % Phillips curve for Germany 1961 to 1996 un 1 un 2 un 3 Unemployment rate in % 48 Goethe Business School 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 49 Goethe Business School Reading Abel, Bernanke and Croushore, Chapter 12.1 and 12.2 50 Goethe Business School 51 Goethe Business School 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 52 Goethe Business School 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 53 Goethe Business School 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 54 Goethe Business School 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 55 Goethe Business School 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 56 Goethe Business School “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 57 Goethe Business School 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 58 Goethe Business School Reading Abel, Bernanke and Croushore, Chapter 12.3 59 Goethe Business School 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” 60 Goethe Business School Example: Germany after WW I 61 Goethe Business School 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 62 Goethe Business School 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) 63 Goethe Business School 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? 64 Goethe Business School