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13e Chapter 07: Inflation McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Learning Objectives • 07-01. Know how inflation is measured. • 07-02. Know why inflation is a socioeconomic problem. • 07-03. Know the meaning of “price stability.” • 07-04. Know the broad causes of inflation. 7-2 What Is Inflation? • Inflation: an increase in the average level of prices, not a change in any specific price of a good. • The prices of specific basket of goods are collected and computed into an average price level for that basket in a year. – A rise in that average price level is inflation. – A decrease in that average price level is deflation. 7-3 Relative Prices • The market mechanism causes the prices of individual goods and services to rise or fall – an essential market function. – Relative price: the price of one good compared to the price of other goods. – Buyers switch from one good to another when their relative prices diverge. • Inflation is a rise in the average price of all goods. – It is not a market function. 7-4 Effects of Inflation • Some prices rise and some fall. • Rising prices require you to reallocate your purchasing power to ensure that you get the most satisfaction per dollar spent. – You might reduce buying goods with higher prices and increase buying goods with lower prices. • This can be seen by the difference between nominal income and real income. 7-5 Effects of Inflation • Nominal income: the amount of money income received in a given time period, measured in current dollars. • Real income: income in constant dollars; nominal income adjusted for inflation. • You may get a raise (nominal income increases) – but if it does not rise as fast as inflation, your purchasing power decreases (real income falls). 7-6 Redistribution of Income and Wealth by Inflation • Price effects. – Those who buy products that are increasing in price the fastest end up worse off. – Those who sell products that are increasing in price the fastest end up better off. – Those who buy products that are increasing in price the slowest end up better off. – Those who sell products that are increasing in price the slowest end up worse off. 7-7 Redistribution of Income and Wealth by Inflation • Income effects. – People with nominal incomes rising more slowly than inflation end up worse off. – People with nominal incomes rising faster than inflation end up better off. 7-8 Redistribution of Income and Wealth by Inflation • Wealth effects. – Those who own assets that are declining in real value end up worse off. – Those who own assets that are increasing in real value end up better off. 7-9 Money Illusion • Money illusion: using nominal dollars rather than real dollars to gauge changes in one’s income or wealth. • Exercise: – In the “good old days” a movie ticket was 50 cents and the minimum wage was $1.00. – Compare the purchasing power of the minimum wage today to the “good old days.” – You could buy two movie tickets with one hour’s work before, but not now. 7-10 Macro Consequences of Inflation • Uncertainty: not knowing the prices of goods in the future makes purchasing and production decision making much more difficult. • Speculation: decisions will shift from standard economic activity to betting on the future prices of goods. • Bracket creep: in a progressive tax system, when nominal incomes rise, the taxpayer gets pushed into a higher tax bracket. 7-11 Deflation • Deflation: a general decrease in average prices. • This has redistribution effects that are just the opposite of those for inflation. • This has macro consequences also. – – – – Sellers are reluctant to stock inventory. Buyers are reluctant to buy now. Businesses are reluctant to borrow funds or invest. Incomes fall, and asset values decrease. 7-12 Consumer Price Index (CPI) • Consumer price index (CPI): a measure (index) of the average price of consumer goods and services. – Used to calculate the inflation rate. • Inflation rate: the annual percentage rate of increase in the average price level. 7-13 Creating a Price Index • Select a “market basket” of goods: a standardized list of goods and services customers usually buy. • Select a base year: the reference year whose dollar value will be used. • Set the price index in the base year always equal to 100. • Measure the prices for the basket of goods in both the current year and in the base year. 7-14 Computing a Price Index Price index in current year Price index base year = Basket price in current year Basket price in base year • Basket price in the base year = $6,000. • Basket price in the current year = $6,600. • Compute the price index (CPI) for the current year: – X/100 = $6,600/$6,000 – X = (6,600 x 100)/6,000 – X = 110 • CPI in the current year is 110. • A CPI of 110 indicates that prices in the current year are 10% higher than prices in the base year. 7-15 Other Measures of Inflation • Core inflation: changes in CPI, excluding food and energy prices. • Producer price index (PPI): changes in the average prices at intermediate steps of production. • GDP deflator: changes in prices of all goods and services included in GDP. – Used to correct nominal GDP to real GDP. 7-16 Computing Inflation Rate from CPI Inflation rate = • • • • CPI year 2 – CPI CPI year 1 X 100 year 1 CPI in 2006 was 201.6. CPI in 2005 was 195.3. Compute the inflation rate for 2006: Inflation rate = (201.6-195.3)x100/195.3 = 3.23% 7-17 The Goal: Price Stability • Price stability: the absence of significant changes in the average price level. – Officially defined as a rate of inflation of less than 3 percent. – Established by Full Employment and Balanced Growth Act of 1978. 7-18 The Goal: Price Stability • Measurement concerns. – We are seeking price stability at the lowest rate of unemployment. – From year to year, there are quality improvements in the basket of goods. – New products change the content of the basket of goods we buy. 7-19 Causes of Inflation • Demand-pull inflation: results from excessive pressure to buy on the demand side of the economy. – A booming economy creates shortages. – Too much money pumped into the economy by the Federal Reserve. • Cost-push inflation: due to higher production costs putting pressure on suppliers to push up prices. 7-20 Protective Mechanisms • Cost of living allowances (COLA): nominal incomes are indexed to automatically rise at the same rate as inflation. • Adjustable-rate mortgage (ARM): interest rate on a mortgage rises along with inflation so that lenders do not lose money. 7-21 The Real Interest Rate • Real interest rate: the nominal interest rate minus the anticipated inflation rate. – The borrower pays the nominal rate. – The inflation-adjusted (real) rate of interest: Real interest rate = Nominal interest rate – Anticipated rate of inflation – Protects the lenders. Hurts the borrowers. – Borrowers will pay back loan using more lowervalued dollars, but lenders receive the same purchasing power. 7-22