Download Lecture 6 Inflation

Principles of Macroeconomics
Lecture 5
INFLATIONTHE CONSUMER PRICE INDEX
AND THE COST OF LIVING
What do you think?
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1976: Starting salary
for an economics
professor was $15,000
2001: Starting salary
for an econ. prof. was
$55,000.
Considering the REALITY
PRINCIPLE, who had a
better life?
Reality Principle

What matters to
people is the real
value of money – its
PURCHASING
POWER – not the
nominal or face value
of money.
CPI:
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Consumer Price Index
A price index that
measures the cost of a
fixed basket of goods
chosen to represent
the consumption
pattern of individuals.
 Tracks
the cost of
living over time.
What is in the “market basket”?
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Food and Beverages
Housing
Apparel
Transportation
Medical Care
Recreation
Education
Other goods and
services
Food and Beverages
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Breakfast Cereal
Milk
Chicken
Wine
Coffee
Service meals
Snacks
Housing
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Rent for primary
residences
Owners equivalent
rent
Fuel Oil (home
heating)
Bedroom furniture
Apparel
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Men’s shirts and
sweaters
Women’s dresses
Jewellery
Transportation
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New cars
Airline fares
Gasoline
Car insurance
Medical Care
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Prescription drugs
Medical supplies
Doctor services
Eyeglasses
Eyeglass services
Hospital care
Recreation
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Television
Pets
Pet products
Sports equipment
Admissions
Education and Communication
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College Tuition
Postage
Telephone Services
Computer Software
Computer accessories
Other Goods and Services
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Tobacco and smoking
products
Haircuts
Other personal
services
Funeral Expenses
CPI

Used by both
government and the
private sector to
measure changes in
prices facing
consumers.
CPI versus GDP
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CPI measures goods
produced in prior years
(older cars) as well as
imported goods.
Chained GDP does not
measure either of these.
ONLY new goods and
those produced in the
country.
CPI vs GDP

Because consumers
will cut back on goods
that cost more – the
CPI will tend to
overstate true
changes in cost of
living.
 If
chicken goes up in
price, we switch to
hamburger.
CPI Problems
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Does not “cut back”
on higher priced
goods like consumers
do.
Would still count the
same share of chicken
as it did before the
price index.
What Economists THINK

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CPI may be
overestimated by
0.5% to 1.5% each
year.
BIG argument among
the econ community.
Cost of Living Adjustments

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Automatic increases in
wages or other
payments that are
tied to a price index.
For Future Reference
on contract
negotiations: Called
COLA.
COLA and CPI

As CPI goes up, our
wages or Social
Security makes
adjustments to keep
up with the cost of
living.
INFLATION

Inflation Rate:
 The
percentage rate
of change of the price
level of the economy.
Calculating Inflation Rates
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Inflation Rate = percentage rate of change of a
price index.
See page 124 for more on how to calculate!
INFLATION
– The trade-off with
more employment.
Types of Inflation
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Demand-Pull Inflation
Cost-Push Inflation
Monetary Inflation
Stagflation
Hyperinflation
Demand-Pull Inflation

When the demand for
goods and services
exceeds the production
capacity.
– Prices rising because
of shortages.
Cost-Push Inflation

Inflation can arise from
changes in the costs of
production of goods and
services.
– Increase in the price of raw
materials
– Increase in the price of
labor
– Increase in the cost of
capital.
Cost-Push v. Demand Pull

They push and pull
prices up.
– Labour contracts
containing COLA
clauses.
 Cost-Of-Living
Adjustments.
Monetary Inflation

Inflation caused by
excessive growth in
the money supply.
– Value of money
decreases if it isn’t that
“rare.”
Rule for Monetary Inflation:
VELOCITY

Quantity Equation
– MxV=TxP
– Money supply times
the velocity at which it
changes hands equals
the number of
transactions times the
average level of prices.
MxV=TxP

Direct relationship
between the money
supply and the price
level.
What happens when the
quantity equation is “off”?

Hyperinflation
 Money supply
increases much, much
faster than an
economy’s output of
goods and services.
– THINK RUSSIA in
1990s.
– Zimbabwe in 2000s
– Germany post WWI
Phillips Curve: The
relationship between
unemployment and inflation.
INVERSE relationship.
Unemployment goes
UP, then inflation goes
DOWN.
Stagflation: When things
REALLY go wrong on the
Phillips Curve

Inflation and
unemployment were at
higher levels.
– Combination of
stagnation and
inflation.
– Both were increasing.
1970s: What caused
Stagflation?

Spending on the Vietnam War PLUS
spending on domestic social programs.
 Inflationary expectations
 Rise in energy costs caused by OPEC
 Monopolistic pricing
What is wrong with Inflation?

Inflation reduces
REAL INCOME of
those whose incomes
do not rise as fast as
the price level.
 Hurts:
– People holding assets
in MONEY
– Lenders
Special Note: Phillips Curve
International
– Europe 1970s had higher
inflation and
unemployment.
– Worse because:
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Labour union practices
Tax structures
Government economic
policies
Consequences of INFLATION

Income Effects:
– Reduced purchasing
power of the dollar
– Reduced real income
for fixed income
receivers
– Reduced real wealth of
savings
Income Effects of Inflation
(cont.)

Benefits those whose
incomes rise faster
than the inflation rate.
 Benefits owners of
real assets (real estate,
precious metals
(kinda!))
 Benefits debtors
How Inflation effects Real
Output

Inflation initially
stimulates output
 Near full employment,
there arise bottlenecks in
supplies
 Costs begin rising faster
than prices
 Interest rates accelerate,
discouraging new
investment.
Helpful Reading
Economics. Samuelson, & Nordhaus (2005) Ch. 29-30