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Introduction to Economics
Macroeconomics
The US Economy
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Outline: Lecture Seven
Inflation
 Money

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8. Thursday, Oct. 22, Lecture Eight: "Inflation"
Cost of living indices
GDP deflator
The impact of inflation on your personal wealth
real rate of return on wealth
real interest rate
The cause of inflation
the quantity theory of money
Reading Assignment:
O’Sullivan and Sheffrin, Ch. 30, “The
Dynamics of Inflation and Unemployment”
Problems O & S Text
p. 623: 1, 2, 3, 4, 5, 6, 7, 8
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Inflation
Historical Cost of Living
 Consumer Price Index
 GDP Deflator
 Real GDP and Growth of the Economy
 Rate of Inflation
 Impact of Inflation on You
 Social Impact of Inflation
 Inflation Forecast
 Cause of Inflation

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Cost of Living Index, 1913=100, Massachusetts: Jan. 1910 - Dec. 1943
225
200
175
150
weights:
food: 37.6%
clothing: 12.8%
shelter: 21.8%
fuel & light: 5.0%
sundries: 22.8%
125
100
75
10
12 14
16
18 20
22
24 26
28
30 32
34
36 38
40
Year
cost of living index, Massachusetts
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Historical Cost of Living: Mass.

World War I & aftermath: inflation
 rapid
increases in 1917, 1918; peak in 1920
twenties: price stability
 early thirties: deflation
 World War II: inflation

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Consumer Price Index: CPI
prepared by the Bureau of Labor Statistics,
BLS, US Dept. of Labor, USDOL
 1982-84=100
 weights for urban consumers, 10,000
families in the survey

 housing
= 42.6%
 transportation = 18.7%
 food & beverages = 17.8%
 apparel & upkeep = 6.5%
 other goods & services = 5.1%
 medical care = 4.8%
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 entertainment = 4.4%
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CPI: Consumer Price Index
Rate of Inflation
 For
example, the annual rate:
[P(t)
- P(t-1)]/P(t-1) = ∆P(t)/P(t-1)
 [CPI(1997)
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- CPI(1996)]/CPI(1996)
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Source: Yardeni’s Economics Network, http://www.yardeni.com/
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Inflation Rate: CPI
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GDP Deflator
Nominal Value $ = Price * Quantity
Nominal GDP = GDP Deflator * Real GDP
 Nominal GDP/Real GDP = GDP Deflator
 Real GDP = Nominal GDP/GDP Deflator

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GDP Deflator, 1992=100 .
120
100
60
40
20
Year
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97
93
89
85
81
77
73
69
65
61
57
53
49
45
41
37
33
0
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Index
80
GDP Deflator, 1992=100, Proportional Scale .
1000
Index
100
10
Year
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97
93
89
85
81
77
73
69
65
61
57
53
49
45
41
37
33
29
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GDP Deflator: History
early thirties: deflation
 World War II: inflation
 Korean War: inflation
 fifties and sixties: price stability
 Vietnam War: inflation

 Lyndon

seventies: inflation
 OPEC:

Johnson: “guns and butter”
energy prices
nineties: price stability
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Is the economy growing less rapidly?

Growth in real GDP over time
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Growth of Real GDP, 1929-1997 .
9000
8000
7000
REAL GDP
Exponential Trend
Billions
6000
5000
4000
3000
y = 247.07e 0.0364x
R2 = 0.9717
2000
1000
0
20
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40
60
Year
80
100
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The Impact of Inflation
 The
impact of inflation on personal
wealth
Is
your wealth growing as fast as the
inflation rate? Are you preserving
purchasing power?
 ∆w/w
= r + s/w
 recall, your rate of growth of wealth, ∆w/w,
equals your rate of return on wealth, r, plus
the ratio of savings to wealth, s/w
 If the inflation rate, ∆p/p, is 3% per year, and
your wealth is growing at 3% per year, then you
are just treading water.
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Inflation can make your personal
investment decision more
difficult
inflation adds to uncertainty about the
future, and about rates of return
 inflation is an argument for investing in
stocks, and sometimes real estate and
tangible personal property such as art,
jewelry, gold

 hedge
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against inflation
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Concepts: real rate of return; real
rate of interest
 real
rate of return plus the expected
rate of inflation equals the nominal rate
of return
rR(t)
+ E[∆p(t)/p(t)] = r(t)
 in
1997, E[∆p(t)/p(t)] = 3 %
 rR(t) + 3% = r(t), your nominal rate of return
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Real Rate of Interest
 real
rate of interest plus the expected
rate of inflation equals the nominal rate
of interest
iR(t)
+ E[∆p(t)/p(t)] = i(t)
 increased
inflation will cause nominal
interest rates to rise
this
is the reason inflation spooks bond
prices
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Bond Prices move inversely with the
interest rate
 Consols:
pay a constant net return, or
interest, indefinitely into the future
interest
= rate*principal
or: net return = interest rate*bond price
 if
the interest rate goes up, then the bond price goes
down
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Bond Prices (continued)
 Recall,
present value equals the
discounted stream of future earnings
PV(t)consol
= NR(t) +NR(t+1)/(1+i) +
NR(t+2)/(1+i)2 +
 NR(t)consol
= NR(t) = NR(t+1) = NR(t+2) =
...
 PV(t)consol = NR(t)consol[1 + 1/(1+i) + 1/(1+i)2
+...]
 PV(t)consol NR(t)consol/i
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http://www.phil.frb.org/
Economics/Survey of Professional Forecasters
August 21, 1988
98 Q3 98 Q4 99 Q1 99 Q2 99 Q3
GDP
112.57 112.90 113.39 113.92 115.20
Deflator
% In- 1.2
crease
Deflator
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1.7
1.9
2.2
2.3
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Inflation hurts groups of people
 hurts
people on fixed income
elderly
 hurts
creditors
people
who loan money
 they
get paid back in dollars with less
purchasing power
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Inflation helps some groups
 debtors
people
who borrow money
 they
get to pay back with less valuable
dollars
 incentive to buy real estate on time during
inflation
big
debtor: government
 consequently,
government may have an
incentive to follow inflationary policies
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Inflation can waste resources

people spend time looking for stores of
value, rather than producing goods and
services
 money
becomes a bad store of value: it loses
purchasing power
 people buy gold, jewelry, art, real estate,
consumer durables
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The Price of Gold
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Source: Yardeni’s Economics Network, http://www.yardeni.com/
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Inflation watch
 Investors
month
watch
to month changes in
 consumer
price index
 producer price index
statements
by the Chairman of the Board
of Governors of the Federal Reserve
 Alan
Greenspan
Federal
Reserve Open Market Committee
 purchases
or sales of government securities:
impact on federal funds rate
price
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of gold
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What is the cause of inflation?
 Too
much money chasing too few
goods
 Quantity theory of money
stock*velocity price*quantity
M1*velocity GDP Deflator*Real GDP
M1*velocity Nominal GDP
velocity Nominal GDP/M1
money
 M1:
currency in the hands of the public +
checkable deposits + travelers checks
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Cause of Inflation (continued)
 If
velocity is constant, and M1 grows
faster than Real GDP, then the GDP
Deflator increases: inflation
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Monetarist Policy Prescription

A constant rate of growth of money, say
3.65 %
 since
Real GDP grew at 3.65% between 1929
and 1996, no pressure on prices, no inflation
 consumers and businesses can form more
accurate expectations about inflation since
growth in the money stock is constant
 avoids timing and analysis errors in monetary
policy that might make the business cycle
worse, instead of better
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Money
Functions
 Definitions
 Reasons to hold

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The Functions of Money

medium of exchange
 instead
of barter, i.e. exchange of goods &
services for goods and services, we can
exchange goods & services for money and vice
versa
 eliminates
the search costs & inconvenience of
barter

store of value
 we
can hold money as an asset
 because
it is a medium of exchange, it is liquid, i.e.
we can convert money into goods & assets quickly

unit of account
measure of value, “ a dollar’s worth of ...”

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Definitions of Money

M1(a measure of media of exchange) =
 currency
held by the public, outside of banks
 checkable deposits
 demand
deposits
 NOW (negotiable order of withdrawal) accounts
• savings & loans, mutual savings banks
 traveler’s

checks
M2 = M1 +
 money
market accounts at banks
 money market mutual fund accounts
 certificates of deposit, CD’s, less than $100,000

M3 = M2 + CD’s over $100,000
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M1, Source: Yardeni’s Economics Network
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Source: Yardeni’s Economics Network
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Reasons for Holding Money
 Convenient
for paying bills
transaction
 flexible,
demand for cash balances
liquid asset
precautionary
 keep
motive
cash on hand for unexpected expenses
speculative
motive
 for
example, convert cash to stocks if the
Dow tumbles
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Opportunity Cost of Holding
Money: Foregone Interest
interest rate
Demand for Money
quantity of money
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Impact of the Money Stock on
Interest Rates
interest rate
Demand for Money
Stock of Money, M1
M1
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quantity of money
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Summary-Vocabulary-Concepts






cost of living index
base year
deflation
inflation
consumer price index
price weights
 budget










shares
rate of inflation
GDP Deflator
purchasing power
hedge against inflation
real rate of return
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


real rate of interest
consol
creditor
debtor
money stock; M1,M2
Quantity Theory of
Money
velocity of money
functions of money
money demand
 transactions
 precautions
 speculations
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