Sherif Khalifa. Sherif Khalifa () Inflation 1 / 30

Transcription

1 Sherif Khalifa Sherif Khalifa () Inflation 1 / 30

2 "The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a premanent ruin. But both are the refuge of political and economic opportunists" Ernest Hemingway. Sherif Khalifa () Inflation 2 / 30

3 Definition The Consumer Price Index is a measure of the overall price of the goods and services bought by a typical consumer. The consumer price index is used to calculate the overall level of prices and the cost of living over time. When the index increases, a typical consumer has to spend more to maintain the same living standards. When the index decreases, a typical consumer has to spend less to maintain the same living standards. Sherif Khalifa () Inflation 3 / 30

4 Fix the basket by determining which goods and services are most important to the typical consumer. Hot Dogs Hamburgers 4 2 Sherif Khalifa () Inflation 4 / 30

5 Find the prices of the goods and services in the basket for each point in time. Year Hot Dogs Hamburgers 2013 $1 $ $2 $ $3 $4 Sherif Khalifa () Inflation 5 / 30

6 Compute the cost of the basket. Year Hot Dogs Hamburgers Basket Cost 2013 $1x4=$4 $2x2=$4 $ $2x4=$8 $3x2=$6 $ $3x4=$12 $4x2=$8 $20 Sherif Khalifa () Inflation 6 / 30

7 Choose a base year and compute the consumer price index. CPI = Cost of basket in current year X 100 Cost of basket in base year Year 2013 ( 8 8 ) CPI x100 = ( 14 ) 8 x100 = 175 ( 20 ) 8 x100 = 250 Sherif Khalifa () Inflation 7 / 30

8 Definition The inflation rate is the percentage change in the price level. Inflation rate = Year Final CPI Initial CPI Initial CPI ( Inflation ) = 75% ( ) 175 = 43% Sherif Khalifa () Inflation 8 / 30

9 6% 6% 6% 15% 4% 4% Housing 42% Transportation Food & Beverages Medical care Recreation Education and communication Apparel 17% Other Sherif Khalifa () Inflation 9 / 30

10 Definition Inflation is an increase in the overall level of prices. Definition Deflation is a decrease in the overall level of prices. Definition Hyperinflation is an extraordinarily high rate of inflation. Sherif Khalifa () Inflation 10 / 30

11 Sherif Khalifa () Inflation 11 / 30

12 Policy makers monitor the GDP Deflator and the CPI to gauge how prices are changing. The GDP deflator reflects the prices of all goods and services produced domestically. The CPI reflects the prices of all goods and services bought by typical consumers. The GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. The CPI compares the price of a fixed basket of goods and services to the price of the same basket in the base year. Sherif Khalifa () Inflation 12 / 30

13 Percent 15 Percent 15 per Year per Year CPI CPI GDP GDP deflator deflator Sherif Khalifa () Inflation 13 / 30

14 Substitution Bias When prices change from one year to another, they do not change proportionately. Consumers buy less of the items whose prices have increased more. Consumers buy more of the items whose prices have increased less or have decreased. Consumers substitute towards the items that have become less expensive. The consumer price index ignores the possibility of consumer substitution. Sherif Khalifa () Inflation 14 / 30

15 New Goods When a new item is introduced, consumers have more variety from which to choose. Greater variety makes each dollar more valuable. This decreases the cost of maintaining the same level of economic well being. The new goods are not included in the calculation of the consumer price index. Sherif Khalifa () Inflation 15 / 30

16 Quality Change If the quality of a good deteriorates from one year to another, the value of a dollar decreases. Because you are getting a worse good for the same amount of money even if the price of the good stays the same. If the quality of a good improves from one year to another, the value of a dollar increases. Because you are getting a better good for the same amount of money even if the price of the good stays the same. Changes in quality poses a problem because quality is hard to quantify. Sherif Khalifa () Inflation 16 / 30

17 The consumer price index can be used to compare dollar amounts at different periods of time. Price level today Amount in Today s $ = Amount in year T $x Price level in year T Sherif Khalifa () Inflation 17 / 30

18 Year CPI Professor salary $24,000 Today 180 $50,000 Amount in Today s $ = 24, 000x = $48, 000 Sherif Khalifa () Inflation 18 / 30

19 Year CPI Athlete Salary $80,000 Today 195 $950,000 Amount in Today s $ = 80, 000x 195 = $1, 026, Sherif Khalifa () Inflation 19 / 30

20 Consumers consume 100 hot dogs and 200 burgers. Year Price Price of Hot dogs of Hamburgers 2013 $1 $ $2 $4 Percentage change in the price of hotdogs = 100% Percentage change in the price of Hamburgers = 33% Inflation = 42% Hotdog producers are better off. Hamburger producers are worse off. Sherif Khalifa () Inflation 20 / 30

21 Year News Paper Wage 1950 $0.15 $3.23/hour Today $0.75 $14.32/hour Percentage Change in the price = = 400% Percentage Change in the wage = = 343% 3.23 The worker s purchasing power in terms of news paper decreased. Sherif Khalifa () Inflation 21 / 30

22 Definition Nominal interest rate is the interest rate announced without correction for the effects of inflation. Definition Real interest rate is the interest rate corrected for the effects of inflation. Real interest rate = Nominal interest rate Inflation rate Sherif Khalifa () Inflation 22 / 30

23 Interest Rates (percent (percent per per year) year) Interest Rates Nominal Nominal interest interest rate rate Real Real interest interest rate rate Sherif Khalifa () Inflation 23 / 30

24 Costs of Inflation Definition Inflation tax is the revenue the government raises by creating money. A government may print money to cover its budget deficit. When tax revenue is inadequate and ability to borrow is limited. Excessive increase in the money supply causes inflation. Inflation causes the dollars in your wallet to be less valuable. The inflation tax is a tax on everyone who holds money. Sherif Khalifa () Inflation 24 / 30

25 Costs of Inflation Definition Shoeleather costs are the resources wasted when inflation encourages people to decrease their money holdings. Because inflation erodes the value of money, one can avoid the inflation tax by holding less money. We go to the bank more often to keep more of our wealth in an interest-bearing account and less in our wallet. Making more frequent trips to the bank causes your shoes to wear out more quickly. The actual cost is the time and convenience you sacrifice to keep less money on hand. Shoeleather costs include the time and transaction costs of more frequent bank withdrawals. Sherif Khalifa () Inflation 25 / 30

26 Costs of Inflation Definition Menu costs are the costs of price adjustments due to inflation. Firms change prices infrequently because there are costs of changing prices. Menu costs include the cost of deciding on new prices, and of printing new price lists and catalogs. Menu costs include the cost of sending the new price lists and catalogs to dealers and customers. Menu costs include the cost of advertising the new prices, and of dealing with customer annoyance over price changes. Sherif Khalifa () Inflation 26 / 30

27 Costs of Inflation Lawmakers often fail to take inflation into account when writing tax laws. Taxes are based on nominal income, and are not adjusted for inflation. Inflation causes people to pay more taxes even when their real incomes do not increase. A B Nominal Interest Rate 4 12 Inflation Rate 0 8 Real Interest Rate 4 4 Sherif Khalifa () Inflation 27 / 30

28 Costs of Inflation A B Before tax Nominal Interest Rate 4 12 Reduced interest due to 25% tax rate 1 3 After tax Nominal Interest Rate 3 9 Inflation Rate 0 8 After tax Real Interest Rate 3 1 Sherif Khalifa () Inflation 28 / 30

29 Costs of Inflation Inflation changes the yardstick we use to measure transactions. Inflation erodes the real value of the unit of account. These changes in the yardstick causes confusion and inconvenience. Complicates long-run planning and the comparison of dollar amounts over time. Sherif Khalifa () Inflation 29 / 30

30 Costs of Inflation Most loan agreements specify a nominal interest rate, based on the rate of inflation expected at the time of the agreement. If inflation turns out higher than expected, the debtor wins and the creditor loses because the repayment is lower than anticipated. Higher-than-expected inflation transfers purchasing power from creditors to debtors. If inflation turns out lower than expected, the creditor wins and the debtor loses because the repayment is higher than anticipated. Lower-than-expected inflation transfers purchasing power from debtors to creditors. Inflation arbitrarily redistributes wealth among individuals. Sherif Khalifa () Inflation 30 / 30