Sherif Khalifa. Sherif Khalifa () Inflation 1 / 40

Transcription

1 Sherif Khalifa Sherif Khalifa () Inflation 1 / 40

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 permanent ruin. But both are the refuge of political and economic opportunists" Ernest Hemingway. Sherif Khalifa () Inflation 2 / 40

3 The consumer price index CPI is a measure of a weighted average of prices of a fixed basket of goods and services typically purchased by consumers. The Consumer Price Index is a measure of the overall price of goods and services. The Consumer Price Index is used to calculate the cost of living over time. The Consumer Price Index provides guidance over consumer purchasing power. When the index increases, a consumer has to spend more to maintain the same living standards. When the index decreases, a consumer has to spend less to maintain the same living standards. Sherif Khalifa () Inflation 3 / 40

4 Fix the basket by determining which goods and services are most important to the typical consumer. Hot Dogs Burgers 4 2 Sherif Khalifa () Inflation 4 / 40

5 Find the prices of the goods and services in the basket for each point in time. Year Hot Dogs Burgers 2015 $1 $ $2 $ $3 $4 Sherif Khalifa () Inflation 5 / 40

6 Compute the cost of the basket in each point in time. Year Hot Dogs Burgers Basket Cost 2015 $1x4=$4 $2x2=$4 $ $2x4=$8 $3x2=$6 $ $3x4=$12 $4x2=$8 $20 Sherif Khalifa () Inflation 6 / 40

7 Choose a base year and compute the consumer price index. CPI = CPI 2015 = CPI 2016 = CPI 2017 = Cost of basket in current year X 100 Cost of basket in base year ( ) 8 x100 = ( ) 14 x100 = ( ) 20 x100 = Sherif Khalifa () Inflation 7 / 40

8 The inflation rate is the percentage change in the price level. Inflation is an increase in the overall level of prices. Deflation is a decrease in the overall level of prices. Hyperinflation is an extraordinarily high rate of inflation. Inflation rate = Inflation = Inflation = Final CPI Initial CPI ( Initial ) CPI = 75% 100 ( ) = 43% 175 Sherif Khalifa () Inflation 8 / 40

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 / 40

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13 Demand-pull inflation arises when aggregate demand in an economy outpaces aggregate supply. Cost-push inflation or supply-shock inflation is a type of inflation caused by large increases in the cost of goods or services where no suitable alternative is available. Sherif Khalifa () Inflation 13 / 40

14 Substitution Bias When prices change from one period 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 / 40

15 New Goods When a new item is introduced, consumers have more variety from which to choose. Greater variety of consumer items makes each dollar more valuable. This decreases the cost of maintaining the same level of well being. New items are not included in the calculation of the consumer price index. Sherif Khalifa () Inflation 15 / 40

16 Quality Change If the quality of a good deteriorates from one year to another, the value of a dollar decreases. 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. 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 / 40

17 GDP Deflator = [ ] Nominal GDP X 100 Real GDP Policy makers monitor the GDP Deflator and the CPI to gauge the change in prices. 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 17 / 40

18 Percent 15 Percent 15 per Year per Year CPI CPI GDP GDP deflator deflator Sherif Khalifa () Inflation 18 / 40

19 Inflation is an increase in the average level of prices. A price is the rate at which money is exchanged for a good or a service. To understand inflation, we must understand money. Sherif Khalifa () Inflation 19 / 40

20 Money is the set of assets in an economy that people use to buy goods and services from other people. Money is the stock of assets that can be used to make transactions. Sherif Khalifa () Inflation 20 / 40

21 In a barter economy, trade requires the double coincidence of wants, the unlikely happenstance of two people each having a good that the other wants at the right time and place to make an exchange. Without money, trade would require barter which is the exchange of one good or service for another. Every transaction would require a double coincidence of wants or the unlikely occurrence that two people each have a good the other wants. Most people would have to spend time searching for others to trade with, which is a waste of scarce resources. Sherif Khalifa () Inflation 21 / 40

22 Monetary System A medium of exchange is an item that buyers give to sellers when they purchase goods and services. As a medium of exchange, money is what we use to buy goods and services. Because money is the medium of exchange, it is the economy s most liquid asset. A unit of account is the yardstick people use to post prices and record debts. As a unit of account, money provides the terms in which prices are quoted and debts are recorded. A store of value is an item that people can use to transfer purchasing power from the present to the future. Money is not a perfect store of value, because if prices are increasing the amount you can buy with a given quantity of money is decreasing. Sherif Khalifa () Inflation 22 / 40

23 The quantity of money available in an economy is called the money supply. The control over the money supply is called monetary policy. Monetary policy is conducted by the Central Bank. The Central Bank controls money supply by open market operations, which is the purchase and sale of government bonds. Sherif Khalifa () Inflation 23 / 40

24 US. Treasury Bond The bearer of the United States Treasury bond is hereby promised the repayment of the principle value plus the interest which it incurs through the terms stated thereof. The United States will justly repay its bearers in its entirety and will not default under any circumstances. Signature of the President Federal Reserve US. Treasury Bond The bearer of the United States Treasury bond is hereby promised the repayment of the principle value plus the interest which it incurs through the terms stated thereof. The United States will justly repay its bearers in its entirety and will not default under any circumstances. Signature of the President Federal Reserve Sherif Khalifa () Inflation 24 / 40

25 MV = PY (Money) (Velocity) = (Price) (Output) Sherif Khalifa () Inflation 25 / 40

26 An economy produces 100 pizzas in a year for $10 each. The quantity of money is $50. V = 10x100 = People spend a total of $1000 per year on pizza. For this $1000 of spending to take place with only $50 of money, each dollar bill must change hands on average 20 times per year. Sherif Khalifa () Inflation 26 / 40

27 U.S. Nominal GDP, M2, and Velocity (1960=100) Velocity is fairly stable over time Nominal GDP M2 500 Velocity Sherif Khalifa () Inflation 27 / 40

28 MV = PY The velocity of money is stable over time. Output is determined by factors of production and the available technology. When the Central Bank alters M, these changes are reflected in changes in the price level P. When the Central Bank increases the money supply, the result is a high rate of inflation. Sherif Khalifa () Inflation 28 / 40

29 % M + % V = % P + % Y The percentage change in money is under the control of the Central Bank. The percentage change in the price level is the rate of inflation. The percentage change in output depends on growth in factors of production and technological progress. The Central Bank has ultimate control over the rate of inflation. Sherif Khalifa () Inflation 29 / 40

30 Costs of Inflation Inflation tax, or seigniorage, is the revenue the government raises by creating money. When tax revenue is inadequate and ability to borrow is limited. A government may print money to cover its budget deficit. Excessive increase in the money supply causes inflation. Inflation lowers the purchasing power of every unit of money. Printing money to raise revenue is like imposing an inflation tax. 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 30 / 40

31 Costs of Inflation The interest rate that the bank pays is called the nominal interest rate. The increase in your purchasing power is called the real interest rate. r = i π real interest rate = nominal interest rate inflation rate Sherif Khalifa () Inflation 31 / 40

32 Costs of Inflation According to the Fisher equation, a 1% increase in the rate of inflation causes a 1% increase in the nominal interest rate r + π = i The one-for-one relation between the inflation rate and the nominal interest rate is called the Fisher effect. Sherif Khalifa () Inflation 32 / 40

33 Costs of Inflation Percent (per year) U.S. Nominal Interest & Inflation Rates The close relation between these variables is evidence for the Fisher effect Nominal interest rate Inflation rate Sherif Khalifa () Inflation 33 / 40

34 A higher inflation rate leads to a higher nominal interest rate according to the Fisher effect. Because inflation erodes the value of money, one can avoid the inflation tax by holding less money. You go to the bank more often to keep more of your wealth in your interest-bearing account and less in your wallet. If people are to hold lower money balances, they must make more frequent trips to the bank to withdraw money. 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. Sherif Khalifa () Inflation 34 / 40 Inflation Costs of Inflation Shoeleather costs are the resources wasted when inflation encourages people to decrease their money holdings.

35 Costs of Inflation Menu costs are the costs of price adjustments due to inflation. Inflation induces firms to change their posted prices more often. 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 35 / 40

36 Costs of Inflation The inconvenience of living in a world with a changing price level. Money is the yardstick with which we measure economic transactions. Inflation changes the yardstick we use to measure transactions. These changes in the yardstick causes confusion and inconvenience. Complicates long-run planning and the comparison of dollar amounts over time. Sherif Khalifa () Inflation 36 / 40

37 Costs of Inflation Lawmakers often fail to take inflation into account when writing tax laws. Many provisions of the tax code do not take into account the effects of inflation. 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. Sherif Khalifa () Inflation 37 / 40

38 Costs of Inflation Before tax r = Before tax i π After tax r = After tax i π After tax i = i (1 t) Sherif Khalifa () Inflation 38 / 40

39 Costs of Inflation A B Before tax Nominal Interest Rate 4 12 Inflation Rate 0 8 Before tax Real Interest Rate 4 4 A B Before tax Nominal Interest Rate % 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 39 / 40

40 Costs of Inflation Loan agreements specify a nominal interest rate, based on the rate of inflation expected at the time of the agreement. If inflation turns out differently from what was expected, the real return that the debtor pays to the creditor differs from what both parties anticipated. 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 40 / 40