LESSON 5. Inflation: Causes and Measurement

Transcription

1 LESSON 5 Inflation: Causes and Measurement Assigned Reading 1. Mankiw, N. Gregory, et al Principles of Macroeconomics (5 th Canadian Edition). Toronto: Thomson Nelson. Chapter 6: Measuring the Cost of Living Chapter 11: Money Growth and Inflation Recommended Reading 1. Mankiw, N. Gregory, et al Study Guide for use with the Principles of Macroeconomics, (5 th Canadian Edition). Toronto: Thomson Nelson. Chapter 6: Measuring the Cost of Living Chapter 11: Money Growth and Inflation Learning Objectives After studying this lesson, students should be able to: 1. Describe how the consumer price index (CPI) is constructed. 2. Explain the three ways the CPI can misrepresent the actual changes in consumers' cost of living. 3. Compare the similarities and differences between the CPI and the GDP deflator as measures of the overall price level. 4. Use the CPI to measure the "real" change the prices of individual goods, incomes, and production over time. 5. Explain how to use the CPI to distinguish between real and nominal interest rates. 6. Describe how inflation is a decline in the value of money. 7. Explain why inflation results from a rapid growth in the money supply. 8. Discuss the meanings of the classical dichotomy and monetary neutrality. 9. Explain how the velocity and the quantity equations can help us analyze the quantity theory of money. 10. Examine what causes a country to experience hyperinflation. 11. Examine how the nominal interest rate responds to the inflation rate. 12. Consider the various costs and consequences of inflation. 5.1

2 Lesson 5 Instructor's Comments Just as GDP measures the economy's total output of goods and services, the consumer price index (CPI) measures the cost of living over time. Chapter 6 of the text discusses the CPI, its construction, limitations, and uses. Chapter 12 analyzes inflation by applying the material presented in Chapter 6. Chapter 12 presents the causes and effects of inflation, emphasizing the role of the rate of growth of money as the primary determinant of inflation. This relationship is demonstrated both through a supply and demand model of money and, under the assumption that the velocity of money is stable, the equation of exchange. In discussing the effects of inflation, the text highlights that these are not always what they seem. Much of the true costs of inflation lie in the inefficiencies of trying to survive in an environment with rapidly changing prices. However, while these costs are clear when inflation is high, there is no consensus on the size of these costs when inflation is moderate. What is true, even with low rates of inflation, is that inflation can benefit certain groups over others: debtors tend to benefit from unexpected inflation, while creditors benefit when the price level declines. There are tax implications to inflation that favour home ownership over other types of investments. As the text describes, inflation can cause after-tax real capital gains to fall because investors pay tax on the increases in the price of their assets that come from inflation. However, in Canada, as in many other countries, capital gains from a principal residence are protected from taxation (in Canada this protection has the form of a one-time life exemption, assuming that homeowners buy a new home within a certain time period of selling their old unit). Therefore, an investment in housing represents a tax-free gain and a form of savings to the owner as compared to investing in equities (assuming house prices are rising). The reason house prices rise with inflation is that inflation drives up rents. This increase is a second benefit of home ownership described in Lesson 1: that a homeowner's implicit rent is not taxed, while renters do not receive any tax benefits from rent payments. The value of the favourable tax treatment of implicit rent rises as rents rise with inflation. In Lesson 3, we discussed how nominal interest rates can be important for mortgage borrowing. When inflation is high, the purchasing power of the dollar declines over time, so that a mortgage will be repaid with increasingly "cheaper" dollars over the life of the mortgage. Most mortgages taken by homeowners have level payments each month; the high rate of inflation means that the real value of these payments will decline over time. This phenomenon is known as "tilt", because in the presence of inflation, the real mortgage payments are tilted downward so that they decline over time. The problem with tilt is that this places a greater burden on the borrower during the early years, so much so that some prospective owners will be excluded from the market because they do not have sufficient income in the first years of the mortgage to qualify for it. In countries with high levels of inflation, other mortgage products have been developed to compensate for this problem, allowing borrowers to take mortgages whose nominal payments increase over time. Review and Discussion Questions 1. What are the three major problems in using the CPI as a measure of the cost of living? Briefly explain each of these problems. 2. What are the differences between the CPI and the GDP deflator? 3. Can the real interest rate be negative? Explain. 5.2

3 Inflation: Causes and Measurement 4. In 1970, Lyle bought a hand calculator for $200. The calculator was more accurate in its four functions of addition, subtraction, multiplication, and division than was Lyle's $35 slide rule. In 1990, Lyle could not buy a calculator that could only perform four functions. The simplest calculator he could find cost $5, and was much superior to his 1970 calculator. The CPI in 1970 was 100, and in 1990 it was 250. (a) Based on the CPI, what was the value of the 1990 calculator in 1970 dollars? (b) By how much had the price of the calculator fallen in real terms from 1970 to 1990? (c) What problems in the use of the consumer price index as a measure of the cost of living does this story illustrate? 5. Les buys a house in He obtains a fixed 10% mortgage interest rate, and makes payments of $1,000 per month. The 2007 CPI is 90, the 2008 CPI is 90, the 2009 CPI is 100, the 2010 CPI is 110, and the 2011 CPI is 120. (a) What is the real mortgage interest rate Les pays in 2008, 2009, 2010, and 2011? (b) What are the values in 2007 dollars of Les's monthly mortgage payments in 2008, 2009, 2010, and 2011? 6. Why do expected and unexpected inflation cause such different effects in the economy? 7. Who are the winners and losers from inflation? 8. What is the difference between the nominal rate of interest and the real rate of interest? How are they related? Think of an instance where the rates would be equal, or the real rate was greater than the nominal rate. 9. What does it mean to have your wage "indexed?" 10. What innovations in the mortgage market have occurred to battle the costs of inflation? 11. What is monetary neutrality, and how is it related to the classical dichotomy? 12. How can the quantity equation be used to explain hyperinflation? 13. What is the inflation tax, and how might it explain the creation of inflation by a central bank? 14. What are the costs of inflation? 15. Is David Hume's description of the classical dichotomy and monetary neutrality a good description of the actual economy? Explain. 16. Ben borrows money to buy a farm in Saskatchewan. When he borrows at a fixed interest rate of 8%, both Ben and the banker expect that inflation will continue at 3% per year in the future. Within a year after Ben buys the farm, the Bank of Canada reduces the rate of inflation to zero, where it remains for many years. How does this development affect the economic position of Ben and the banker? 5.3

4 Lesson 5 ASSIGNMENT 5 CHAPTER 6: Measuring the Cost of Living CHAPTER 11: Money Growth and Inflation Marks: 1 mark per question 1. If a Starbucks Frappuccino costs $4 in 2009 (the base year), $4.50 in 2010 and $5 in 2011, use the consumer price index to compute the inflation rate from 2010 to (1) 12.5% (2) 11.11% (3) 125 (4) Jane deposits $10,000 into a saving account at the first of the year. The saving account pays 5% interest. There is inflation during the year. Which of the following is a correct statement about Jane's savings at the end of the year? (1) Jane will earn $500 interest by the end of the year. (2) When Jane withdraws her principal, she will have $10,500. (3) Jane will be richer by $500 in real terms. (4) All of the above are correct statements. 3. An increase in the price of French wine imported into Canada will be reflected in: (1) both the GDP deflator and the consumer price index. (2) neither the GDP deflator nor the consumer price index. (3) the GDP deflator but not in the consumer price index. (4) the consumer price index but not in the GDP deflator. The next TWO (2) questions use the following information: George Farmer earns $6,000 from his farm operation in In 2010, George's grandson Karl earns $60,000 from the same farm. The price index for 1950 is 10, and the price index for 2010 is What is George's income equivalent to in 2010? (1) $6,000 (2) $50,000 (3) $60,000 (4) $72, What is Karl's income equivalent to in 1950? (1) $5,000 (2) $6,000 (3) $7,200 (4) $50, ***Assignment 5 continued on next page***

5 Inflation: Causes and Measurement 6. Which is the most accurate statement about the consumer price index? (1) When the consumer price index increases, the standard of living of the average family increases. (2) When the consumer price index increases, the average family has to spend less to maintain their standard of living. (3) When the consumer price index increases, the average family has to spend more to maintain their standard of living. (4) The consumer price index has nothing to do with the standard of living of the average family. 7. Charlie buys a house in 2009, and finances it with a mortgage that carries an annual interest rate of 7%. Inflation in 2009 is 3%, inflation in 2010 is 7%, and inflation in 2011 is 14%. What is the real interest rate Charlie pays on his mortgage in 2009? (1) -3% (2) 4% (3) 7% (4) 10% 8. Economists have identified several costs of inflation, are the resources wasted when inflation encourages people to reduce their money holdings and are the costs of changing prices. (1) menu costs; shoeleather costs (2) shoeleather costs; menu costs (3) misallocation of resources; menu costs (4) misallocation of resources; arbitrary redistributions of wealth 9. Which is the most accurate statement about the GDP deflator and the consumer price index? (1) Both the GDP deflator and the consumer price index compare the price of a fixed basket of goods and services to the price of the basket in the base year. (2) Both the GDP deflator and the consumer price index compare the price of currently produced goods and services to the price of the same goods and services in the base year. (3) The GDP deflator compares the price of a fixed basket of goods and services to the price of the basket in the base year, but the consumer price index compares the price of currently produced goods and services to the price of the same goods and services in the base year. (4) The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year, but 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. 10. Consumers begin purchasing houses incorporating steel studs instead of wooden studs after the price of lumber increases. This situation best represents which problem in the construction of the CPI? (1) substitution bias (2) introduction of new goods (3) unmeasured quality change (4) All of the above. ***Assignment 5 continued on next page*** 5.5

6 Lesson In the long-run, if the money supply is increased, the price level will and the quantity of money demanded will. (1) decrease, decrease (2) increase, increase (3) decrease, increase (4) increase, decrease 12. Classical dichotomy is the theoretical separation of (variables measured in monetary units) and (variables measured in physical units). (1) nominal variables; real variables (2) real variables; nominal variables (3) nominal variables; relative variables (4) relative variables; real variables 13. As the price level increases, the value of money and the demand for money. (1) increases, increases (2) increases, decreases (3) decreases, decreases (4) decreases, increases 14. If prices increase by 10% and nominal wages increase by 6%, then the: (1) real wage has not changed. (2) nominal wage has not changed. (3) real wage has decreased by 4%. (4) real wage has increased by 6%. 15. Unexpected inflation redistributes wealth from to. (1) debtors, creditors (2) owners of real property, owners of financial assets (3) creditors, debtors (4) the government, fixed income recipients 16. According to the quantity theory of money, what is the effect of a monetary injection in an economy? (1) The monetary injection shifts the supply curve left. (2) The value of money increases and the equilibrium price level increases. (3) The value of money decreases and the equilibrium price level increases. (4) The value of money decreases and the equilibrium price level decreases. 17. Governments may prefer an inflation tax to some other kind of tax since the inflation tax: (1) reduces the real cost of government expenditure. (2) is hidden, making it less obvious to people that they are being taxed. (3) reduces inflation. (4) falls mainly on high-income individuals. 5.6 ***Assignment 5 continued on next page***

7 Inflation: Causes and Measurement 18. According to the Fisher effect, an increase in the rate of inflation from 3% to 6% will the interest rate by percentage points. (1) increase, nominal, 3 (2) increase, real, 3 (3) decrease, nominal, 3 (4) increase, nominal, less than Based on the quantity equation, if M = 5, V = 20, and Y = 200, then P = (1) 100 (2) 2 (3) 1/2 (4) 1/ The interest rate corrected for the effects of inflation is known as the: (1) nominal interest rate. (2) effective interest rate. (3) inflation rate. (4) real interest rate. 20 Total Marks PLANNING AHEAD Note that Project 1 is due in two weeks, on the same due date as Assignment 7. You should be well advanced into the work required for this project by now. ***End of Assignment 5 *** 5.7