Inflation is an increase in the average level of prices, not a change in any specific price.

The average price is determined by finding the average price of all output.◦ A rise in the average price is called inflation.◦ A fall in the average price is called deflation.

Changes in relative prices may occur in a period of stable average price, or in periods of inflation or deflation.

A relative price is the price of one good in comparison with the price of other goods.

By reallocating resources in the economy, relative price changes are an essential ingredient of the market mechanism.

A general inflation doesn’t perform this market function.

Although inflation makes some people worse off, it makes some people better off.

The three major methods inflation redistributes money by are:◦ The Price Effect◦ The Income Effect◦ The Wealth Effect

Nominal income is the amount of money income received in a given time period, measured in current dollars.

Real income is income in constant dollars: nominal income adjusted for inflation.

Two basic lessons about inflation:◦ Not all prices rise at the same rate during

inflation.◦ Not everyone suffers equally from inflation. Not all prices rise at the same rate

during inflation. Not everyone suffers equally from

inflation.

People who prefer goods and services that are increasing in price least quickly end up with a larger share of income.

Even if all prices rose at the same rate, inflation would still redistribute income.

Redistributive effects originate both in expenditure and income patterns.

What looks like a price to a buyer looks like an income to a seller.

If prices are rising, incomes must be rising too.

People whose nominal income rise faster than inflation end up with a larger share of total income.

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140

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1980 1982 1984 1986 1988 1990 1992 1994 1996

Wages

YEAR1998 2000

Prices

People hold wealth in different forms (accounts, stocks, commodities).

When the value of these changes due to inflation, some people will get wealthier and some will lose wealth.

Asset Percentage change in value: 1991-2001

Asset Percentage change in value: 1991-2001

Stocks +250 Silver +22

Diamonds +71 Bonds +20

Oil +66 Stamps –9

Housing +56 Gold –29

U.S. farmland +49

The average price level increased 32%

One of the most immediate consequences of inflation is uncertainty.

Uncertainties created by changing price levels affect consumption and production decisions.

People tend to shorten their time horizons in the face of inflation uncertainties.

Time horizons are shortened as people attempt to spend money before it loses further value.

During the German hyperinflation, workers were paid two or three times a day so that they could buy goods in the morning before prices increased in the afternoon.

Hyperinflation is an inflation rate in excess of 200 percent, lasting at least one year.

If you expect prices to rise, it makes sense to buy things now for resale later.

Few people will engage in production if it is easy to make speculative profits.

People may be encouraged to withhold resources from the production process, hoping to sell them later at higher prices.

As such behavior becomes widespread, production declines and unemployment rises.

Bracket creep is the movement of taxpayers into higher tax brackets (rates) as nominal incomes grow.

As prices rise, incomes rise, and then taxes rise.

Deflation — a falling price level — might not make people happy either.

Deflation reverses the redistributions caused by inflation.

Lenders win and creditors lose.

When prices are falling, people on fixed incomes and long-term contracts gain more real income.

Falling price levels have similar macro consequences.

Time horizons get shorter. Businesses are more reluctant to borrow

money or to invest.

People lose confidence in themselves and public institutions when declining price levels deflate their incomes and assets.

Measuring inflation serves two purposes:◦ Gauges the average rate of inflation.◦ Identifies its principal victims.

The CPI is the most common measure of inflation.

The consumer price index (CPI) is a measure (index) of changes in the average price of consumer goods and services.

By observing the extent of price increases, we can calculate the inflation rate.

The inflation rate is the annual percentage rate of increase in the average price level.

The Bureau of Labor Statistics constructs a market basket of goods and services that consumers usually buy.

Specific goods and services are itemized within the broad categories of expenditures.

The relative importance of a product in the CPI is reflected in its item weight.

Item weight is the percentage of total expenditure spent on a specific product; used to compute inflation indexes.

The impact on the CPI of a price change for a specific good is calculated as follows:

percentage change in CPI =

item weight X percentage change in price of item

Transportation19.0%

Housing32.6% Food

13.6%

Clothing 4.7%

Miscellaneous 10.5%

Health care 5.3%

Entertainment 5.1%

Insurance and pensions 9.3%

There are three producer price indexes (PPI) which keep track of average prices received by producers.

One includes crude materials, another intermediate goods, and the last covers finished goods.

PPIs are watched as a clue to potential changes in consumer prices.

In the short run, the PPIs usually increase before the CPI.

The PPIs and the CPI generally reflect the same inflation rate over long periods.

The GDP deflator is a price index that refers to all goods and services included in GDP.◦ It is the broadest price index is the GDP deflator. ◦ It covers all output including consumer goods,

investment goods, and government services.

The GDP deflator usually registers a lower inflation rate than the CPI.

Unlike the CPI and PPI, the GDP deflator is not limited to a fixed basket.

Its value reflects both price changes and market responses to those changes.

The GDP deflator is used to adjust nominal output values for changing price levels.◦ Nominal GDP is the value of final output

produced in a given period, measured in the prices of that period (current prices).

◦ Real GDP is the value of final output produced in a given period, adjusted for changing prices.

Nominal and Real GDP are connected by the GDP deflator:

Price stability is the absence of significant changes in the average price level; officially defined as an inflation rate of less than 3 percent.

A little bit of inflation might be the “price” the economy has to pay to keep unemployment rates from rising.

Some unemployment may be the “price” society has to pay for price stability.

In the long view of history, the U.S. has done a good job in maintaining price stability.

Upon closer inspection, however, our inflation performance is very uneven.

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1920 1930 1940 1950 1960 1970 1980 1990 2000

Inflation

B

A

Deflation

Inflation is rooted in supply and demand. The most common types of inflation come

from demand-pull and cost-push.

Demand-pull inflation results from excessive pressure on the demand side of the economy.

“Too much money chases too few goods” enabling producers to raise prices.

The pressure on price could also originate on the supply side.

Higher production costs put upward pressure on product prices.

Low rates of inflation don’t have the drama of hyperinflation, but they still redistribute real wealth and income.◦ For example, if prices rise by an average of just 4

percent a year, the real value of $1,000 drops to $822 in five years and to only $676 in ten years.

Cost-of-living adjustments (COLAs) are automatic adjustments of nominal income to the rate of inflation.

COLAs are commonly used by landlords as well as in labor agreements and government transfer programs.

An adjustable-rate mortgage (ARM) is a mortgage (home loan) that adjusts the nominal interest rate to changing rates of inflation.

ARMs were developed to protect lenders against losses during long term rises in inflation.

The real interest rate is the nominal interest rate minus the anticipated inflation rate.

Real interest rate = nominal interest rate – anticipated interest rate

If prices rise faster than interest accumulates, the real interest rate will be negative.

End of Chapter 7