ECONOMICS: Principles and Applications 3eHALL & LIEBERMAN© 2005 Thomson Business and Professional Publishing

Slides by: John & Pamela Hall

The Monetary System, Prices, and Inflation

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The Monetary System

• Establishes two different types of standardization in the economy– Unit of value—a common unit for measuring how much

something is worth• Refers to the way we think about and record transactions

– Means of payment—things we can use as payment when we buy goods and services

• Refers to how payment is actually made

• In United States, the dollar is centerpiece of our monetary system

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History of the Dollar

• How did the dollar come to play such an important role in the economy?

• Prior to 1790, each colony had its own currency– Called the “pound” in every colony, but it had a different

purchasing power in each of them– In 1790 Congress created a new unit of value called the dollar

• Primary means of payment in United States until Civil War was paper currency issued by private banks

• However, during Civil War government issued first federal paper currency—greenback– Functioned as both unit of value and major means of payment until

1879• In 1913, a new institution was created to be the national

monetary authority in United States – Federal Reserve System

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Why Paper Currency is Accepted as A Means of Payment

• Paper currency is a relatively recent development in the history of the means of payment

• Earliest means of payment were precious metals and other valuable commodities such as furs or jewels– Called commodity money because they had important uses other than as

a means of payment• Commodity money eventually gave way to paper currency• Today paper currency is no longer backed by gold or any other

physical commodity– This type of currency is called fiat money

• Fiat, in Latin, means “Let there be,” and fiat money serves as a means of payment by government declaration

• While government can declare that paper currency is to be accepted as a means of payment, it cannot declare the terms

• Value of the dollar—its purchasing power—does change from year to year– Reflected in changing prices of things we buy

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Measuring the Price Level and Inflation

• Microeconomic causes—changes in individual markets—can explain only a tiny fraction of price change– For the most part, price rises came about

because of a continually rising price level• Average level of dollar prices in the economy

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Index Numbers

• Most measures of the price level are reported in the form of an index– Series of numbers, each one representing a different period

• In general, an index number for any measure is calculated as

100 period base in measure of Value

period current in measure of Valuex

• Compress and simplify information so that we can see how things are changing at a glance

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The Consumer Price Index

• Most widely used measure of the price level in United States – Designed to track price paid by typical consumer– Compiled and reported by Bureau of Labor Statistics (BLS)

• Two problems must be solved before we even begin– Must decide which goods and services should be included in

average– How to combine all the different prices into a average price level

• CPI’s approach is to track cost of CPI market basket– Collection of goods and services typical consumer bought in some

base period

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From Price Index to Inflation Rate

• Consumer Price Index is a measure of the price level in the economy– Inflation rate measures how fast price level is

changing, as a percentage rate– When price level is rising, as it almost always

is, inflation rate is positive– When price level is falling, as it did during Great

Depression, we have a negative inflation rate• Called deflation

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How the CPI is Used

• CPI is one of the most important measures of performance of the economy

• Used in three major ways– As a policy target

• Measure most often used to gauge our success in achieving low inflation

– To index payments• A payment is indexed when it is set by a formula so that it rises and

falls proportionately with a price index– To translate from nominal to real values

• In order to compare economic values from different periods, we must – Translate nominal variables

» Measured in the number of dollars– Into real variables

» Adjusted for the change in dollar’s purchasing power• CPI is often used for this translation

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Figure 1: The Rate of Inflation Using the Consumer Price Index, 1950-2001

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Real Variables and Adjustment for Inflation

• Suppose that from December 2004 to December 2005, your nominal wage rises from $15 to $30 per hour– Are you better off?

• That depends

– To track your real wage, need to look at number of dollars you earn relative to price level

• Real wage formula is as follows

100 x yearthat in CPI

yearthat in wageNominal any year in wageReal

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Real Variables and Adjustment for Inflation

• Important point – When we measure changes in macroeconomy, we usually care

about purchasing power those dollars represent • Not about the number of dollars we are counting

• Translate nominal values into real values using the formula

100 x index price

value nominal value real

• How most real values in the economy are calculated– One important exception

• To calculate real GDP, government uses a different procedure

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Inflation and the Measurement of Real GDP

• A special price index called GDP price index is calculated for GDP

• Most important differences between CPI and GDP price index– Types of goods and services covered by each index

• GDP price index includes some prices that CPI ignores– GDP price index excludes some prices that are part of

CPI• Can summarize chief difference between CPI and

GDP price index – GDP price index measures prices of all goods and

services that are included in U.S. GDP– While CPI measures prices of all goods and services

bought by U.S. households

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The Inflation Myth

• Most people think inflation erodes average purchasing power of income – By making goods and services more expensive– However, this statement is mostly wrong

• Inflation can redistribute purchasing power from one group to another– But it does not directly decrease average real

income • Often blame inflation for lowering our

purchasing power when the real cause lies elsewhere

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The Redistributive Cost of Inflation

• One cost of inflation is that it often redistributes purchasing power within society

• How does inflation sometimes redistribute real income?– An increase in price level reduces purchasing power of any

payment that is specified in nominal terms

• Inflation can shift purchasing power away from those who are awaiting future payments specified in dollars– Toward those who are obligated to make such payments

• Does inflation always redistribute income from one party in a contract to another?– No—if inflation is expected by both parties, it should not

redistribute income

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Expected Inflation Need Not Shift Purchasing Power

• Over any period, percentage change in a real value (%Δ Real) is approximately equal to percentage change in associated nominal value (%Δ Nominal) minus the rate of inflation

– %ΔReal = %ΔNominal – Rate of Inflation

• If inflation is fully anticipated, and if both parties take it into account, then inflation will not redistribute purchasing power

• When inflation is not correctly anticipated, however, our conclusion is very different

• Nominal interest rate– Annual percent increase in a lender’s dollars from making a loan

• Real interest rate– Annual percent increase in a lender’s purchasing power from making a loan

• In absence of inflation, real and nominal interest rates would always be equal

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Unexpected Inflation Does Shift Purchasing Power

• When inflationary expectations are inaccurate– Purchasing power is shifted between those

obliged to make future payments and those waiting to be paid

– An inflation rate higher than expected harms those awaiting payment and benefits the payers

– An inflation rate lower than expected harms the payers and benefits those awaiting payment

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The Resource Cost of Inflation

• Inflation imposes an opportunity cost on society as a whole and on each of its members– When people must spend time and other resources

coping with inflation they pay an opportunity cost• Sacrifice goods and services those resources could have

produced instead

• Resources used by consumers to cope with inflation– Time you could have spent earning income or enjoying

leisure activities

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The Resource Cost of Inflation

• Inflation also forces sellers to use up resources– Sellers of goods and services are also buyers of resources and

intermediate goods– Each time sellers raise prices, labor is needed to

• Put new price tags on merchandise• Enter new prices into a computer scanning system• Update HTML code on a Web page• Change prices on advertising brochures, menus, and so on

• Inflation makes us all use up resources managing our financial affairs

• All these additional activities—use up not only time, but other resources as well– From society’s point of view, these resources could have been

used to produce other goods and services that we’d enjoy

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A Preliminary Word About Deflation

• In early 2000s, as annual inflation rate approached 2%, a new worry appeared on the American political and economic scene– That disinflation ( a decreasing inflation rate)

might lead to deflation (a negative inflation rate)– In some respects, deflation creates costs for

society similar to those of inflation

• However, deflation has some special costs and risks of its own, entirely different from those of inflation

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Is the CPI Accurate?

• Bureau of Labor Statistics spends millions of dollars gathering data to ensure measure of inflation is accurate

• BLS is a highly professional agency, typically headed by an economist– Billions of dollars are at stake for each 1% change in CPI– BLS deserves high praise for keeping its measurement honest and

free of political manipulation– Economists widely agree CPI overstates U.S. inflation rate

• Even those who work at BLS

• BLS has been working hard to reduce this upward bias, and—especially in the late 1990s—it made some progress– But significant bias remains

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Sources of Bias in the CPI

• Several reasons for upward bias in CPI– Substitution bias– New technologies– Changes in quality– Growth in discounting

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Substitution Bias

• Until recently, CPI almost completely ignored a general principle of consumer behavior– People tend to substitute goods that have become

relatively cheaper in place of those that have become relatively more expensive

• Although BLS has partially fixed the problem, CPI still suffers from substitution bias– Categories of goods whose prices are rising most

rapidly tend to be given exaggerated importance in CPI– Categories of goods whose prices are rising most

slowly tend to be given too little importance in CPI

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New Technologies

• CPI excludes new products that tend to drop in price when they first come on the market– When included, CPI regards them as entirely

separate from existing goods and services• Instead of recognizing that they lower cost of

achieving a given standard of living

– Result is an overestimate of the inflation rate

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Changes in Quality

• Many products are improving over time

• BLS struggles to deal with these changes

• In recent years, BLS has adopted some routine statistical procedures to automatically adjust price changes for quality improvements

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Growth in Discounting

• CPI treats toothpaste bought at a high-priced drugstore and toothpaste bought at Wal-Mart or Drugstore.com as different products– Assumes we continue to buy from high- and low-priced

stores in unchanged proportions• But that is not what has been happening

– In fact, Americans are buying more and more of their toothpaste and other products from discounters

• CPI omits reductions in the prices people pay from more frequent shopping at discount stores – Overstates inflation rate

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Using the Theory: The Use and Misuse of an Imperfect CPI

• Inaccuracies in measuring CPI suggest that CPI should be used and interpreted with great care– Unfortunately, CPI is often used for purposes which—by its nature—it

cannot handle accurately• Indexing

– Justification for indexing is to protect these people from any deterioration in living standards caused by inflation

• But because changes in CPI overstate inflation, these beneficiaries are overindexed

• Nominal benefit rises by a greater percentage than a more accurately measured price index would rise

– When a payment is indexed and price index overstates inflation, real payment increases over time

• Purchasing power is automatically shifted toward those who are indexed, and away from rest of society

• General principle applies whether the economy is growing rapidly or slowly, and it applies to anyone who is indexed– Social security recipients, government pensioners, union workers with

indexed wage contracts, or anyone else

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Using the Theory: Long-Run Comparisons

• Because BLS does not correct previously-reported CPI numbers to reflect later methodological improvements– Long-term comparisons of real variables based on

official CPI will remain inaccurate, even as CPI measurement improves

• Using or viewing CPI as an index of the cost of living creates an added source of inaccuracy– Because CPI ignores impact of new goods on living

standards– Raises a further objection to CPI-based indexing for

maintaining (rather than increasing) living standards– Ad to CPI-based inferences about changes in economic

well-being over time

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Using the Theory: What the CPI Does Well

• CPI has another purpose besides indexing and making inferences about living standards– To measure inflationary tendencies in economy– CPI is one of several useful tools to help achieve this goal

• Other measures not based on the CPI are available for tracking consumer prices– Including a special index calculated by commerce department’s Bureau of

Economic Analysis (BEA) to track prices of consumer goods in GDP– Called chain-type consumer expenditures price index

• While the two measures of inflation tend to rise and fall together, they often give different results– Inflation based on the BEA’s index is generally lower than inflation based

on CPI– Still, because the CPI is based on a different set of data, and because it

includes some goods ignored by other indices, it provides policy makers with valuable information about price changes