Topic 2

1

The Monetary System, Prices, and Inflation

2

The Monetary System

• A monetary system establishes two different types of standardization in the economy

– Unit of value—a common unit for measuring how much something is worth

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

examples: dollar bills, personal checks, money orders, credit cards

3

History of Currency

• In a barter economy, where there is no commonly accepted currency : cows, sheep, fish…

• Commodity money (with intrinsic value) like precious metals: gold, silver

• Paper currency used to be backed by physical commodity Now, we have ‘fiat’ money, i.e. a means of payment by government

declaration. Legal tender – payment that cannot be refused in settlement of a debt

denominated in the same currency by virtue of law.

4

Price Level and Inflation

• Price levelAverage level of dollar prices in the economy

• Index numbers Series of numbers used to track the change of a

variable over time: crime index, air pollution index Most measures of the price level are reported in the

form of an index Dow Jones Index, S&P 500, Consumer Price Index

5

Index Numbers

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

100 period base in measure of Valueperiod current in measure of Value x

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Index Numbers

• Create index numbersExample: the number of traffic accidents in Youngstown, Ohio

  Year # of traffic accidents index

2000(base year) 325 100

2004 382 5.117100325382

2005 411

7

The Consumer Price Index

An index of the cost, through time, of a fixed market basket of goods and services purchased by a typical household in some base period (1983).

The market basket does not include goods and services purchased by businesses, government, and foreigners, but include consumer goods and services currently produced in the U.S., used goods and imported goods.

8

From Price Index to Inflation Rate

• Consumer Price Index is a measure of the price level in the economy

• Changes in price index– Inflation when price level is rising– Deflation when price level is falling, or negative

inflation

9

Calculate Inflation

Year CPI Inflation2003 1.8402004 1.889 2.7%2005 1.953 3.4%2006 2.016 3.2%2007 2.073 2.8%

Year CPI Inflation1929 0.1711930 0.167 –2.3%1931 0.152 –9.0%1932 0.137 –9.9%1933 0.130 –5.1%

• The rate of inflation is the annual percentage change in the price level

• Inflation in 2004(1.889 – 1.840) / 1.840

= 0.027 = 2.7%• Inflation in Great Depression– Period of falling output

and prices – Inflation rates are negative

10

The Rate of Inflation Using the Consumer Price Index, 1947-2014

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Inflation, Nominal and Real Values

• 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

𝑟𝑒𝑎𝑙𝑣𝑎𝑙𝑢𝑒𝑡=𝑛𝑜𝑚𝑖𝑛𝑎𝑙𝑣𝑎𝑙𝑢𝑒𝑡

𝑝𝑟𝑖𝑐𝑒𝑖𝑛𝑑𝑒𝑥𝑡×100

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Inflation, Nominal and Real Values

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

• Real wage formula is as follows

100 x yearin that CPI

yearin that wageNominal year any in wageReal

13

Production Workers’ Wages, 1960 - 2006

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Inflation, Nominal and Real Values

An example:

Year CPI Nominal Hourly Wage Real Wage

1983 100 8 8100100

8

1995 150 12 810015012

2004 180 15 ?10018015

2005 200 20 ?

15

Redistributive Effect of Inflation

• Inflation is not the cause behind the erosion of purchasing power, but just the mechanism

• Inflation can redistribute purchasing power from one group to another

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Redistributive Effect of Inflation

• How does inflation redistribute real income? Inflation hurts those who receive a fixed amount of

payment specified in nominal terms Example: salary specified in a contract

Inflation benefits those who make a fixed amount of payment specified in nominal terms

Examples: mortgage payment, car loan monthly payment

17

Expected vs. Unexpected Inflation

• 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• Real interest rate is the annual percentage increase in the purchasing

power of financial assets– Real interest rate = nominal interest rate – inflation

r = i - • 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, inflation does shift purchasing power from one group to another.

18

US Inflation and Interest Rates, 1960 - 2006

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US Real Interest Rates, 1960 - 2006

20

Expected vs. Unexpected Inflation

An example: Joe borrows $100 from Mike and promises to pay

back the money plus interest in a year. Mike wants to charge a real return of 3%. Meanwhile, Mike expects the inflation rate to be 3% for the next year and Joe expects it to be 5%. So, Joe happily agrees to pay Mike 6% nominal interest rate. If the actual inflation rate is 4%, how will the purchasing power shift between Joe and Mike?

Expected vs. Unexpected Inflation

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Continue with the previous example: The key is to figure out the realized real rate of return –

r = i - Since the actual inflation rate is 4% () and Joe pays Mike

6% (i), the real interest rate is r = 6% - 4% = 2%. As a result, in the real term, Mike receives 2%, which is 1% less than he wants, and Joe pays 2%, which is 1% less than he agrees to pay. Therefore, the purchasing power shifts from Mike to Joe.

See the generalization on the next slide.

22

Positive and Negative Unexpected Inflation

• Positive unexpected inflation– An inflation rate higher than expected harms those

awaiting payment and benefits the payers

• Negative unexpected inflation– An inflation rate lower than expected harms the payers

and benefits those awaiting payment

• Fisher effect is the tendency for nominal interest rates to be high when inflation is high and low when inflation is low