chapter 5 atw 108 usm tutorial slides

8/7/2019 Chapter 5 ATW 108 USM Tutorial slides

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Chapter 5Inflation and the Price Level


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Which Bond Movie is more

profitable?

USD 456 Million USD 202 Million

2002 1981


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Compare It based on the

living cost

If you bought corn flake in 1981,

the price is $ 1.12. But If you

bought corn flake in 2002, the

price is $ 3.00

You have $ 3000 income during

1981, and can buy around 3000

boxes of corn flakes, but your$6000 in 2002 only can buy

around 2000 boxes of corn flakes

in 2002


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So, Which Bond Movie is more

profitable?

Yes! The For Your Eyes Only is more

profitable than Die Another Day!

How you know it? Based on the Living Cost!

Why the living cost is different in one year toother years? Because the Inflation!

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What is Inflation?

It is a rise of the general price level of goods

and services in a certain period of time

If the price is increasing, you just can buyfewer goods

In other words, inflation shows the erosions

of Purchasing Power of Money


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How to Measure CPI?

yearbaseinservicesandgoodsofbasketyearBaseofCost

yearcurrentinservicesandgoodsofbasketyearBaseofCostCPI

Cost of Living CPI = 1050 / 850 = 1.31

2000 Spending Monthly Cost in 2000

Rent (2 bedroom apartment) $500

Hamburgers (60 at $2 each) 120

Movie tickets (10 at $6 each) 60

Sweaters (4 at $30) 120

Monthly expenditures $800

2005 Spending Monthly Cost in 2005

Rent (2 bedroom apartment) $630

Hamburgers (60 at $2.50 each) 150

Movie tickets (10 at $7 each) 70

Sweaters (4 at $50) 200

Monthly expenditures $1,050


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INTERMEZZO

WHAT IS BASKET? In economy, basket means a group of goods

and services.


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Is there any other way to measure

Inflation?

Yes! There are many other ways to measure

inflation. The key is that inflation is measured

by price index

Price Index is a measure of the average price

of a given class of goods or services relative to

the same goods and services in a base year.

The measurement of price index is: CPI,

Producer Price Index, Commodity Price Index,

and Core Price Index.


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Inflation Adjustment

CPI can be used to adjust economic data toeliminate the effects of inflation.

There are two ways to do inflation

adjustment: Deflating and Indexing Deflating is the process of adjusting the

nominal quantity to real quantity because of

inflation Indexing is the process of preventing the

purchasing power of nominal quantity from

being eroded by inflation


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Deflating ExampleReal Wages

Real wage is the purchasing power ofworker's nominal wages

The real wage for any given period is

calculated by dividing the nominal wage bythe CPI for that period

US production worker wages

CPI uses 1982 1984 as base year

Real wages were higher in 1970Year Average Wage

1970 $3.40

2004 $15.68

CPI

0.388

1.889

Real Average Wage

$3.40 / 0.388 = $8.76

$15.68 / 1.889 = $8.30


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Indexing ExampleAdjusting for Inflation

An indexed labor contract First year wage is $12 per hour

Real wages rise by 2% per year for next 2 years

Relevant price index is 1.00 in first year, 1.05 inthe second, and 1.10 in the third

Nominal wage is real wage times the price

indexYear Real Wage

1 $12.00

2 $12.24

3 $12.48

Price Index

1.00

1.05

1.10

Nominal Wage

$12.00

$12.85

$13.73


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Does CPI Measure TRUE

Inflation?

Quality Adjustment Bias CPI only measures the changes of Price, not the quality. Even though

the corn flake of today is probably much better than the 1981 corn

flake, the CPI only captures the price.

Substitution Bias Again, CPI does not measure the switching effect because of the price

changes of substitution goods

In 1981, Corn Flake and Star Honey is the same. But suddenly there

was frost in US and made the Corn Price increasing in double. Then,people changes to Star Honey and didnt consume Corn Flake, a switch

that doesnt make the standard of living worse. In other word, it

creates a bias in measuring the living cost.


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The Causes of Inflation

Demand-pull inflation caused by increases in aggregate demand due to increased private and

government spending, etc. Demand inflation is constructive to a faster rate of

economic growth since the excess demand and favourable market conditions

will stimulate investment and expansion.

Cost-push inflation / supply shock inflation caused by a drop in aggregate supply (potential output). This may be due to

natural disasters, or increased prices of inputs. For example, a sudden

decrease in the supply of oil, leading to increased oil prices, can cause cost-

push inflation. Producers for whom oil is a part of their costs could then passthis on to consumers in the form of increased prices.

Built-in inflation It involves workers trying to keep their wages up with prices (above

the rate of inflation), and firms passing these higher labor costs on totheir customers as higher prices, leading to a 'vicious circle'.


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Negative Effect of Inflation Cost-push inflation

High inflation can prompt employees to demand rapid wage increases,

to keep up with consumer prices. Wage growth will be set as afunction of inflationary expectations, which will be higher when

inflation is high. This can cause a wage spiral. In a sense, inflation

begets further inflationary expectations, which beget further inflation.

Hoarding People buy durable and/or non-perishable commodities and other

goods as stores of wealth, to avoid the losses expected from the

declining purchasing power of money, creating shortages of the

hoarded goods.

Hyperinflation If inflation gets totally out of control (in the upward direction), it can

grossly interfere with the normal workings of the economy, hurting its

ability to supply goods. Hyperinflation can lead to the abandonment of

the use of the country's currency, leading to the inefficiencies of

barter.

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Allocative efficiency A change in the supply or demand for a good will normally cause its

relative price to change, signaling to buyers and sellers that they

should re-allocate resources in response to the new marketconditions. But when prices are constantly changing due to inflation,

price changes due to genuine relative price signals are difficult to

distinguish from price changes due to general inflation, so agents are

slow to respond to them. The result is a loss of allocative efficiency.

Shoe leather cost High inflation increases the opportunity cost of holding cash balances

and can induce people to hold a greater portion of their assets in

interest paying accounts. However, since cash is still needed in order

to carry out transactions this means that more "trips to the bank" are

necessary in order to make withdrawals, proverbially wearing out the"shoe leather" with each trip.

Menu costs With high inflation, firms must change their prices often in order to

keep up with economy-wide changes. But often changing prices is

itself a costly activity whether explicitly, as with the need to print newmenus, or implicitly.

Negative Effect of Inflation


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Positive Effect of Inflation

Labor-market adjustments

Inflation would lower the real wage if nominal wages are kept constant,

Economists argue that some inflation is good for the economy, as it would

allow labor markets to reach equilibrium faster.

Room to maneuver The primary tools for controlling the money supply are the ability to set the

discount rate, the rate at which banks can borrow from the central bank, and

open market operations which are the central bank's interventions into the

bonds market with the aim of affecting the nominal interest rate. If an

economy finds itself in a recession with already low, or even zero, nominal

interest rates, then the bank cannot cut these rates further (since negativenominal interest rates are impossible) in order to stimulate the economy - this

situation is known as a liquidity trap. A moderate level of inflation tends to

ensure that nominal interest rates stay sufficiently above zero so that if the

need arises the bank can cut the nominal interest rate.


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Avoiding the Financial Market Inefficiency

Mundell-Tobin effect

Moderate inflation would induce savers to substitute lending for some

money holding as a means to finance future spending. That

substitution would cause market clearing real interest rates to fall. Thelower real rate of interest would induce more borrowing to finance

investment. In a similar vein, noted that such inflation would cause

businesses to substitute investment in physical capital (plant,

equipment, and inventories) for money balances in their asset

portfolios. That substitution would mean choosing the making ofinvestments with lower rates of real return. (The rates of return are

lower because the investments with higher rates of return were

already being made before). The two related effects are known as the

Mundell-Tobin Effect.

Positive Effect of Inflation


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Controlling Inflation

There many ways to control the inflation. There

are:

Monetary Policy

Fiscal Policy


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Monetary Policy Government uses monetary approach to stabilize the

economy by controlling the inflation.

How? By using monetary tools, which are usually

related to interest rate or money supply

Monetary Policy: Target Market Variable: Long Term Objective:

Inflation Targeting Interest rate on overnight debt A given rate of change in the CPI

Price Level Targeting Interest rate on overnight debt A specific CPI number

Monetary Aggregates The growth in money supply A given rate of change in the CPI

Fixed Exchange Rate The spot price of the currency The spot price of the currency

Gold Standard The spot price of goldLow inflation as measured by the

gold price

Mixed Policy Usually interest rates Usually unemployment + CPI change


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Fiscal Policy

Government uses the Government

Expenditure or Revenue to influence the

economy

The methods are:

Tax

Seigniorage (Printing Money)

Borrowing Money

National Reserve Consumption

Selling of Assets (Land for example)

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