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INFLATION

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DefinitionsDefinitions

• Inflation: a sustained increase in all money prices

• Deflation: a sustained decrease in all money prices

• Anticipated inflation: inflation which is correctly foreseen

• Unanticipated inflation: inflation which is unforeseen or incorrectly foreseen as to its timing, rate or duration

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Question for Discussion

1. Are the following examples of inflation?(a) There is a rise in the price of only single good.(b) There is a once-and-for-all rise in the price level.(c) There is a temporary rise in the price level, like the p

rice of vegetables rises after typhoon or flood.

All the 3 cases are not examples of inflation. Inflation is a general and continuous rise in the money prices of goods and services. The 3 cases do not fit in the definition of inflation.

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Answer

(a) A rise in the price of only one good is not a general rise in the price level.

(b) A once-and-for-all increase in general price level is not a continuous rise in price level.

(c) A temporary increase in the price level(e.g., a rise in the price of fruit and vegetables after a typhoon) is not a persistent and continuous rise in price level.

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Measurement of Inflation

1. Meaning of price indexes

A price index is a series of indexed numbers constructed according to the change in the prices of goods and services over a period of time.

Examples: Consumer price indexes (CPIs)

Implicit GNP or GDP deflator

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How is the CPI computed?How is the CPI computed?

Current year prices are compared to prices of a similar basket of goods and services in a base year

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What is a Base Year?What is a Base Year?

A year chosen as a reference point for comparison with some earlier or later year

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Why is the CPI always 100 Why is the CPI always 100 in the Base Year?in the Base Year?

The numerator and the denominator of the CPI formula are the same in the base year

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CPI = CYPBYP

*CYP = cost of the market basket of products at current-year prices

*BYP = cost of the market basket of products at base-year prices

X 100

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3. Consider an economy with only two goods: bread and wine. In 1982, the the typical family bought 4 loaves of bread at 50 cents per loaf and two bottles of wine for $9 per bottle. In 1996, bread cost 75 cents per loaf, and wine cost $10 per bottle. The CPI for 1996 (using a 1982 base year) is a. 100.b. 115.c. 126.d. 130.B.

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CPI = CYPBYP

*CYP = cost of the market basket of products at current-year prices

*BYP = cost of the market basket of products at base-year prices

X 100

$23$20

X 100115 =

What about HKSAR CPI?

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How is theHow is theInflation Rate computed?Inflation Rate computed?

The annual inflation rate is computed as the percentage change in the official CPI from one year to the next

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Calculation of inflation rate

Inflation rate = CPI2 - CPI1

*100% CPI1

*100% Inflation rate =

GNP deflator2 - GNP deflator1

GNP deflator1

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Year

12345

CPI

100110115120125

Exhibit 5

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4. As shown in Exhibit 5, the rate of inflation for Year 2 is a. 5 percent.b. 10 percent.c. 20 percent.d. 25 percent.

B. A percent increase or decrease between two numbers is the difference divided by the original number. In this case, it is 10 / 100 = 10%

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5. As shown in Exhibit 5, the rate of inflation for Year 5 is a. 4.2 percent.b. 5 percent.c. 20 percent.d. 25 percent.

A. A percent increase or decrease between two numbers is the difference divided by the original number. In this case, it is 5 / 120 = 4.2%

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Question for Discussion

2. Read the following table and answer the questions.

Annual Average of CPI(A)Base Year 1988 1989 1990 1991 1992 19931984-85 117.5 129.4 142.0 159.1 174 188.81989-90 84.6 93.1 102.2 114.5 125.2 135.9

(a) Compute the inflation rate in 1989 and 1993 respectively, taking 1989-90 as the base year.

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Ans. The inflation rate in 1989 is : (93.1-84.6)/84.6*100%=10.05%

The inflation rate in 1993 is : (135.9-125.2)/125.2*100%=8.55%

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Refer to the following CPIs A & B of Hong Kong.

95C6

Year

1992

1993

Index A

125.2

135.9

Index B

125.1

136.1

(a) Calculate the inflation rates in 1993 as measured by the two CPIs respectively. Give TWO reasons to explain why the two inflation rates are different. (6 marks)

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Implicit GNP deflator

Implicit GNP deflator = Nominal GNP

Real GNP *100

The GDP figures (in HK$ millions) for the last 3 years as follows:

93B1

At current market prices

At constant 1980 prices

1989

499,157

254,434

1990

555,856

262,189

1991

633,023

272,480

(a) What are the GDP implicit price deflators for all 3 years? (1980=100) Show your working.

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The GDP figures (in HK$ millions) for the last 3 years as follows:

93B1

At current market prices

At constant 1980 prices

1989

499,157

254,434

1990

555,856

262,189

1991

633,023

272,480

(b) What are the inflation rates as measured by the GDP deflators for 1990 and 1991? Show your working.

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Functions of Price Functions of Price IndexesIndexes

to measure the value or purchasing power of money

to show the cost of living

to reflect on the economic situation (the intensity ofinflation/deflation) and facilitate the formulation of policies

to estimate the state of a country in international trade

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Problems of Using PIsProblems of Using PIsA. Sample bias: CPI covers only some selected consumer goods in the economy. Such consumption basket may not be a representative one. (Does GDP deflator have the same problem?)

B. Change in Quality: Since the price indexes do not consider changes in the quality of goods, they may overstate the inflation rate

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8. Suppose a typical automobile tire cost $50 in 1982 and had a useful life of 40,000 miles. In 1995, the typical automobile tire cost $75 and had a useful life of 75,000 miles. If no adjustment is made for mileage, the CPI would a. underestimate inflation between the two

years.b. overestimate inflation between the two years

.c. accurately measure inflation between the tw

o years.d. not measure inflation in this case.

b. Quality changes are difficult to measure. When the quality of items improves, increases in the CPI overstate the change in prices.

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Problems of Using PIsProblems of Using PIs

C. Substitution Effect: Price index does not consider people making substitutions from relatively higher priced goods to lower priced goodsD. Changing spending pattern: As fixed weights are used in constructing the indexes, changes in spending pattern may not be represented.

E. Omission of capital goods: CPI does not consider the changes in the prices of capital goods. ( Does GDP deflator have the same problem?)

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Does the makeup of the Does the makeup of the CPI change?CPI change?

As people’s tastes and preferences change, some of the goods and services that go into the basket change

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P

Q0(a)

Figure 1 The causes of inflation

AD

AS

AD’

P

Q0(b)

AD

ASAS’

Causes of InflationCauses of Inflation

Equation of ExchangeEquation of Exchange

• The nominal money supply (M) is the total dollar value of all paper money and coins in the economy.

Equation of ExchangeEquation of Exchange

• The equation of exchange says that the nominal quantity of money multiplied by the velocity of money equals nominal GDP, (PY).

MV=PY

Equation of ExchangeEquation of Exchange

• The price level equals the nominal money supplied multiplied by velocity divided by real GDP.

P=MV/Y

What Affects/Causes Inflation?What Affects/Causes Inflation?

• Any one of the following raises inflation: Increases in the growth rate of the money supply.

Increases in the growth rate of velocity.

Reductions in the growth rate of real GDP.

Equilibrium InflationEquilibrium Inflation

• The equilibrium rate of inflation is the growth rate of the equilibrium price level.

• Solving for the equilibrium rate of inflation:

% P = % M + % V - % y

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The Ultimate Cause of The Ultimate Cause of InflationInflation

According to Q.T.M.: MV = PY

M/M+V/V=P/P+Y/Y

Since V/V = 0,

M/M - Y/Y = P/P

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The Ultimate Cause of The Ultimate Cause of InflationInflationInflation (i.e. P/P > 0) occurs

when

a. the stock of money increases at a rate faster than the supply of real output (i.e. M / M > Y / Y) ORb. the quantity of goods is reduced (i.e. Y / Y < 0) without an equivalent reduction in the money supply (i.e. M / M =0)

Short- and Long-Run Inflation Short- and Long-Run Inflation and Money Supply Growthand Money Supply Growth

• Generally, inflation reflects the growth rate of the money supply. Because of changes in velocity (V) and real GDP (Y), they are not closely related in the short run.Over long periods of time, money growth and inflation move closely together.

U.S. Inflation and Monetary U.S. Inflation and Monetary Growth Rate by DecadesGrowth Rate by Decades

7.5

10.0

Mon

ey G

rowt

h Ra

te (p

erce

nt p

er y

ear)

5.02.5– 2.5Inflation (percent per year)

7.5

5.0

1880s

2.5

0.0

1870s 1890s

1920s

1930s

1950s 1990s

1900s1960s1980s

1940s 1970s

1910s

Inflation and Money Supply Inflation and Money Supply Growth in the United StatesGrowth in the United States

1995 1998

16%

Inflation

Infla

tion

and

Mon

ey G

rowt

h Ra

tepe

rcen

t per

yea

r

199019851980197519701965Money Growth 2 Years Earlier

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8

4

Annual Inflation Rate

Annual Money Growth Rate (2 years earlier)

Figure 7.2Figure 7.2 The relationship between The relationship between money growth and inflationmoney growth and inflation

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The Ultimate Cause of The Ultimate Cause of InflationInflation

Therefore, inflation is only a monetary phenomenon. It will not last for a long time unless there is a sustained increase in the money stock relative (in %) to the real output.

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Question for Discussion

3. Can inflation also exist in a barter economy?

Ans. Inflation can only exist in monetary economies but not in barter economies. This is because when the price of e.g. good X relative to the price of good Y increases, then the price of good Y relative to the price of good X will fall. It is impossible for a sustained increase in the prices of all goods.

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• Monetary assets: claims to fixed amount of money in the future, e.g. money, bonds

• Monetary liabilities: obligations to pay those fixed amounts of money

• Real assets: claims to goods and services whose real values remain unchanged by inflation, e.g. cake coupons

• Real liabilities: obligations to deliver goods and services whose value remain unchanged by inflation.

Effects of Inflation: Effects of Inflation: RedistribuRedistributive effecttive effect

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Redistributive effectRedistributive effect

• Net monetary creditors: monetary assets > monetary liabilities

• Net monetary debtors: monetary liabilities > monetary assets

Inflation causes wealth Inflation causes wealth redistributionredistribution

NV RV Effects

MA Constant Fall Hurt

ML Constant Fall Benefit

RA Rise Constant Gain if % rise > IR

RL Rise Constant Lose if % rise > IR

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Real assets & liabilities: no redistributive effect

Monetary assets & liabilities

Anticipated inflation: no redistributive effect

Unanticipated inflation:

Redistributive effect: net monetary debtors gain

net monetary creditors lose

Redistributive effectRedistributive effect

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Table 1 Balance sheets before and after unanticipated inflation for a net monetary debtor, showing real increase in equity

Before inflation

After inflation (Unanticipated doubling of price level)

Assets LiabilitiesCash $ 1,000 Debt $100,000House 200,000 Equity(Net Worth) 101,000

$201,000 $201,000

Assets LiabilitiesCash $ 1,000 Debt $100,000House 400,000 Equity(Net Worth) 301,000

$401,000 $401,000

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Question for Discussion

4. Decide who are the gainers and losers during inflation.

Ans. If the monetary creditors do not foresee inflation correctly (i.e. underanticipated as the actual inflation rate is greater than the expected inflation rate), they may ask for an interest rate that cannot compensate the loss of the money’s purchasing power when the monetary debtors repay the money in the future. Thus, there is an income redistribution from the lenders to the borrowers: net monetary creditors lose and net monetary debtors gain during underanticipated inflation. Fixed money income earners lose and the government gains during underanticipated inflation.

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Losers during Losers during underanticipatedunderanticipated inflainflationtion

• Underanticipated inflation: net monetary creditors e.g. lender

• Fixed income earners, e.g. bond holders, pensioners

• Public• Anyone whose growth rate of mon

ey income < inflation rate

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-1%

Last year the Harrison family earned $50,000. This year their income is $52,000. In an economy with an inflation rate of 5 per cent, which of the following is correct?

a. The Harrison’s nominal income and real income have both risen.b. The Harrison’s nominal income and real

income have both fallen.c. The Harrison’s nominal income has fallen,

and their real income has risen. .d. The Harrison’s nominal income has risen,

and their real income has fallen. 52,000 - 50,000

50,000 - 5%,

4% - 5% =

d. % change real income =

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Gainers during Gainers during underanticipatedunderanticipated infl inflationation

• Underanticipated inflation: Net monetary debtors e.g. borrower

• Government

• Anyone whose growth rate of money income > Inflation rate

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Discuss how inflation affects the wealth of creditors and debtors when

98B5

(a) the inflation rate is correctly anticipated. (4 marks)

When inflation is correctly anticipated, both creditors and debtors will adjust the nominal interest rates by the inflation rate in the absence of excessive adjustment cost. The real interest rate creditors receive and debtors pay is the same as the expected amount. Wealth redistribution described above does not occur.

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Discuss how inflation affects the wealth of creditors and debtors when

98B5

(b) the inflation rate is completely unanticipated. (4 marks)

When inflation is completely underanticipated, the nominal interest rate does not take into account sufficiently the inflation rate. As a result, the real interest rate creditors receive & debtors pay will be less than the expected amount. There is a redistribution of wealth from creditors to debtors.

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Effects of InflationEffects of InflationInflation is a TAX: Inflation tends to redistribute income from the public to the government. It is a kind of tax without legislation.progressive income tax

Tax allowances

Government bonds

Tax on cash balances

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Tax allowance : $100,000

Taxable income Tax rate

1st $100,000 10%

2nd $100,000 15%

3rd $100,000 20%

Person A: $90,000 $110,000

Person B: $200,000 $220,000

Inflation raises money income

Inflation tax: proportionately Inflation tax: proportionately more money income are taxablemore money income are taxable

Pre-tax income

Tax allowance Taxable income in %

$1000 $100 1000-100=900/1000=90%

$1100 $105 1100-105=905/1100=90.45%

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Costs of InflationCosts of Inflation

• Misallocation of resources

– encourages speculation

– discouraged from carrying out long-term investment

– unwilling to accept money & insist on trading goods or services directly for other goods & services

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Costs of InflationCosts of Inflation

Higher transaction costs in finding ways to hedge against inflation

Higher inflation rate => greater variability in relativeprice movements => greater uncertainties

Inflation encourages speculation rather than a productive use of saving, and discourages long-term investment projects

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Costs of InflationCosts of Inflation

• Transaction costs:– Anticipated inflation: hedge against

inflation– Unanticipated inflation: obtain

information about future prices

• Higher & unanticipated inflation causes uncertainties – reduce the willingness to lend & borrow – reduce the willingness to invest

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Effects of InflationEffects of Inflation

Real and nominal rates of interest

Nominal interest rate = Real interest rate + Expected rate of inflation

Actual real = Nominal interest - Actual rateinterest rate rate of inflation

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If the nominal rate of interest is less than the inflation rate, a. lenders win.b. savers win.c. the real interest rate is negative.d. the economy is at full employment.

C. The real rate of interest is negative because the lender is receiving less money back, in real terms, than was lent out.

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What is a Wage-price Spiral?What is a Wage-price Spiral?

A situation (vicious circle/+ve feedback) that occurs when increases in nominal wage rates are passed on in higher prices, which, in turn, result in even higher nominal wages and prices

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Do people’s Expectations Do people’s Expectations affect Inflation?affect Inflation?Yes, expectations can

influence both demand-pull and cost-push inflation

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• Inflation rates have declined worldwide

• Some countries such as Japan and China have deflation

• Some causes for concern– Lower commodity prices could devastate emerging

economies– Unions might not anticipate falling prices

• Don’t confuse deflation with falling relative prices

Issues and Applications:Issues and Applications:Is the World Facing the Danger of Deflation?Is the World Facing the Danger of Deflation?

9.3 Inflation and the Nominal 9.3 Inflation and the Nominal Interest RateInterest Rate

• The Fisher equation says that the nominal interest rate (R) equals the real interest rate (r) plus the expected rate of inflation (e).

R = r +e

Inflation and the Nominal Inflation and the Nominal Interest RateInterest Rate

1995 1998

20%

Infla

tion

and

Nom

inal

Inte

rest

Rat

e(p

erce

nt p

er y

ear)

199019851980197519701965

Inflation Rate Nominal Interest Rate

12

8

4

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