Chapter IV: Prices and Inflation

Goethe Business SchoolGoethe Business School

Chapter IV: Prices and Inflation

A. Measuring prices and inflation

B. The AS-AD Model and inflation

C. Cost-push and demand-pull inflation

D. Inflation as a monetary phenomenon

E. Effects of inflation and inflation hedging

F. Controlling inflation


2

Distinguishing real and nominal values Keynes had reasons to treat

the aggregate price level as given, but in many instances the price level will change over time

In this case we need to know more about the price deflator for GDP

It allows to distinguish between real GDP growth and nominal values of GDP

First we look at how prices are measured


3

Measuring prices:Two approaches Prices are often given with reference

to a standard product for raw materials Other prices are given as a compound measure

for a basket of goods and services Example:

When newspapers write about oil prices, they usually mean one of two reference crudes: Brent from the North Sea, or West Texas Intermediate (WTI)

When ministers from the Organization of the Petroleum Exporting Countries (OPEC) discuss prices, they usually refer to a basket of heavier cartel crudes, which trade at a discount to WTI and Brent


4

Consumer price index (CPI) An important indicator is the

consumer price index (CPI) It attempts to measure the evolution,

over time, of the cost of living of a typical household

It implies definition of A typical household A typical basket of goods and services

of that household


5

Constructing the CPI

What do we need to construct a CPI? A base year t0 (in Germany 2000)

A “typical household” (in Germany various types)

A “basket” with “typical” of goods and services of the household (xi,0 ) for t0 (in Germany about 750)

Prices of the base year pi,0 and current prices pi,t for that basket


6

Two types of price indices

If the weights xi,0 of the base period remain fixed, it will give us a “Laspeyres index”

If the weights are updated every period (flexible basket), xi,t, we obtain a “Paasche index”

∑

∑

=

=

⋅

⋅= n

iii

i

n

iti

Laspeyrest

xp

xpPI

10,0,

0,1

,

∑

∑

=

=

⋅

⋅= n

itii

n

ititi

Paaschet

xp

xpPI

1,0,

1,,


8

The CPI according to Laspeyres

overstates the cost of living

Problems of the Laspeyres index

Reasons: The following is not measured Shoppers revise shopping plan in response to

changes in price relativities (substitution bias) There are new products that are not incorporated

in the original basket There are improvements in the quality of products and

services (quality bias)


9

Problems of the Paasche index The Paasche index

Is more difficult to administer (the denominator has to be re-calculated every year)

Requires quantity data for each year, which may be difficult to obtain

Could be misleading, because each time different quantities are used, and therefore changes may not solely be attributable to price changes


10

Impact of CPI on public and private agents In the U.S., the CPI affects the income of almost

80 million people as a result of statutory action Social Security beneficiaries, Military and Federal civil service retirees, Food stamp recipients

Changes in the CPI also affect the cost of lunches for children who eat lunch at school

Some private firms and individuals use the CPI to keep rents, royalties, alimony payments and child support payments in line with prices


11

“Chain-linked” indices

To alleviate the burden of the traditional CPI on the federal budget, the US Bureau of Labor Statistics publishes chain-weighted indexes using a rolling base year since 1995

Other countries followed

€

PI tLaspeyres=

pi,t ⋅i=1

n

∑ xi,t− j

pi,t− j ⋅xi,t− j

i=1

n

∑,where j = 2


12

Real GDP

Real GDP is measured in prices of a base year

For instance:Real GDP of 2005 (in prices of 2000):

€

GDP2005real = pi,2000

output ⋅xi,2005output

i=1

n

∑ − pi,2000input ⋅xi,2005

input

i=1

n

∑


13

Real GDP and the GDP deflator

Nominal GDPReal GDP

The GDP deflator is defined as follows:

GDP deflator =


14

Reading

Reading 4-1“Fighting America’s inflation flab”, The Economist, October 5, 2000(on methodological tricks with indices)

Abel, Bernanke and Croushore, Chapter 2 (only 2.4 and 2.5)


15

CPI and GDP deflator:Differences The CPI is a Laspeyres index, whereas

the GDP deflator is a Paasche index The difference depends on what basket

of goods we use to calculate the index Is it best to use the same one

(of the reference year)? Or should we use the one at time t,

which changes period by period? The answer is not obvious!


16

Example: Oil shock (1)

Suppose we choose the Laspeyres index and take the time-zero basket fixed

There is an oil shock at time 0, the oil price skyrockets: households reduce the demand for gasoline

and cars increase the use of substitute means

of transportation (for instance subways)


17

Example: Oil shock (2)

At time t the actual basket of goods includes much less gasoline than at time zero, but the Laspeyres formula does not take it into account, so it will overstate inflation

The Paasche tends to understate inflation instead, because it gives a smaller weight to gasoline (the share of gasoline expenditures at time t)


Reading: Oil shock and prices

18

Reading 4-2“Pistol pointed at the heart”, The Economist, May 29th, 2008


19

Differences between CPIand GDP deflator: summary

Price index GDP deflator

Goods and services

Only private goods and services are

included

All private and public goods are

included

International trade

No distinction between national or international goods

and services

Only national goods and

services are summarized

Basket Fixed composition

Flexible composition


20

The inflation rate and the growth rateThe annual inflation rate is calculated as

The annual growth rate is calculated as

€

π t +1 =Pt +1

Pt

−1 ⎡

⎣ ⎢

⎤

⎦ ⎥×100

€

gt +1 =GDPt +1

real

GDPtreal

−1 ⎡

⎣ ⎢

⎤

⎦ ⎥×100


21

International GDP deflators1971-2005: North and South America

Source: Worldbank; own calculations

GDP Deflators: North America

0

20

40

60

80

100

120

140

160

197119731975197719791981198319851987198919911993199519971999200120032005

United States

Canada

Mexico

GDP Deflators: South America

0

20

40

60

80

100

120

140

160

180

197119731975 197719791981198319851987 198919911993199519971999 200120032005

Argentina

Brazil

Other South America


22

International GDP deflators1971-2005: Europe and Asia

GDP Deflators: Europe

0

20

40

60

80

100

120

140

160

1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

EU 25

EU 15

Other Europe

GDP Deflators: Asia

0

20

40

60

80

100

120

1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

China

Japan

Korea

Source: Worldbank; own calculations


23

World inflation

0

5

10

15

20

25

Jan91

Jan92

Jan93

Jan94

Jan95

Jan96

Jan97

Jan98

Jan99

Jan00

Jan01

Jan02

Jan03

Jan04

Source: Worldbank

Developingeconomies

High revenue economies

Consumer price inflation, median for developing- and GDP weighted mean for high-income

Per

cent

age

incr

ease

p.a

.


24

Inflation history of the United States


A useful link

http://www.bls.gov/data/inflation_calculator.htm

25


Inflation in the Euro area, recent trends (HICP)

26


World inflation

27


Inflation in transition economies

28

Inflation rates of transition economies even dwarf those of Latin America in the early 1990s


29

The AS-AD modeland inflation

If the AS curve is steeper, a

variation of the AD changes GDP at constant prices

and triggers an increase of the

price deflator


30

Output and employment

This seems to suggest that there is a positive relationship between the price level and output for varying AD functions

Given the production function: Is there a tradeoff between unemployment and price stability? I.e. If we want more employment, we have to accept higher prices?

This hypothesis is expressed in the so-called “Phillips curve”


31

Phillips curve

Unemployment

Infl

ati

on

2 3 4 5 6 7

8

7

6

5

4

3

2

1

Source: Economic Report to the President, 1985

Phillips curve


32

Phillips curve The discussion about the Phillips curve is

very much related to Keynesian demand management

Unfortunately there is no trade off between unemployment and inflation

The Phillips curve simply overlooks long term reactions on the supply side

Let’s see what happens if the economy is constrained by its potential


33

The AS-AD modeland inflation

In the long run the AS curve is vertical,

the expansion of output is only

temporary In the long run we

return to potential output at point C

All we have achieved is an

increase of the price level

B

A

C


34

Long run Phillips curve

In the long run employment is to remain at its “natural” level (“natural employment”)

So the Phillips curve tradeoff works only in the short term

(We shall come back to this when we discuss demand pull inflation)

Let us come back to the price increase induced by shifting along the AS curve


35

Price level increaseand inflation Is this price increase called inflation? For most people it is, but economists

speak of inflation only if it is reoccurring and persistent

So the case discussed here is a one-time price adjustment only, not necessarily inflation

How then is inflation generated?


36

Why is there inflation? Inflation could result from activist

economic policies There are two types of mechanisms:

Cost push Demand pull

Each on its own will provoke price increases, but not necessarily inflation

However both mechanisms in tandem could cause inflation indeed


37

Oil shock and policy reactions Let’s assume there is an oil price shock as

in the example discussed It would shift the supply curve to the left

creating a price increase and reducing production

Reduced production entails unemployment The government reacts with expansionary

fiscal policies


38

Cost-push inflation

Price level

Aggregate output

Inflation is dueto accommodating

fiscal policy

GDPpotential

Each time the priceincrease feeds

back into wagesand costs


39

Government demand asa driving force of inflation Let’s assume that the “natural rate of

employment” is reached, but there is residual structural unemployment

The government does not tolerate this and expands government outlays to inflate aggregate demand

It must drive prices up, which then feed back into wages and costs shifting the AS curve to the left


40

Demand-pull inflation

Price level

Aggregate outputGDPpot GDPtarget

Fiscal policy drivesprices up,

and each time the price increase

feeds back into wagesand costs


41

“Inflation is always and everywhere

a monetary phenomenon”

Milton Friedman 1912-2006, Nobel prize in 1976

The role of monetary policy

But neither cost push nor demand pull could provoke inflation without monetary

expansion

But neither cost push nor demand pull could provoke inflation without monetary

expansion


42

Views on inflation: the monetarists

1

1: initial equilibrium

1’ 1’: expansion of money supply and of AD

2’

2’: expansion of money supply and of AD

2

2: restoration of “natural output” level

3

3: restoration of “natural output” level

3’4

Price level

Aggregate outputGDPnatural


43

Inflation and the supply of money

Growth rate of the money supply in percent

Gro

wth

rate

of

the Inflati

on

1930

1920

1950

1870

1890

1880

1900

19601980

1940

1970 1910

Increase in Inflation and money supply in the USA(10 years annual average)


44

Reading

Reading 4-3“An old enemy rears its head”, The Economist, May 22nd, 2008


45

Once more:the Phillips curve

Activist fiscal or monetary policies trying to push employment beyond the “natural employment rate” should show up in the Phillips curve

Let’s have a look at the Phillips curve for Germany


46

Phillips curve for Germany

Years

1961 to 1996

Unemployment rate in %

Inflati

on r

ate

in

%


Years

1961 to 1973

Inflati

on r

ate

in

%


47

“Natural unemployment”and hysteresis As the short-term tradeoff between

unemployment and inflation is exploited, there are “irreversible” structural effects

People thrown out of job loose their qualification and become “structurally unemployed”

This process is called “hysteresis” It is exacerbated by structural changes

in the economy (the production function)


48

Inflation and hysteresisof unemployment

Phillips curve for Germany

1961 to 1996


Inflati

on r

ate

in

%

un2un

1 un3


49

The dynamics of the Phillips curve

π

uThe shift toward the right supports hysteresis

Turning clock-wise does in fact support the thesis that expansionary policy is followed by inflation


50

Reading

Abel, Bernanke and Croushore, Chapter 12.1 and 12.2


51


52

Creeping progression and “inflation tax” As the income tax is progressive, inflation will

automatically increase the tax burden relative to GDP in real terms (“bracket creep”)

There is an “inflation tax” on money holdings The counterpart is “seignorage” It could diminish welfare by reducing cash

holdings below the optimum for transactions The “inflation tax” hits the poor more than the

rich, because the latter can hedge assets against inflation


53

Inflation and distortions of allocation Inflation can cause serious distortions on

the allocation of capital because the tax system ignores inflationary gains

(losses), and it charges certain activities too heavily (lightly)

profits could be inflated by deficient accounting which (inter alia) fixes depreciation at historical costs leads to difficulties in evaluating inventory flows treats dividends and debt charges differently


54

Inflation and distortions of allocation If inflation is expected, consumers could reduce

savings to spend more on consumption, which would increase the costs of investment, and reduce growth

Inflation entails uncertainty, which could affect consumers’ and investors’ behavior negatively

Accounting techniques could be improved to adjust for inflation, but this leads to higher information costs


55

Inflation and redistribution There are distributional arguments against

inflation. It is alleged to let profit income earners benefit more

than wage earners to penalize nominal income earners

Pensioners?Fixed-income earners (from securities etc.)?

to benefit debtors at the expense of creditors to make the the government

win at the expense of the private sector


56

Hedging against inflation The distributional effects largely depend on

whether inflation is expected, or not If inflation is expected, it could be built into

contracts One way of incorporating unforeseeable inflation

is to use indexing Indexing is also an incentive for governments

to control the price level It is crucial to distinguish between “passive”

contract from self-referencing contracts


57

“Scala mobile” in Italy An example for a self-referencing indexing

scheme is the “scala mobile” in Italy From 1946 until 1992, Italy had linked wage

increases to the CPI This lead to continuous inflationary pressures

that were hard to resist by monetary policies Moreover the Banca d’Italia was dependent on

the government In 1992 the “scala mobile” was repealed The central bank became more independent


58

Prohibition of indexation in Germany In 1948 indexation was prohibited in Germany It was only permitted by Bundesbank authorization,

and permissions were rare The introduction of the euro in 1999 changed this

policy, but the indexation of wages and leasing fees is still forbidden

The central government has heralded an inflation-indexed bond with a volume of 10 billion € for the year of 2005

Nowadays more than 26 countries worldwide offer inflation-indexed bonds


59

Reading

Abel, Bernanke and Croushore,

Chapter 12.3


60

Different “types” of inflation

There are different types of inflation: creeping, rapid, and hyperinflation

The German hyperinflation is a striking example of money expansion driving the inflation rate

This experience qualifies as a “controlled experiment” and support Friedman’s thesis that

“inflation is always and everywhere a monetary phenomenon”


61

Example:Germany after WW I


62

The German hyperinflation 1922-23

Whole sale price index

1,E+00

1,E+01

1,E+02

1,E+03

1,E+04

1,E+05

1,E+06

1,E+07

1,E+08

1,E+09

1,E+10

1,E+11

1,E+12

July 1914 Jan 1919 July 1919 Jan 1920 Jan 1921 July 1921 Jan 1922 July 1922 Jan 1923 July 1923 Nov 1923

Whole sale price index

1,E+00

1,E+01

1,E+02

1,E+03

1,E+04

1,E+05

1,E+06

1,E+07

1,E+08

1,E+09

1,E+10

1,E+11

1,E+12

July 1914 Jan 1919 July 1919 Jan 1920 Jan 1921 July 1921 Jan 1922 July 1922 Jan 1923 July 1923 Nov 1923


63

Is inflation under control now? Today, both the Fed and the European

Central Bank are independent institutions with conservative monetary policies

The two world currencies, the dollar and the euro, show little signs of inflation

Many countries have “anchored” their currencies in one of the world currencies

Sometimes anchoring even entails deflation (e.g. Argentina)


64

Discussion 4:Inflationary risks and corporate management

Why should firms be concerned about inflation?

What strategies can be adopted to hedge inflationary risks at the firm level?

Do firms need inflationary risk management where currency boards appear to guarantee price stability?

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Chapter IV: Prices and Inflation

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