MACRO

MACRO - Inflation

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• Inflation Explained in 2 minutes…

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• Inflation is defined as a sustained/ persistent increase in the general price level over a given period of time.

• Deflation is a persistent fall in the general price level of goods and services over a given period of time.

• It is usually measured as an annual percentage rate.

• Inflation is usually calculated using a Consumer Price Index (CPI). If the figure is negative eg -2% we say there has been deflation.

• The annual rate of inflation (using a CPI) is a key macro economic performance indicator.

• Details of measuring inflation will come later…

• The CPI is updated monthly, based on the change in price of a representative basket of goods/services for a typical domestic household. The prices of approx 700 items are surveyed monthly. If there is a rise in the average price level we say there has been inflation

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Global Inflation

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World Advanced economiesEmerging and developing economies

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Emerging Economies: Inflation

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Some inflation terminology• Creeping inflation

Small rises in the general level of prices over a long period of inflation

• DisinflationA fall in the rate of inflation. This means a slower increase in prices but not a fall in prices

• Price stability A period of low stable inflation of between 1-4% when price rises are modest

• StagflationA combination of slow economic growth and rising inflation, can lead to stagflation. The most notable recent period of stagflation occurred during the 1970s, when world oil prices rose dramatically, and UK inflation rose at one point to nearly 30 per cent.

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• http://www.guardian.co.uk/business/interactive/2011/jan/25/recession-gdp-unemployment-statistics-interactive

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Other Measures of inflation• Retail Price Index (RPI)

The RPI is a measure of inflation based on a slightly different basket of goods/services than the CPI. It includes mortgage repayments and some taxes, and excludes the top 4 per cent of earners. It is used to calculate increases in wages, state benefits and pensions

• HICP – Harmonised index of consumer prices• The European standard measure, which the UK CPI is derived

from. The CPI is, therefore, comparable with other EU members inflation figures.

• RPIX – Retail price index X• excluding mortgage interest repayments• RPIY – Retail price index Y• excluding mortgage interest repayments and indirect taxation

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Inflation rates, using different measures, for the UK (2002-2008)

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The PPI

• Producer Price Index

• PPI for inputs• PPI for intermediate goods• PPI for final goods (at wholesale level, not retail)

• Changes in the PPI are considered to be predictors of changes in the CPI, hence predictors of inflation because they measure price changes at an earlier stage in the production process.

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http://www.statistics.gov.my/portal/download_Prices/files/PPI/2012/MAC/03Graf1-2.pdf

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CAUSES OF INFLATION?

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Handout

• Inflation inches up in April, poses fresh policy headache

• http://timesofindia.indiatimes.com/business/india-business/Inflation-inches-up-in-April-poses-fresh-policy-headache/articleshow/13132466.cms

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Causes of Inflation:

AD

SRAS2Price Level

Real National Output

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P1

Y1 Y

P

1- Cost Push InflationWhere the price level is pushed up by sustained increases in the costs of production.

SRAS1

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Causes of Inflation:

2- Demand Pull InflationWhere the price level is pulled up by increases in aggregate demand.

LRASPrice Level

Real National Output

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P2

Y1 Y2

P1

AD2

Can also be shown with a short run AS

curve. However, using a long run AS

curve will allow flexibility to show the

extent to which inflation occurs

depends on whether there is spare capacity in the

economy.

AD1

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Causes of Inflation:

3- Inflation due to excess monetary growthWhere excessive increases in the money supply, leading to increases in AD, will result in inflation. Neo Classical view, LRAS is vertical. See handout on Monetarism and the Quantity Theory of Money for more details (extension material)

LRASPrice Level

Real National Output

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P1

Yfe

P

AD2

AD1

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Causes of Inflation:

Possible causes of Cost Push Inflation

• Increasing raw material costs (maybe due to a falling e/r= increased costs of imports)

• Increased real wages (in excess of productivity gains)• (Anything that causes a fall in SRAS)

Possible causes of Demand Pull Inflation• Increasing consumer confidence• Increased demand for exports (possibly due to depreciation of the

currency)

• Increased government spending • (Anything that causes a rise in AD)

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CONSEQUENCES OF INFLATION

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The consequences of Inflation:

Reducing value of moneyThe purchasing power of money falls. The same amount of money will buy progressively less.

UncertaintyInflation, especially when unanticipated, can lead to uncertainty. Firms will be less certain of future costs and prices they will receive for their products. Firms are less likely to invest. Consumers will be less certain about their future spending requirements and savings.

Redistribution effectsIf some workers do not receive wage increases that keep pace with inflation, while others do, there can be a redistribution effect. Those whose disposable incomes rise faster than inflation, are said to have a rise in their real disposable income.Eg. If inflation is 5% and you get a pay rise of 6% your ‘real’ income has risen by 1%Savers may lose out. Eg. If interest rates are 5%, but inflation is 6%, the ‘real’ interest rate is -1% Borrowers may gain. If person borrowed money at 0%, but inflation was 5% the amount of money they have to repay has fallen in ‘real terms’.

We say there may be a redistribution of income from savers to borrowers.

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The consequences of Inflation:

Loss of international competitivenessDomestic inflation, if higher than other countries, may lead to prices of domestically produced goods and services becoming less competitive in international markets. Lower price competitiveness is likely to reduce demand for exports and possibly increase demand for imports.

Menu CostsAdditional costs incurred by firms when they need to change their prices. These costs increase when inflation is high, as prices are changed more frequently. There can be considerable costs incurred when changing catalogues, menus, price lists and website prices etc. Labour costs, printing and distribution.

Shoe Leather CostsThe costs incurred when time and effort are required to ensure money does not lose its value. When inflation is high, interest rates tend to be high. People are less willing to hold cash and will make more trips to building societies and banks. Banking transaction costs also tend to increase.

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The consequences of Inflation:

Administrative CostsAdditional costs can include, costs of labour to renegotiate contracts with customers, adjusting accounts and negotiation with unions about wages.

Inflationary noiseThe increasing prices of products can lead to market signals being distorted. It is difficult for consumers to recognise if price increases are due to the general level of inflation or if they reflect a change in price relative to other products.

Fiscal dragIf tax brackets are not changed in line with price rises, there can be redistribution from taxpayers to the government. As prices rise, higher rates of taxation may be paid. If taxpayers pay a higher proportion of their income in tax there will be fiscal drag. If a government does not adjust tax bands as incomes rise (in response to increasing prices) this could be significant.

Inflation causing further inflationInflation can lead to expectations that prices will continue to rise in the future. AD may increase as more goods and services are demanded now. Increased wage demands due to expectations of future inflation may also lead to inflation when wage increases lead to increased prices. Wage- price spiral.

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The consequences of Inflation:

Danger of HyperinflationWhen inflation gets out of hand eg. Several hundred % a year, the

whole basis of the economy will be undermined

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Consequences of Inflation

• a sign somewhere near the South Africa-Zimbabwe border

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Imagine that during the time it took to drink a cup of coffee, the price of that cup of coffee doubled. Although extreme, this becomes the reality of hyperinflation, where prices change so rapidly that everyday items rise exponentially and money becomes worthless, virtually overnight or even in the course of a working day. Top 5 cases?

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5. Greece, Oct. 1944Highest monthly inflation: 13,800% Prices doubled every 4.3 days

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4. Germany, Oct. 1923Highest monthly inflation: 29,500% Prices doubled every: 3.7 days

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3. Yugoslavia, Jan. 1994Highest monthly inflation: 313,000,000% Prices doubled every: 1.4 days

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2. Zimbabwe, Nov. 2008Highest monthly inflation: 79,600,000,000% Prices doubled every: 24.7 hours

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1. Hungary 1946Highest monthly inflation: 13,600,000,000,000,000% Prices doubled every: 15.6 hours

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Inflation The following photographs help illustrate how money can become worthless when

inflation gets out of control.

Title: Money Kite. Date: 1922. Description: A boy with a kite made of banknotes in Germany, during the depression when escalating inflation rendered much currency worthless. Copyright: Getty Images,

available from Education Image Gallery (http://edina.ac.uk/eig/)

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Inflation

Title: Overflowing Riches. Date: 1922. Description: A shopkeeper using a tea chest to store money which won't fit in the cash register during Germany's high inflation. Copyright: Getty

Images, available from Education Image Gallery (http://edina.ac.uk/eig/)

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InflationTitle: The Value Of Money

Date: circa 1923 Description: Children using notes of money as building blocks during the

1923 German inflation crisis.

Copyright: Getty Images, available from Education Image Gallery (http://edina.ac.uk/eig/)

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The consequences of Inflation:

Significant Benefits of low and stable Inflation:

Low and stable rates of inflation may encourage firms to invest. If firms feel prices of their products will steadily rise, they are more likely to increase output.

Consumers are more likely to continue to spend a reasonably high proportion of their incomes, when the general price level steadily increases. There is a significant increase in confidence when prices increase at a low and stable rate.

Go to the student share folder and read March 2003 page 2 ‘What’s So Bad About Inflation’U:\_Economics (IB & IGCSE)\et Economics today Volumes 10 , 11 & 12

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Policies to deal with inflation?• Use India article plus own knowledge of Malaysia and

other countries• List & explain methods- think of causes of inflation

hence how could they be dealt with?• Fiscal• Monetary• Appreciation of e/r• Incomes policy (wage controls)• Labour market reform- flexibility of labour market,

control labour costs• Supply side policy• Handout- What are the merits of both fiscal and

monetary policy to control inflation in the UK? Et Jan 2009

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Deflation• Deflation is defined as a sustained/

persistant fall in the general price level over a given period of time.

V Important Note a fall in the rate of inflation from 5% to 3% is not deflation

-2% is deflation

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Causes & Consequences of Deflation

• Using the article’ Is deflation more worrying than inflation answer the following questions for your notes

1. What are the 2 causes of deflation, include diagrams in your answer

2. Explain the problems associated with deflation3. What can governments do to escape deflation?4. What are the problems the government face in

dealing with deflation?

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Inflation dr q3

• M07/3/ECONO/SP2/ENG/TZ0/XX

• h/w

MACROMeasuring Inflation

More detail…

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• The CPI measures price changes, not price levels. • Index numbers are used to calculate price changes• In the UK 2005 is given as the base year and has

an index number of 100• The index for January 2010 was 112.4 • This indicates that £112.40 would buy the same

amount of goods and services as £100.00 would have in 2005. This represents a rise in prices of 12.4 per cent.

• The annual rate of inflation is simply the percentage change in the latest index compared to the value recorded twelve months previously.

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• The CPI measures prices of 700 items• From the price changes of these items an average price

change is calculated• Prices are recorded every month using a large sample of

shops and other outlets, including the internet (180,000 prices are collected each month)

• The 700 chosen items are referred to as a ‘typical basket of goods’

• i.e. they reflect the ‘typical’ items bought by households• The content of the basket is fixed for a period of 12 months

(updated yearly to reflect changes in spending habits)

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BBC link inflation in UK

• http://www.bbc.co.uk/news/business-16535721

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Weighting• All items in the index are ‘weighted’ to reflect the

importance of the various items in the average shopping basketPetrol is given a higher weighting than stamps as more of a household budget will be spent on petrol, hence a change in the price of petrol will have a more significant impact on people.

• The CPI’s weights are based on the monetary expenditure of all private households in the UK, foreign visitors to the UK and residents of communal establishments such as nursing homes, retirement homes and university halls of residence.

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The CPI is a weighted measure – reflecting the proportion of income spent on different items (shown here by category)

The categories of products, for a basket of goods/services, and their weightings

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• In practice people spend different amounts on various goods and services that show different price movements.

• For example someone who does not drink alcohol, does not use a car and does not go to the cinema will have a different personal inflation rate to someone who does.

• But, while no one is ‘average’, it is still convenient to have summary price measures.

• The index simply indicates what we would need to spend in order to purchase the same things we bought in an earlier period, irrespective of whether particular products are ‘needed’ or are ‘good for you’.

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Handout

• Tablet computers added to UK inflation basket

• BBC news 13 March 2012

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• Adjusting for quality• It is important that the index calculations are based each month on ‘like

for like’ comparisons of prices for each of the items in the basket. • However, some brands or varieties of particular products priced at the

start of the year may not be available in later months. This is common in markets where the rate of technological progress is high, as is the case with many electronic goods, or where consumer tastes change rapidly, for example in clothing.

• When particular products do disappear from the market, care is taken to ensure that replacements are of broadly comparable quality so that price comparisons are not distorted. If this is not possible, prices are adjusted to take account of the change in quality, using one of a range of techniques, from fairly simple methods, to procedures that relate the prices of goods to their features.

• Explicit adjustments are made, for example, in the case of personal computers, where most replacement models are of higher quality than their predecessors. A rise in price might be accompanied by improvements say in processing speed. In this case, an index which did not take account of improved quality would show higher inflation than an index that does adjust for quality change.

• In this way, quality adjustment helps to focus the index on ‘underlying’ price changes for a fixed basket of goods and services.

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Exam Question

• Explain how inflation can be measured and explain 3 problems associated with the measurement of inflation (10 marks)