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The McGraw-Hill Companies, 2008
Chapter 26Inflation, expectations and
credibility
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,9th Edition, McGraw-Hill Education, 2008
PowerPoint presentation by Alex Tackie and Damian Ward
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The McGraw-Hill Companies, 2008
Inflation is ...
Inflation is a rise in the price level.
Pureinflation is when goods andinput
prices rise at the same rate. One of the first acts of the Labour
government in 1997 was to make theBank of England independent with a
mandate to achieve low inflation.The rental contracts and the civil servant wages
are indexed to inflation in Turkey.
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Some questions about inflation
What are the causes of inflation?
What are the effects and hence costs
of inflation?
What can be done about it?
These are the questions we seek to
answer in what follows.
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Calculating Inflation
We use price indices to measure
inflation.
Consumer Price Index (CPI) Producer Price Index (PPI)
Gross Domestic Product deflator
(GDP deflator)
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Inflation in the UK, 1950-2007
0
5
10
15
20
25
30
1950
1960
1970
1980
1990
2000
%p.a.
Source: Economic Trends Annual Supplement, Labour Market Trends
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Inflation in Turkey2003-2011
6Source: TEPAV
0
2
4
6
8
10
12
14
16
18
20
2003 2004 2005 2006 2007 2008 2009 2010 2011
Inflation
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THE CONSUMER PRICEINDEX
The consumer price index (CPI) is ameasure of the overall cost of thegoods and services bought by a
typical consumer.
The Bureau of Labor Statisticsreports the CPI each month.
It is used to monitor changes in thecost of living over time.
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THE CONSUMER PRICEINDEX
When the CPI rises, the typical familyhas to spend more dollars tomaintain the same standard of living.
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How the Consumer Price Index IsCalculated
Fix the Basket:Determine whatprices are most important to thetypical consumer.
The Bureau of Labor Statistics (BLS)identifies a market basket of goods andservices the typical consumer buys.
The BLS conducts monthly consumersurveys to set the weights for the pricesof those goods and services.
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How the Consumer Price Index IsCalculated
Find the Prices:Find the prices ofeach of the goods and services in thebasket for each point in time.
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How the Consumer Price Index IsCalculated
Compute the Baskets Cost:Usethe data on prices to calculate thecost of the basket of goods and
services at different times.
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How the Consumer Price Index IsCalculated
Choose a Base Year and Computethe Index:
Designate one year as the base year,making it the benchmark against whichother years are compared.
Compute the index by dividing the price
of the basket in one year by the price inthe base year and multiplying by 100.
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How the Consumer Price Index IsCalculated
Compute the inflation rate:Theinflation rate is the percentagechange in the price index from the
preceding period.
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How the Consumer Price Index IsCalculated
The Inflation RateThe inflation rate is calculated as
follows:
Inflation Rate in Year 2 =CPI in Year 2 -CPI in Year 1
CPI in Year 1100
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Table 1 Calculating the Consumer Price Indexand the Inflation Rate: An Example
Copyright2004 South-Western
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Table 1 Calculating the Consumer Price Indexand the Inflation Rate: An Example
Copyright2004 South-Western
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Table 1 Calculating the Consumer Price Indexand the Inflation Rate: An Example
Copyright2004 South-Western
bl l l i h i d
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Table 1 Calculating the Consumer Price Indexand the Inflation Rate: An Example
Copyright2004 South-Western
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Table 1 Calculating the Consumer Price Indexand the Inflation Rate: An Example
Copyright2004 South-Western
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CPI 851 goods and services
included in 12 main categories. CPI-Turkey 2012 (%)
1. Food and nonalcoholic beverages 26,222. Alcoholic beverages and tobacco 5,213. Clothing and shoes 6,87
4. Housing 16,445. House appliances 7,456. Health 2,297. Education 2,188. Communication 4,69. Transportation 16,73
10.Recreation and culture 2,9811.Restaurants and Hotels 5,6312.Other 3,4
TOTAL 100
Source: TK
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The McGraw-Hill Companies, 2008
The GDP Deflator
The GDP deflator is a measure of theprice level calculated as the ratio ofnominal GDP to real GDP times 100.
It tells us the rise in nominal GDPthat is attributable to a rise in pricesrather than a rise in the quantities
produced.
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The McGraw-Hill Companies, 2008
The GDP Deflator
The GDP deflator is calculated asfollows:
GDP deflator =
Nominal GDP
Real GDP100
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The Causes of Inflation
Demand-Pull Inflation: Increaseswhen the demand increases.
Example: Good economic conditionscause demand to increase.
Cost-Push Inflation: The increase incosts can push the prices up.
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The McGraw-Hill Companies, 2008
Hyperinflation
Hyperinflations are periods wheninflation rates are very large
During such periods there tends to be aflight from cash, i.e. people hold aslittle cash as possible e.g. Germany in 1922-23, Hungary 1945-
46, Brazil in the late 1980s.
Large government budget deficits helpto explain such periods persistent inflation must be accompanied by
continuing money supply growth
i fl i
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The McGraw-Hill Companies, 2008
German Hyperinflation,1922-23
(January 1922=1)Date Money
SupplyPrices Real Money Monthly
inflation(%)
Jan 1922 1 1 1.00 5
Jan 1923 16 75 0.21 189
July 1923 354 2021 0.18 386
Sept. 1923 227777 645946 0.35 2532
Oct. 1923 20201256 191891890 0.11 29720
25
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Seigniorage and InflationTax
Seigniorage: The real income that thegovernment gets by printing money
Inflation Tax: The decrease in realnational debt because of the increase ininflation.
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Inflation illusion
People have inflation illusion when theyconfuse nominal and real changes.
Welfare depends upon real variables, not
nominal variables. If all nominal variables (prices and
incomes) increase at the same rate, realincome does not change.
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The costs of inflation (1)
Fully anticipated inflation: Institutions adapt to known inflation:
nominal interest rates
tax rates transfer payments
there is no inflation illusion
Some costs remain:
shoe-leather people economise on money holdings menu costs
firms need to alter price lists etc.
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The costs of inflation (2)
Even if inflation is fully anticipated,the economy may not fully adapt
interest rates may not fully reflectinflation
taxes may become distorted fiscal drag may have unintended effects on
tax liabilities capital and profits taxes may be distorted
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The McGraw-Hill Companies, 2008
The costs of unanticipatedinflation
Unintended redistribution of income from lenders to borrowers
from private to public sector
from old to young Uncertainty
firms find planning more difficult underinflation, which may discourage investment
This has been seen as the mostimportant cost of inflation
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Defeating inflation
Monetary policy: Inflation will be lower ifthe rate of money growth is lower.
Fiscal Policy: If the government spends
less, then it needs to print less money tocover its debt.
Price policy: The government tries to
control the prices. (e.g. Limit the raise inrental contracts).