The Goals of Macro Economic Policy Part 3

8/3/2019 The Goals of Macro Economic Policy Part 3

1/33

Part 3

The Goals of Macroeconomic Policy

Macroeconomics

Prof. Rushen Chahal


2/33

Chapter 5: Part 3

Inflation

Low inflation

High inflation

Hyperinflation

Calculating Inflation

Inflation and Real Wages

Costs of Inflation Real Versus Nominal Interest Rates


3/33


4/33

Low inflation

Low inflation is characterized by prices thatrise slowly and predictably (single digit annualinflation rates)

When prices are relatively stable,people trustmoney.

Most industrial countries have experiencedlow inflation over the last decade


5/33

High inflation

High inflation is in the double, or triple-digitrange of 10, 100, or 200 percent

In these conditions, money loses its valuevery quickly, so people hold on to only thebare-minimum amount of money needed

for daily transactions


6/33

High Inflation

People hoard goods, buy houses, andnever, never lend money at low

nominal interest ratesInterestingly, economies can continue

to experience healthy growth, despite

the presence of galloping inflation


7/33

Hyperinflation

Hyperinflation is a type of inflationeven more extreme than high

inflation.Unlike high inflation, hyperinflation

will almost always inflict heavy

damage upon the economy


8/33


Adjusting for Inflation:

Nominal value - not adjusted for inflation

Real value - adjusted for inflation

Real value =

Nominal Value_____________Price Index X 100


9/33


Price Index =

Price level(2001)___________

Price level(1983)

X 100

=$142

$100

______ X 100 = 142

If the same basket of goods cost $100 in 1983 and $142 in 2001,

then prices in 2001 are 142% of prices in 1983, so the inflationfrom 1983 to 2001 was 42%.


10/33

Calculating Inflation: Using the CPI

Assume my friend earned $39,000 five years ago,

and now earns $40,500

The CPI five years ago was 100, and now it is 105Is my friend better off today?

Real income=$40,500______105

X 100 = $38,571.43


11/33


12/33

Inflation Rates of Selected

Countries 2003United States 1.6%Mexico 6.4%

United Kingdom 2.1%Zimbabwe 134.5%

Russia 15%

China 1.2%


13/33

China and Inflation

Economic instability, 1930s-1940s

Hyperinflation in China during this period

Wholesale prices in Shanghai increased 7.5million times in 3 years

Thus stopping inflation became one of the

governments major goals in the early 50s


14/33

China and Inflation

Between 1952 and 1978 consumer prices rose

only 0.6% a year on average

During the reform period, inflation returned

Consumer prices rose 7.5% in 1980

Consumer prices rose 11.9% in 1985


15/33

China and Inflation

This inflation has been widely attributed to:

1. A shortage in consumer goods (previous

years had concentrated on manufacture ofproducer goods) resulting in excess demand


16/33

China and Inflation

This inflation has been widely attributed to:

2. A change in the real value of goods:

-Real cost of producing agricultural outputsrose with increased use of modern inputs

-Introduction of new products, TVs,Refrigerators, etc.


17/33

Chinas CPI

Inflation rose to over 5% in 2004

Until recently the Peoples Bank of China has

had a relaxed monetary policyEnergy and raw material shortages also

pushed prices up


18/33

Chinas CPI

In 2005, inflation fell to 1.9%

This means consumer prices in 2005 only rose

1.9% over the previous yearThis is an incredibly low number


19/33

Inflation and Real Wages

People think that inflation causes prices to goup, which in turn makes things moreexpensive to buy

BUT

Wages are also affected by inflation, and do infact rise as well as a result of inflation


20/33


21/33

Inflation and Relative Prices

The Importance of Relative Prices: Inflation is

not usually to blame when some goods

become more expensive relative to others.


22/33

The Costs of Inflation

A redistribution of income and wealthamong groups

Distortion of price signals and tax dollars

Menu costs


23/33


24/33

Inflation and Redistribution of

Income Imagine you lend out $100,000 in 1996, and

are to receive $110,000 in 2000

The nominal interest rate is 10% If inflation over the period is 10%

The real interest rate is 0%

The real value of what you get back is still$100,000 in 1996 dollars


25/33

Inflation and Redistribution of

IncomeThose who borrow money are likely

to be aided by inflation. Imagine you borrow $100,000 to purchase a house, and

your annual fixed-interest-rate mortgage payments are$10,000.

But if inflation suddenly doubles all prices and wages,your nominalmortgage payment is still $10,000 per year,

but its realcost is halved.


26/33

Distortion of price signals

In a low inflation economy, prices signal

availability (supply) and demand for a product

If prices for one product rise sharply, peoplestop buying it or substitute away

If prices drop sharply, more people start

buying the product


27/33

Distortions of price signals

In a high inflation economy its harder to

distinguish changes in relative prices and

changes in overall price levels

Inefficiencies arise when price signals are not

clear to producers and consumers


28/33


29/33

Distortions of tax dollars

If I have made an investment that has gotten areturn of 5%, I must pay taxes on the money Ihave earned off this investment.

But if inflation over the period has been 10%,the realvalue of my investment has decreased

But I still must pay taxes!


30/33

Inflation and Menu Costs

When prices are changed, firms must spend

real resources adjusting their prices

Taxi companiesMail order firms

Restaurants

more


31/33


32/33

Real Versus Nominal Interest Rates

But what about anticipated inflation?

If a money lender wants to make a 3% profit on money lent. If he

anticipates that during the course of the loan, prices will increase by6%, it might make sense to charge an interest rate of 9%

3% as the increase in purchasing power and

6% as compensation for expected inflation


33/33

Real Versus Nominal Interest Rates

But what about anticipated

inflation? The total interest rate of 9% is viewed as nominalinterest.

But a realinterest rate is reflected at 3% interest rate (9%

- 6% inflation)

Date post:	06-Apr-2018
Category:	Documents
Upload:	dr-singh
View:	215 times
Download:	0 times

The Goals of Macro Economic Policy Part 3

Documents