Chapter 21 Macroeconomics- Inflation and Price Level

Macroeconomics Chapter 21: Inflation and Price Level Measuring Inflation • Inflation: overall growth in prices in an economy • Hyperinflation: extremely high rate of inflation • 100% inflation rate means prices double • Prices don’t all move together: some might fall and some might rise • Some prices affect consumers more than others • price level is an index of the average prices of goods and services throughout an economy • The Bureau of Labor Statistics’ goals are to: o (1) determine the prices of all the goods and services that a typical consumer buys o (2) identify how much of a typical consumer’s budget is spent on these particular items. o Steps to calculating CPI: 1-Come up with a basket of goods bought by a typical consumer. 2-Find out the prices of the different goods. 3-Calculate how much the basket costs in each period. 4-Convert the cost of a basket to an index number • Consumer Price Index: is the measure of the price level based on the consumption patterns of a typical consumer o The price of a typical set of goods and services purchased by a representative American consumer (includes groceries, medicine, housing, transportation, etc) o Gives realistic measure of cost of living o Reflects overall price changes for consumers on average o CPI= (basket price/basket price in base year) x 100 ▪ • Inflation rates If CPI today was 240, inflation rate since the base year would be 140% o Measuring inflation rates from Period 1 to Period 2 is calculated by: o This is a growth rate, computed just like growth rate of GDP (new-old/old x 100) o Inflation rate is also the difference in price indexes o The long-run average of US inflation is about 4% Uses of CPI • Equating Dollar Values o To convert an old price to how expensive it would be today’s dollars, use: • Indicating national economic conditions o Rapid fall in inflation signals a recession • Adjusting wages for inflation o If the CPI overstates inflation, the miscalculation can cost companies millions of dollars. Business owners worry loan rates are too high and about not being able to charge high enough prices o If the CPI understates inflation, this hurts workers, since their wages will not rise as much as they should. Lenders worry loan rates are too low. Overstating Inflation • The most common concern is that the CPI overstates true inflation. • There are three reasons for this concern: the substitution of different goods and services, changes in quality, and the availability of new goods, services, and locations. o Substitution: When the price of a good rises, consumers instinctively look to substitute less expensive alternatives. This changes the consumer product set (aka basket) ▪ when consumers substitute less expensive goods, that change alters the weights of all the goods and services in the typical consumption basket. Without acknowledging the substitution of less expensive items, the CPI would exaggerate the effects of the price increase o Changes in quality: product and service quality have improved over time but the technology is frequently more expensive ▪ The price might go up, but it might be because of the increased quality, not just inflation o New services, goods, and locations: new products, services, and ways to sell them alter what the average consumer basket looks like ▪ chained CPI: a measure of the CPI in which the typical consumer’s basket of goods and services is updated monthly • difficult to measure and takes longer to estimate, the chained CPI is a better indicator of inflation for the typical consumer. o The vertical distance between the two lines indicates the upward bias of the traditional CPI, which updates the basket of goods and services less often. Notice that the distance grows over time. Billion Prices Project • The Billion Prices Project (BPP) is an academic initiative at the Massachusetts Institute of Technology that monitors daily price fluctuations of approximately 5 million items sold by roughly 300 online retailers in more than 70 countries. o it only tracks the prices of goods and services that are sold online, and it does not weight those prices to reflect their importance in a typical consumer basket o coincides with the CPI Problems with Inflation • People think inflation hurts the purchasing power of income but it also raises it to compensate • Shoe-leather costs: the resources that are wasted when people change their behavior to avoid holding money o To avoid the “tax” on holding money, people hold less money, which means more trips to the bank to make withdrawals • Money Illusion: occurs when people interpret nominal changes in wages or prices as real changes. o although wages and prices might rise because of inflation, people frequently respond as if the prices are higher in real terms o If they treat a price increase from inflation as a change in relative price, they may go see fewer movies or make other decisions based on the new price. o Must distinguish between nominal and real wage ▪ nominal wage: a worker’s wage expressed in current dollars, like $60 per hour or $120,000 per year. ▪ real wage: the nominal wage adjusted for changes in the price level • Real wages are more informative because it describes earning in terms of purchasing power • Menu costs: costs of changing prices o It is costly to reprint signs and menus to adjust for new prices o Discourages firms from quickly changing prices but that also magnifies macroeconomic disturbances • Future price level uncertainty: to increase future success, firms must invest today, and the funds required to do so are frequently borrowed o Prepare to produce > produce > sell ▪ Starting this process generally requires 2 promises for future spending: workers and lenders (wages and loans) o Inflation impacts the value of the future dollars, making long-term agreements risky and less appealing o When firms cannot borrow money or hire long-term workers, future production is limited, meaning lower economic output and then lower GDP • Wealth Redistribution: changes the distribution of wealth between borrowers and lenders if loans do not account for future inflation o Surprise inflation is rare but costly o nations with higher inflation rates also have a higher variability of inflation • Price confusion: If firms cannot determine which price changes are due to inflation, resources may be misdirected o Rising prices signal firms to increase output but could just be inflation • Tax distortions: tax laws normally don’t account for inflation o Capital gains taxes: taxes on the gains from selling an asset for more than its purchase price. ▪ Arise with sales of homes, stocks, bonds, and other financial securities ▪ Inflation combined with capital gains taxes makes people less likely to make these purchases • Inflation cost summary: Inflation Causes • inflation is consistently caused by increases in a nation’s money supply relative to the quantity of real goods and services in the economy. • when the supply of money in an economy grows relative to the quantity of goods and services, then it takes more money to buy any particular good or service. Money then becomes less valuable relative to goods and services • Governments often increase the money supply too quickly when they are in debt or when they desire a short-run stimulus for the economy. Exchange • Equation of exchange: summarizes the long-run relationship between price-level and quantity of money o MV=PY o M is quantity of money in the economy, V is the velocity of money, P is the price level, and Y is the real GDP o velocity of money: the number of times a unit of money exchanges hands in a given year o %ΔM+%ΔV=%ΔP+%ΔY Reasons for Inflating Money Supply • large government debts often spur governments to choose to increase the money supply rapidly • surprise increases in the money supply can temporarily stimulate an economy towards more rapid growth rates Bonus Notes: • CPI and GDP deflator are both price indexes but CPI deals with a smaller basket of good and only with selling to consumers • Government debt can be paid off by printing money, a sluggish economy can be jumpstarted by a surprise increase in money supply • Money supply grows, inflation rate increases