Chapter 5

Inflation and the Price Level

 Which Bond Movie is more
profitable?
• 1981 • 2002

• USD 202 Million • USD 456 Million

Compare It based on the
living cost
• If you bought corn flake in 1981,
the price is $ 1.12. But If you
bought corn flake in 2002, the
price is $ 3.00
• You have $ 3000 income during
1981, and can buy around 3000
boxes of corn flakes, but your
$6000 in 2002 only can buy
around 2000 boxes of corn flakes
in 2002
 So, Which Bond Movie is more
profitable?
• Yes! The “For Your Eyes Only” is more
profitable than “Die Another Day”!

• How you know it? Based on the Living Cost!

• Why the living cost is different in one year to

other years? Because the Inflation!

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 What is Inflation?

• It is a rise of the general price level of goods

and services in a certain period of time
• If the price is increasing, you just can buy
fewer goods
• In other words, inflation shows the erosions
of Purchasing Power of Money
 How To Measure Inflation?
• The Basic tools to measure the price level and
inflation is the consumer price index (CPI)
• CPI is a measure of the cost of living during
particular period
• The Increase of CPI is called as inflation

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 How to Measure CPI?
Cost of Base  year basket of goods and services in current year
CPI 
Cost of Base  year basket of goods and services in base year
Cost of Living CPI = 1050 / 850 = 1.31
2000 Spending Monthly Cost in 2000
Rent (2 bedroom apartment) $500
Hamburgers (60 at $2 each) 120
Movie tickets (10 at $6 each) 60
Sweaters (4 at $30) 120
Monthly expenditures $800
2005 Spending Monthly Cost in 2005
Rent (2 bedroom apartment) $630
Hamburgers (60 at $2.50 each) 150
Movie tickets (10 at $7 each) 70
Sweaters (4 at $50) 200
Monthly expenditures $1,050
 INTERMEZZO
• WHAT IS BASKET?
• In economy, basket means a group of goods
and services.
Is there any other way to measure
Inflation?
• Yes! There are many other ways to measure
inflation. The key is that inflation is measured
by price index
• Price Index is a measure of the average price
of a given class of goods or services relative to
the same goods and services in a base year.
• The measurement of price index is: CPI,
Producer Price Index, Commodity Price Index,
and Core Price Index.
 Inflation Adjustment
• CPI can be used to adjust economic data to
eliminate the effects of inflation.
• There are two ways to do inflation
adjustment: Deflating and Indexing
• Deflating is the process of adjusting the
nominal quantity to real quantity because of
inflation
• Indexing is the process of preventing the
purchasing power of nominal quantity from
being eroded by inflation
 Deflating Example
Real Wages
• Real wage is the purchasing power of
worker's nominal wages
– The real wage for any given period is
calculated by dividing the nominal wage by
the CPI for that period
• US production worker wages
– CPI uses 1982 – 1984 as base year
– Real wages were higher in 1970
Year Average Wage CPI Real Average Wage
1970 $3.40 0.388 $3.40 / 0.388 = $8.76
2004 $15.68 1.889 $15.68 / 1.889 = $8.30
 Indexing Example
Adjusting for Inflation
• An indexed labor contract
– First year wage is $12 per hour
• Real wages rise by 2% per year for next 2 years
– Relevant price index is 1.00 in first year, 1.05 in
the second, and 1.10 in the third
• Nominal wage is real wage times the price
index
Year Real Wage Price Index Nominal Wage
1 $12.00 1.00 $12.00
2 $12.24 1.05 $12.85
3 $12.48 1.10 $13.73
 Does CPI Measure “TRUE”
Inflation?
• Quality Adjustment Bias
– CPI only measures the changes of Price, not the quality. Even though
the corn flake of today is probably much better than the 1981 corn
flake, the CPI only captures the price.

• Substitution Bias
– Again, CPI does not measure the switching effect because of the price
changes of substitution goods
– In 1981, Corn Flake and Star Honey is the same. But suddenly there
was frost in US and made the Corn Price increasing in double. Then,
people changes to Star Honey and didn’t consume Corn Flake, a switch
that doesn’t make the standard of living worse. In other word, it
creates a bias in measuring the living cost.
 The Causes of Inflation
• Demand-pull inflation
– caused by increases in aggregate demand due to increased private and
government spending, etc. Demand inflation is constructive to a faster rate of
economic growth since the excess demand and favourable market conditions
will stimulate investment and expansion.

• Cost-push inflation / supply shock inflation

– caused by a drop in aggregate supply (potential output). This may be due to
natural disasters, or increased prices of inputs. For example, a sudden
decrease in the supply of oil, leading to increased oil prices, can cause cost-
push inflation. Producers for whom oil is a part of their costs could then pass
this on to consumers in the form of increased prices.

• Built-in inflation
– It involves workers trying to keep their wages up with prices (above
the rate of inflation), and firms passing these higher labor costs on to
their customers as higher prices, leading to a 'vicious circle'.
 Negative Effect of Inflation
• Cost-push inflation
– High inflation can prompt employees to demand rapid wage increases,
to keep up with consumer prices. Wage growth will be set as a
function of inflationary expectations, which will be higher when
inflation is high. This can cause a wage spiral. In a sense, inflation
begets further inflationary expectations, which beget further inflation.
• Hoarding
– People buy durable and/or non-perishable commodities and other
goods as stores of wealth, to avoid the losses expected from the
declining purchasing power of money, creating shortages of the
hoarded goods.
• Hyperinflation
– If inflation gets totally out of control (in the upward direction), it can
grossly interfere with the normal workings of the economy, hurting its
ability to supply goods. Hyperinflation can lead to the abandonment of
the use of the country's currency, leading to the inefficiencies of
barter.
 Negative Effect of Inflation
• Allocative efficiency
– A change in the supply or demand for a good will normally cause its
relative price to change, signaling to buyers and sellers that they
should re-allocate resources in response to the new market
conditions. But when prices are constantly changing due to inflation,
price changes due to genuine relative price signals are difficult to
distinguish from price changes due to general inflation, so agents are
slow to respond to them. The result is a loss of allocative efficiency.
• Shoe leather cost
– High inflation increases the opportunity cost of holding cash balances
and can induce people to hold a greater portion of their assets in
interest paying accounts. However, since cash is still needed in order
to carry out transactions this means that more "trips to the bank" are
necessary in order to make withdrawals, proverbially wearing out the
"shoe leather" with each trip.
• Menu costs
– With high inflation, firms must change their prices often in order to
keep up with economy-wide changes. But often changing prices is
itself a costly activity whether explicitly, as with the need to print new
menus, or implicitly.
 Positive Effect of Inflation

• Labor-market adjustments
– Inflation would lower the real wage if nominal wages are kept constant,
Economists argue that some inflation is good for the economy, as it would
allow labor markets to reach equilibrium faster.
• Room to maneuver
– The primary tools for controlling the money supply are the ability to set the
discount rate, the rate at which banks can borrow from the central bank, and
open market operations which are the central bank's interventions into the
bonds market with the aim of affecting the nominal interest rate. If an
economy finds itself in a recession with already low, or even zero, nominal
interest rates, then the bank cannot cut these rates further (since negative
nominal interest rates are impossible) in order to stimulate the economy - this
situation is known as a liquidity trap. A moderate level of inflation tends to
ensure that nominal interest rates stay sufficiently above zero so that if the
need arises the bank can cut the nominal interest rate.
 Positive Effect of Inflation

• Avoiding the Financial Market Inefficiency

• Mundell-Tobin effect
– Moderate inflation would induce savers to substitute lending for some
money holding as a means to finance future spending. That
substitution would cause market clearing real interest rates to fall. The
lower real rate of interest would induce more borrowing to finance
investment. In a similar vein, noted that such inflation would cause
businesses to substitute investment in physical capital (plant,
equipment, and inventories) for money balances in their asset
portfolios. That substitution would mean choosing the making of
investments with lower rates of real return. (The rates of return are
lower because the investments with higher rates of return were
already being made before). The two related effects are known as the
Mundell-Tobin Effect.
 Controlling Inflation
There many ways to control the inflation. There
are:
• Monetary Policy
• Fiscal Policy
 Monetary Policy
• Government uses monetary approach to stabilize the
economy by controlling the inflation.
• How? By using monetary tools, which are usually
related to interest rate or money supply
Monetary Policy: Target Market Variable: Long Term Objective:

Inflation Targeting Interest rate on overnight debt A given rate of change in the CPI

Price Level Targeting Interest rate on overnight debt A specific CPI number

Monetary Aggregates The growth in money supply A given rate of change in the CPI

Fixed Exchange Rate The spot price of the currency The spot price of the currency

Low inflation as measured by the

Gold Standard The spot price of gold
gold price

Mixed Policy Usually interest rates Usually unemployment + CPI change

 Fiscal Policy
• Government uses the Government
Expenditure or Revenue to influence the
economy
• The methods are:
– Tax
– Seigniorage (Printing Money)
– Borrowing Money
– National Reserve Consumption
– Selling of Assets (Land for example)