Unit 7 - Inflation

1. Unit 7 - Inflation • Inflation Measures Common inflation measures are: • Consumer Price Index • Producer Price Index • GDP deflator Macroeconomics

2. Unit 7 - Inflation • The Consumer Price Index (CPI) • is the most common inflation measure. • measures consumer goods only. • is a weighted index (an increase in the price of eggs is more important than an increase in the price of black-and-white televisions). Macroeconomics

3. Unit 7 - Inflation • The Producer Price Index (PPI) • measures business goods only. • is a weighted index. Macroeconomics

4. Unit 7 - Inflation • The GDP Deflator • measures price increases of all goods and services based on real and nominal GDP calculations • Equals nominal GDP divided by real GDP. Example: nominal GDP=$120, and real GDP=$100. GDP deflator = $120/$100=1.2. Macroeconomics

5. Unit 7 - Inflation • United States CPI-U History for selected years (average percentage change) Source: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt Macroeconomics

6. For a United States consumer, $100 in 1990 bought the same as _____ in 2010. • $93 • $100 • $142 • $166 • $196 • $223 :10

7. Unit 7 - Inflation • For an inflation calculator, visit: http://www.bls.gov/data/inflation_calculator.htm Macroeconomics

8. What causes steady price increases in the long run: • Too much demand • Too little demand • Too much government spending • Steady increases in the money supply • Trade deficits :10 0 of 5

9. Unit 7 - Inflation • The Cause of Inflation In the long run, a steady increase in the nation’s money supply is the only cause of constantly rising prices. Macroeconomics

10. Unit 7 - Inflation • The Cause of Inflation Let’s look at a very simplified economy with only two products to understand the cause of price changes. Macroeconomics

11. Unit 7 - Inflation Assume, for simplicity, that in year 1, an economy produces only 2 products: oranges and hammers. Macroeconomics

12. Unit 7 - Inflation Assume that there are 10 orange producers. Each producer makes 2 oranges, so total production of oranges is 20. Macroeconomics

13. Unit 7 - Inflation Assume that there are 5 hammer producers. Each producer makes 1 hammer, so total production of hammers is 5. Macroeconomics

14. Unit 7 - Inflation Assume that the country’s money supply is $100. Macroeconomics

15. Unit 7 - Inflation Assume that the price of an orange is the same as the price of a hammer and that consumers spend their entire income (no savings) on oranges and hammers. Then what is the average equilibrium price per product? Macroeconomics

16. Unit 7 - Inflation Answer: Money supply is $100.Total production is 25 (20 oranges and 5 hammers). The equilibrium price is $100 / 25, or $4. If the price is less than $4, there is a surplus of money. If the price is more than $4, there is a surplus of products. Macroeconomics

17. Unit 7 - Inflation Assume that in year 2, the money supply increases to $200.Now what is the equilibrium price per product? Macroeconomics

18. Unit 7 - Inflation Year 2 money supply is $200.Total production is 25.Equilibrium price is $200 / 25, or $ 8. If the price is less than $8, there is a surplus of money. If the price is more than $8, there is a surplus of products. Macroeconomics

19. Unit 7 - Inflation Without an increase in production, an increase in the money supply causes average prices to increase. Macroeconomics

20. Unit 7 - Inflation What does it take for production to increase? Is it necessary to increase the money supply in order to experience economic growth and make incomes increase? Macroeconomics

21. Unit 7 - Inflation Let’s assume a constant money supply. Will technological progress occur? What will happen to profits and average incomes? Macroeconomics

22. Unit 7 - Inflation Consider the orange and hammer example.One orange and one hammer producer improve their technology and double their production. Macroeconomics

23. Unit 7 - Inflation What is total production now? What is the average equilibrium price of an orange and a hammer? Macroeconomics

24. Unit 7 - Inflation Total production is 28 products:22 oranges (9 times 2, plus 4) + 6 (4 times 1, plus 2) hammers. Average price per product = $100/28 = $3.57. Macroeconomics

25. Unit 7 - Inflation Revenue of the orange producer that doubled its production is 4 times $3.57, or $14.28 (compared to $ 8 in year 1). Revenue of the hammer producer that doubled its production is 2 times $3.57, or $7.15 (compared to $ 4 in year 1). Macroeconomics

26. Unit 7 - Inflation Both innovative producers are better off. Innovation pays. Macroeconomics

27. Unit 7 - Inflation But what happens if the technology is shared and all producers adopt the improved technology? What is total production and what will be the average equilibrium price? Macroeconomics

28. Unit 7 - Inflation Total orange production is 40 (10 times 4). Total hammer production is 10 (5 times 2). Equilibrium price per product is $2 ($100 divided by 50). What is the revenue per producer? Macroeconomics

29. Unit 7 - Inflation Revenue per orange producer = $8 (4 times $2). Revenue per hammer maker = $4 (2 times $2). This is the same revenue as in year 1, before the technology improvements. Is anyone better off? Does innovation really pay in a constant money supply economy? Macroeconomics

30. Unit 7 - Inflation How many oranges does $8 buy in year 1? How many hammers does $8 buy in year 1? How many oranges does $8 buy after the technology improvements? How many oranges does $8 buy after the technology improvements? Lower prices means greater purchasing power and increased real incomes. Macroeconomics

31. Unit 7 - Inflation • Falling Prices Are falling pricesharmful to the economy? Macroeconomics

32. Unit 7 - Inflation • Falling Prices Why are some peopleconcerned about falling prices? Large pizza: $2.50 Macroeconomics

33. Unit 7 - Inflation S Average Price Level $30 $20 D1 D2 Quantity Demanded/Quantity Supplied 496 578

34. Unit 7 - Inflation • Falling Prices Falling prices due to a decrease in demandis harmful. Jacket: $20 Macroeconomics

35. Unit 7 - Inflation S1 Average Price Level S2 $35 $25 D Quantity Demanded/Quantity Supplied 296 379

36. Unit 7 - Inflation • Falling Prices Falling prices due to an increase in supplyis beneficial. Ipod: $25 Macroeconomics

37. Unit 7 - Inflation Understanding economics: priceless Macroeconomics

38. Unit 7 - Inflation • Harmful Consequences of Inflation Inflation leads to: • Increases in long-term interest rates • Decreases in exports • Decreases in savings • Mal-investments (people buy houses instead of investing in new businesses) • Higher taxes (COLAS increase nominal, not real income) • Inefficient government spending (government is not accountable for printed money) Macroeconomics

39. Unit 7 - Inflation • Short-run versus Long-run Consequences of Inflation In the short run, an increase in the money supply decreases interest rates and stimulates spending. In the long run, an increase in the money supply increases prices, increases long-term interest rates, and slows down the economy. Macroeconomics

40. Unit 7 - Inflation • A Constant Money Supply System In a constant money supply system: • The quantity of money in circulation is constant or nearly constant. • Average prices decrease with increases in production. • Purchasing power, profits, wealth and incomes increase. Macroeconomics

41. Unit 7 - Inflation • The Gold Standard The Gold Standard is an example of a system with an constant (or nearly constant) money supply. In a gold standard, the supply of money is only allowed to grow as much as the supply of gold grows each year. Historically this has been between 1 and 2 % per year. Macroeconomics

42. Unit 7 - Inflation • The Gold Standard An appropriately applied gold standard forces the Federal Reserve System to keep the money supply limited to the growth of the gold supply. In a growing economy and an appropriately applied gold standard, prices will fall. The Gold Standard failed in the 1960s, because the Fed was not disciplined enough to limit the money supply. Macroeconomics

43. Unit 7 - Inflation • The Gold Standard If the Fed is disciplined to keep the money supply constant without a gold standard, then we would not need a gold standard. This is actually preferable, because the supply of gold in some years fluctuates more than 1-2%. Macroeconomics