INFLATION AND THE PRICE LEVEL

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INFLATION AND THE PRICE LEVEL. Chapter 5. Price Level. Price level (Consumer Price Index(CPI)) — A measure of the cost of a standard basket of goods and services relative to the cost of the same basket in a fixed year, called the base year for a period.

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INFLATION AND THE PRICE LEVEL

Chapter 5

Price Level
• Price level (Consumer Price Index(CPI)) — A measure of the cost of a standard basket of goods and services relative to the cost of the same basket in a fixed year, called the base year for a period.
• The CPI is a measure of cost of living in a particular period

Cost of base-year basket of goods and services in base year

Example: Cost (in 2011) Cost (in 2005)

Total Expenditure \$850 \$680

CPI in year 2011 = \$850/\$680 = 1.25

Inflation

Inflation—The inflation rate (π) is the percentage rate per period at which the price level is rising

π2010 = (P2010 – P2009 ) / P2009 X 100%

CPI VS INFLATION
• The CPI provides a measure of the average level of prices relative to prices in the base year.
• Inflation, on the other hand, is a measure of how fast the average price level is changing.
• The rate of inflation hence is the annual % rate of change in the price level (for eg. CPI).
Inflation

Inflation—a situation in which the prices of most goods and services are rising over time.

Hyperinflation

Hyperinflation – a situation in which the inflation rate is extremely high

Deflation

Deflation - a situation in which the prices of most goods and services are falling over time.

Quantities

Nominal quantity—aquantity that is measured in terms of current (today’s) dollars.

Real quantity - a quantity that is measured in physical terms (units)—for example, in terms of the quantity of goods or services.

Deflating a (nominal) quantity—the process of dividing a nominal quantity by the price level to express the quantity in real terms.

Examples

1. real M1 =M1/P

Real M1 is nominal M1 expressed in terms of purchasing power—the quantity of goods and services that a given amount of nominal M1 will buy.

2. real wage = nominal wage/P

Hence, the real wage is the nominal wage expressed in terms of purchasing power.—The quantity of goods and services a given nominal wage will purchase.

FACT

Since 1960 the nominal wage for production workers has increased from around \$2.00 per hour to around \$18.00 per hour.

Since 1960, the real wage has remained relatively constant.

Indexing—the practiceof increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index (inflation). Indexing prevents the purchasing power of the nominal quantity from decreasing over time.

Real rate of interest

= nominal rate of interest – expected

inflation

or

r = i - πe

r = real rate of interest

i = nominal rate of interest

πe =expected inflation

In the short run, increases in πe reduce r. This leaves lenders worse off and borrowers better off.

Why?

In the long run, increases in πe lead to increases in i. In fact, the increase in πe is a good predictor of future increases in i.

Long Run

1) Periods of high inflation, and expected inflation (πe), are associated with high i.

2) Periods of low inflation, and low expected inflation (πe), are associated with periods of low i.

Fisher Effect

Fisher Effect—a situation where an x% increase in πe leads to an x% increase in i so that r is unchanged.

Example

↑ πe = 3%

↑ i = 3%

Costs of inflation

1) Noise in the price system

2) Distortions of the tax system

3) Shoe-leather costs

4) Unexpected redistribution of wealth

5) Interference with long-term planning

Noise in the price system

When inflation is high, the signals transmitted by the price system become more difficult to interpret. (In the same way that noise, or static, makes it more difficult to understand voices on a radio.)

Noise in the price system
• People may be unsure if a price increase is due to inflation or due to supply and demand shifts. Because of this, they may make bad choices.
• Inflation: No change in relative prices.
• Shifts in supply and demand: change in relative prices.
Example

People lose track of the price of SUVs versus the price of trucks.

Distortions of the Tax System

Most parts of the tax system are not indexed. Because of this, when inflation increases nominal values, tax payments to the government increase.

The Michigan sales tax is an example of a non-indexed tax.

U.S. IncomeTax Brackets Are Indexed

Inflation tends to increase nominal incomes. That is, during inflationary times, people find their nominal incomes rising.

Also, in the U.S., people with higher incomes pay a larger percentage of their incomes in federal income taxes.

If tax brackets were not indexed, inflation would cause people to pay more and more of their incomes in the form of taxes.

Shoe-Leather Costs

Inflation increases the cost of holding currency. That is, inflation makes currency more expensive to hold. Because currency is more expensive to hold, people hold less currency and make more trips to get currency. The cost of these trips is known as shoe-leather costs.

Unequal Redistribution of Wealth

1. Inflation, especially unexpected inflation, redistributes income from individuals on fixed incomes to individuals on flexible incomes.

Unequal Redistribution of Wealth

2. Inflation redistributes income from lenders to borrowers. Inflation reduces the real rate of interest.

Interference with Long-Term Planning

Interference with long-term planning - Inflation makes planning, especially financial planning, more difficult.