Chapter 8 Notes: Price Level and Inflation
Chapter 8 Notes: Price Level and Inflation 2105
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Macroeconomics 2105 Fall 2015 Chapter 8 Price Level and In ation 1 High in ation can cause the destruction of wealth across an entire economy a Unpredictable in ation can wreak havoc 2 How Is In ation Measured a In ation growth in the overall level of prices in an economy b When overall prices rise affects how much you can buy with your income i When they fall income goes farther and we can buy more goods c Hyperin ation an extremely high rate of in ation completely stymies economic activity d De ation negative in ation occurs when overall prices fall e Dif culties with measuring in ation i Prices don t always move together some prices fall even when most others rise ii Some prices affect consumers more than others 1 EX 10 increase in the cost of housing more signi cant than a 10 increase in cost of hot dogs f Bureau of Labor Statistics BLS s goal i Determine the prices of all goods and services that a typical consumer buys ii Identify how much of a typical consumer s budget is spent on these particular items g Consumer Price Index CPI the measure of the price level based on the consumption patterns of a typical consumer i Most common price level used to compute in ation ii Essentially the price of a typical basket of goods purchased by a representative consumer in the US 1 What s in the basket a Groceries clothing transportation housing medical care education etc iii Computing CPI h Measuring In ation Rates i i CPI used to measure in ation rates i Using CPI to Equate Dollar Values over Time i To compare the prices of goods over time ii Pieces of CPI Largest to smallest Housing transportation food and beverages medical care education and communication recreation apparel other j The Accuracy of the CPI i Rapid fall in in ation signals recession ii Why does it have to be accurate 1 Because when employers adjust wages for in ation they generally use CPI a When CPI rises wages rise b When CPI falls wages fall c If CPI overstates in ation costs companies millions d If CPI understates in ation hurts workers since wages aren t rising as much as they should iii Most common concern CPI overstates true in ation l 3 reasons a Substitution of different goods and services b Changes in quality c Availability of new goods services and locations 2 Substitution a Consumers want to substitute for less expensive alternatives i Causes the basket to change often ii Alters the weights of all the goods in the basket 3 Changes in Quality a Quality of goods generally increases i Causes prices to rise 4 New products and locations a Upward bias i Prices of new products typically drop in the rst few years after their introduction 1 If not included price drop lost ii New retail outlets such as Internet stores typically offer lower prices than traditional retail stores do 1 If continuously checked at traditional retail stores would overstate the price that consumers actually pay b Chained CPI a measure of the CPI in which the typical consumer s basket of goods is updated monthly i Better indicator of in ation for typical consumer k The Billion Prices Project i MIT ii Only tracks the prices of goods that are sold online and does not weight those prices to re ect their importance in a typical consumer basket 3 What Problems Does In ation Bring a Most believe in ation is most harmful because it reduces the purchasing power of their income b Shoeleather Costs i The resources that are wasted when people change their behavior to avoid holding money ii iii iv To avoid the tax on holding money people hold less money which means more trips to the bank to make withdrawals 1 Ex Fuel costs time and effort expended during multiple trips to a bankATM The higher the rate of in ation the more likely people are to change their normal patterns of spending and moneyholding 1 In ation essentially a tax on holding money As the prices of goods and services rise with in ation the value of dollars in people s wallets falls c Money Illusion 1 ii iii iv Occurs when people interpret nominal changes in wages or prices as real changes Ex If the price of a movie goes up by 10 but our wages and all other prices go up by a similar amount nothing has changed in real terms but many people mistakenly conclude that movies have become more expensive which leads them to watch fewer movies Nominal wage a worker s wage expressed in current dollars Real wage the nominal wage adjusted for changes in the price level 1 More informative because it describes what the worker earns in terms of purchasing power d Menu Costs i ii The costs of changing prices physically 1 Ex Printing new menus when prices change gas prices a Can cause regular customers to take their business elsewhere Discourages rms from adjusting prices quickly e Uncertainty about Future Price Levels i ii Before businesses can make a pro t they must spend funds on resources 1 In order to increase GDP in the future rms must invest today 2 Funds typically borrowed from others Output the production that a rrn creates 1 Firms sell their output 2 In a normal production process funds must be spent today and then repaid in the future after the output sells a For this to occur businesses must make promises to deliver payments in the future includes payments to workers and lenders i 2 types of longterm agreements form foundation for production 1 Wage 2 Loan contracts ii In ation affects real value of these future dollars 1 People less likely to enter into longterm agreements because they re risky now 2 Can cripple loan markets because people don t know what future price levels will be a When firms cannot borrow money or hire longterm workers future production is limited 3 Can lead to lower economic output GDP gtgt 1 1 1 1 Today T Future periods Ime f Wealth Redistribution i In ation can redistribute wealth between borrowers and lenders 1 When in ation rises unexpectedly it will devalue future loan payments to the bank a Result You will be better off Banks worse off b Surprise in ation redistributes wealth from lenders gt borrowers 2 If in ation is expected banks will require more in return for the loan ii Nations with higher rates of in ation have higher variability of in ation which makes it dif cult to predict the future 1 High in ation increases the risk of making loans that are an important source of funding for business ventures g Price Confusion i Market prices signals to consumers and rms Helps to allocate resources 1 Ex If demand increases prices rise and rms have an incentive to increase the quantity of output that they supply 2 All else equal rms take risking prices as a signal to increase output and falling prices as signal to decrease output a Since in ation also shows up as rising prices if rms cannot determine which price changes are due to in ation resources may be misdirected in the economy b If rms always react to price changes by increasing their output they run the risk of overbuilding ii Ex Housing market 1 In 2005 the rising house prices re ected in ation 2 Did not re ect real longrun increases in demand 3 However high prices spurred builders to develop more properties h Tax Distortions i Tax laws do not typically account for in ation which causes a distortion 1 One area in which particularly distortionary effects occur is capital gains taxes ii Capital gains taxes taxes on the gains realized by selling an asset for more than its purchase price 1 Ex Buying a house in 1980 for 80K and then selling it in 2012 for 230K made a 150K capital gain on the sale of the house However if CPI rose by exactly the same amount between 1980 and 2012 the value of the house just kept pace with in ation so in real terms the value of the house did not climb a But still required to pay signi cant tax upon sale of the house b Amount of tax determined by in ation and not by tax laws if there had been no in ation there would be no tax to owe 2 Arise on home sales sales of stocks and bonds and other nancial securities 3 In ation combined with capital gains taX makes it less likely that people will make those kinds of purchases 4 Possible solution rewrite taX laws to take account of in ation s effects 4 What is the Cause of In ation a Consistently caused by increases in a nation s money supply relative to the quantity of real goods and services in the economy Milton Friedman b 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 i Money then becomes less valuable relative to goods and services ii This relationship constitutes in ation iii AMOUNT OF MONEY GROWS BUT NOT THEIR VALUE DECREASES IN VALUE SINCE THERE IS MORE MONEY WHICH MAKES IT LESS RARE SO VALUE IS LESS Real increase Inflation c Reasons Governments In ate the Money Supply i Large government debts l Often spurs them to increase money supply rapidly to pay off their debts ii Shortterm gains 1 Governments will increase the money supply to temporarily stimulate an economy toward more rapid growth rates L V