InflationChapter 14

Impact & Measurement

If you were to ask a worker what he wants from his job, what might you expect the answer to be?

More pay?

Does more pay mean more wealth?

What effect would rising prices of goods and services have on a person’s pay?

Inflation:a sustained rise in the average price level.

Note: Some prices may go down.

HyperinflationVery rapid inflationExample Zimbabwe.

2002 April Z$120 to US $12002 December Z$6200 to US $12005 Z$25000 to US $1

InflationWinners LosersPension fund

holder/former employer of retirees

BorrowersFinancial institutions

Persons on fixed income (pensions)

CreditorsSavers –inflation rate

is higher than interest rate.

Consumers

Everyone really loses.Loss of

Confidence in the economyConfidence in the governmentDesire to maintain work ethicRegard for thrift and saving

GDP Deflator Adjusts inflation to measure real growth in

the economy. Measures GDP against a base year.

Problem with GDP DeflatorMeasures changes in prices of all goods. Some prices rise, some fall. Example: Price of military hardware goes up,

price of basic necessities and other items remain stable, the GDP deflator will still rise.

You don’t want to raise the pay for military hardware builders because they were the cause of the inflation in the first place. That would further increase inflation.

Consumer Price IndexMeasures changes in the prices that affect a selected

market basket of goods and services. (400 goods & services)

Uses a base period from which to compare prices. See figure 14.1 page 286.

(Recent CPI – Earlier CPI/Earlier CPI) X 100 = Rate of inflation

Calculate from 1993 – 2007Figure out purchasing power: nominal earnings

divided by CPI for that year.How much has the purchasing power changed from

1993 to present?

IndexingTying present wages and prices to some adjustment figure to maintain a balance between real wages and real prices.

Limitations of the CPI

Assumes people buy the same “market basket” month after month.

Does not consider quality changes. (Improvements in tvs/ cell phones, computers)

Ignores the law of demand. (Demand drops as prices increase; CPI assumes consumers keep buying in same quantities.)

Causes & CuresOf Inflation

Inflation has a scary tendency to rise rapidly.

Start slowly but then accelerate.

Prices can double or triple on a daily basis.

Example: Germany’s Weimar Republic.

Two key variables determine prices.

What are they?DemandSupply

Supply & Demand CurvesSee graphs p. 288-289.

Two Possible Causes of Inflation1. Decrease in the nation’s supply of goods and services

2. Increase in the nation’s demand for goods and services

Cost-Push Inflation:

Business firms begin the inflationary process by charging higher prices (shifting total supply curve to the right).

Workers want increased wages to pay the higher prices.

Businesses raise prices to pay the higher wages.Workers want higher wages.Cost-Push Inflationary SpiralFails to explain the cause of sustained inflationMoney supply has to keep increasing for cost-push

to happen.

Demand-Pull Inflation:Inflation begins with an increase in demand.Consumers begin demanding more goods and

services.Shift rightward in demand curve (price increase).Prices lead to increased wages.Higher production costs due to higher wages

passed to consumers in the form of even higher prices.

Consumers demand higher wages, etc. Demand-Pull Inflationary Spiral

Money Growth: The Root Cause of InflationDoes it really matter what the cause

is? The continual increase in the money

supply keeps the price level going up.

Rising prices are really just a SYMPTOM of inflation, not actually inflation itself.

Inflation CAUSES a rise in prices.

Inflation is an increase in the supply of money, which is not driven by growth in production.

Cures for Inflation

How people try to cure inflation depends on their view of what causes it.

Wage-Price Controls (Cost-Push cause)

Make it illegal to raise prices and wages. (Freeze the total supply and total demand curves.)

Cannot work if government continues to increase the money supply.Demand for goods and services continue to increase, but

businesses have no ability to meet the demand.Result is losses of profit and/or development of a black

market, selling for higher prices.Price controls create an artificial shortage for a product.A free market would allow prices to rise in response to

demand and an increase in production to meet that demand.Economically dangerous – Put a lid on a boiling pot without

turning down the heat.

Limitation of Money CreationIf increases in money supply is the cause, then quantity of money being created should be decreased to lower/eliminate inflation.

Bolivian example:1985 inflation was 25000% per year. Prices

changed by the minute. In August 1985, the Bolivian president

announced that government would stop creating money. It stopped borrowing to pay its bills.

Within two months inflation was at 20% per year.

“Just when I thought I could make ends meet, someone moved the ends.”

Christians want to support policies to curb inflation, but make sure the policies don’t have UNINTENDED CONSEQUENCES.

Godliness with CONTENTMENT is great gain. I Timothy 6:6