Unit 7 - Inflation

Unit 7 - Inflation

Inflation MeasuresInflation MeasuresCommon inflation measures are:Common inflation measures are:Consumer Price IndexConsumer Price IndexProducer Price IndexProducer Price IndexGDP deflatorGDP deflator

MacroeconomicsMacroeconomics

Unit 7 - Inflation

The Consumer Price Index (CPI)The Consumer Price Index (CPI)

is the most common inflation measure.is the most common inflation measure. measures consumer goods only.measures consumer goods only. is a weighted index (an increase is a weighted index (an increase

in the price of eggs is in the price of eggs is more important than an more important than an increase in the price of increase in the price of black-and-white televisions).black-and-white televisions).


Unit 7 - Inflation The Producer Price Index (PPI)The Producer Price Index (PPI)

measures business goods only.measures business goods only.is a weighted index.is a weighted index.


Unit 7 - Inflation The GDP DeflatorThe GDP Deflator

measures price increases of measures price increases of allall goods and goods and services based on real and nominal GDP services based on real and nominal GDP calculationscalculations

Equals nominal GDP divided by real GDP.Equals nominal GDP divided by real GDP.

Example: nominal GDP=$120, and real Example: nominal GDP=$120, and real GDP=$100. GDP=$100. GDP deflator = $120/$100=1.2.GDP deflator = $120/$100=1.2.


Unit 7 - Inflation United States CPI-U History for selected years (average United States CPI-U History for selected years (average

percentage change)percentage change)


19141914 11 20002000 3.43.4

19181918 1818 20012001 2.82.8

19421942 10.910.9 20062006 3.23.2

19461946 8.38.3 20072007 2.82.8

19801980 13.513.5 20082008 3.83.8

19851985 3.63.6 20092009 -.4-.4

19901990 5.45.4 20102010 1.61.6Source:Source:ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txtftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

For a United States consumer, $100 in 1990 bought the same as _____ in 2010.

1.1. $93$93

2.2. $100$100

3.3. $142$142

4.4. $166$166

5.5. $196$196

6.6. $223$223

:10:10

Unit 7 - Inflation

For an inflation calculator, visit:For an inflation calculator, visit:

http://www.bls.gov/data/inflation_calculator.htmhttp://www.bls.gov/data/inflation_calculator.htm


What causes steady price increases in the long run:

1.1. Too much demandToo much demand2.2. Too little demandToo little demand3.3. Too much Too much

government government spendingspending

4.4. Steady increases in Steady increases in the money supplythe money supply

5.5. Trade deficitsTrade deficits

:10:100 of 50 of 5

Unit 7 - Inflation

●The Cause of InflationThe Cause of Inflation

In the long run, a steady increase in In the long run, a steady increase in the nation’s money supply is the only the nation’s money supply is the only cause of constantly rising prices.cause of constantly rising prices.


Unit 7 - Inflation

The Cause of InflationThe Cause of Inflation

Let’s look at a very simplified Let’s look at a very simplified economy with only two products to economy with only two products to understand the cause of price changes.understand the cause of price changes.


Unit 7 - Inflation

Assume, for simplicity, that in year 1, Assume, for simplicity, that in year 1, an economy produces only 2 products: an economy produces only 2 products:

oranges and hammers.oranges and hammers.


Unit 7 - Inflation

Assume that there are 10 orange Assume that there are 10 orange producers.producers.

Each producer makes 2 oranges, so Each producer makes 2 oranges, so total production of oranges is 20.total production of oranges is 20.


Unit 7 - Inflation

Assume that there are 5 hammer Assume that there are 5 hammer producers.producers.

Each producer makes 1 hammer, so Each producer makes 1 hammer, so total production of hammers is 5.total production of hammers is 5.


Unit 7 - Inflation

Assume that the country’s money Assume that the country’s money supply is $100.supply is $100.


Unit 7 - Inflation

AAssume that the price of an orange is the ssume that the price of an orange is the same as the price of a hammer and that same as the price of a hammer and that consumers spend their entire income (no consumers spend their entire income (no savings) on oranges and hammers.savings) on oranges and hammers.

Then what is the average equilibrium price Then what is the average equilibrium price per product?per product?


Unit 7 - Inflation

Answer:Answer:

Money supply is $100.Money supply is $100.Total production is 25 (20 oranges and 5 hammers). Total production is 25 (20 oranges and 5 hammers). The equilibrium price is $100 / 25, or $4.The equilibrium price is $100 / 25, or $4.

If the price is less than $4, there is a surplus of If the price is less than $4, there is a surplus of money.money.If the price is more than $4, there is a surplus of If the price is more than $4, there is a surplus of products.products.


Unit 7 - Inflation

Assume that in year 2, the money Assume that in year 2, the money supply increases to $200.supply increases to $200.

Now what is the equilibrium price per Now what is the equilibrium price per product?product?


Unit 7 - Inflation

Year 2 money supply is $200.Year 2 money supply is $200.Total production is 25.Total production is 25.Equilibrium price is $200 / 25, or $ 8.Equilibrium price is $200 / 25, or $ 8.

If the price is less than $8, there is a surplus If the price is less than $8, there is a surplus of money.of money.If the price is more than $8, there is a If the price is more than $8, there is a surplus of products.surplus of products.


Unit 7 - Inflation

Without an increase in production, Without an increase in production, an increase in the money supply an increase in the money supply causes average prices to increase.causes average prices to increase.


Unit 7 - Inflation

What does it take for production to What does it take for production to increase?increase?

Is it necessary to increase the money Is it necessary to increase the money supply in order to experience economic supply in order to experience economic growth and make incomes increase?growth and make incomes increase?


Unit 7 - Inflation

Let’s assume a constant money supply.Let’s assume a constant money supply.

Will technological progress occur?Will technological progress occur?

What will happen to profits and What will happen to profits and average incomes?average incomes?


Unit 7 - Inflation

Consider the orange and hammer Consider the orange and hammer example.example.One orange and one hammer producer One orange and one hammer producer improve their technology and double improve their technology and double their production. their production.


Unit 7 - Inflation

What is total production now?What is total production now?

What is the average equilibrium price What is the average equilibrium price of an orange and a hammer?of an orange and a hammer?


Unit 7 - InflationTotal production is 28 products:Total production is 28 products:22 oranges (9 times 2, plus 4) + 6 (4 22 oranges (9 times 2, plus 4) + 6 (4 times 1, plus 2) hammers.times 1, plus 2) hammers.

Average price per product = $100/28 = Average price per product = $100/28 = $3.57.$3.57.


Unit 7 - Inflation

Revenue of the orange producer that Revenue of the orange producer that doubled its production is 4 times $3.57, ordoubled its production is 4 times $3.57, or$14.28 (compared to $ 8 in year 1).$14.28 (compared to $ 8 in year 1).

Revenue of the hammer producer that Revenue of the hammer producer that doubled its production is 2 times $3.57, or doubled its production is 2 times $3.57, or $7.15 (compared to $ 4 in year 1).$7.15 (compared to $ 4 in year 1).


Unit 7 - Inflation

Both innovative producers are better Both innovative producers are better off.off.

Innovation pays.Innovation pays.


Unit 7 - Inflation

But what happens if the technology is But what happens if the technology is shared and all producers adopt the shared and all producers adopt the improved technology?improved technology?

What is total production and what will What is total production and what will be the average equilibrium price?be the average equilibrium price?


Unit 7 - InflationTotal orange production is 40 (10 times 4).Total orange production is 40 (10 times 4).Total hammer production is 10 (5 times 2).Total hammer production is 10 (5 times 2).

Equilibrium price per product is $2 ($100 Equilibrium price per product is $2 ($100 divided by 50).divided by 50).

What is the revenue per producer?What is the revenue per producer?


Unit 7 - Inflation

Revenue per orange producer = $8 (4 times Revenue per orange producer = $8 (4 times $2).$2).Revenue per hammer maker = $4 (2 times $2).Revenue per hammer maker = $4 (2 times $2).

This is the same revenue as in year 1, before This is the same revenue as in year 1, before the technology improvements. Is anyone the technology improvements. Is anyone better off? Does innovation really pay in a better off? Does innovation really pay in a constant money supply economy?constant money supply economy?


Unit 7 - Inflation

How many oranges does $8 buy in year 1?How many oranges does $8 buy in year 1?How many hammers does $8 buy in year 1?How many hammers does $8 buy in year 1?How many oranges does $8 buy after the How many oranges does $8 buy after the technology improvements?technology improvements?How many oranges does $8 buy after the How many oranges does $8 buy after the technology improvements?technology improvements?

Lower prices means greater purchasing power and Lower prices means greater purchasing power and increased increased realreal incomes. incomes.


Unit 7 - Inflation

Falling PricesFalling Prices

Are falling pricesAre falling pricesharmful to harmful to the economy?the economy?


Unit 7 - Inflation Falling PricesFalling Prices

Why are some peopleWhy are some peopleconcerned about concerned about falling prices?falling prices?


Large pizza: $2.50Large pizza: $2.50

Average Price Level

Quantity Demanded/Quantity Supplied

D1

S

$30

578

$20

496

D2

Unit 7 - Inflation


Falling prices due to Falling prices due to a decrease in demanda decrease in demandis harmful.is harmful.


Jacket: $20Jacket: $20

Average Price Level

Quantity Demanded/Quantity Supplied

S2

S1

296 379

D

$35

$25

Unit 7 - Inflation


Falling prices due to Falling prices due to an increase in supplyan increase in supplyis beneficial.is beneficial.


Ipod: $25Ipod: $25

Unit 7 - Inflation


Understanding economics: pricelessUnderstanding economics: priceless

Unit 7 - Inflation Harmful Consequences of InflationHarmful Consequences of Inflation

Inflation leads to: Inflation leads to: Increases in long-term interest ratesIncreases in long-term interest rates Decreases in exportsDecreases in exports Decreases in savingsDecreases in savings Mal-investments (people buy houses instead of investing in Mal-investments (people buy houses instead of investing in

new businesses)new businesses) Higher taxes (COLAS increase nominal, not real income)Higher taxes (COLAS increase nominal, not real income) Inefficient government spending (government is not Inefficient government spending (government is not

accountable for printed money)accountable for printed money)


Unit 7 - Inflation Short-run versus Long-run Consequences of Short-run versus Long-run Consequences of

InflationInflation

In the short run, an increase in the money supply In the short run, an increase in the money supply decreases interest rates and stimulates spending.decreases interest rates and stimulates spending.

In the long run, an increase in the money supply In the long run, an increase in the money supply increases prices, increases long-term interest rates, increases prices, increases long-term interest rates, and slows down the economy. and slows down the economy.


Unit 7 - Inflation A Constant Money Supply SystemA Constant Money Supply System

In a constant money supply system:In a constant money supply system: The quantity of money in circulation is The quantity of money in circulation is

constant or nearly constant.constant or nearly constant. Average prices decrease with increases in Average prices decrease with increases in

production.production. Purchasing power, profits, wealth and incomes Purchasing power, profits, wealth and incomes

increase.increase.


Unit 7 - Inflation The Gold Standard The Gold Standard

The Gold Standard is an example of a system with The Gold Standard is an example of a system with an constant (or nearly constant) money supply. an constant (or nearly constant) money supply.

In a gold standard, the supply of money is only In a gold standard, the supply of money is only allowed to grow as much as the supply of gold allowed to grow as much as the supply of gold grows each year. Historically this has been grows each year. Historically this has been between 1 and 2 % per year. between 1 and 2 % per year.


Unit 7 - Inflation

The Gold Standard The Gold Standard

An An appropriately appliedappropriately applied gold standard forces the gold standard forces the Federal Reserve System to keep the money supply limited Federal Reserve System to keep the money supply limited to the growth of the gold supply. to the growth of the gold supply.

In a growing economy and an appropriately applied gold In a growing economy and an appropriately applied gold standard, prices will fall.standard, prices will fall.

The Gold Standard failed in the 1960s, because the Fed The Gold Standard failed in the 1960s, because the Fed was not disciplined enough to limit the money supply.was not disciplined enough to limit the money supply.


Unit 7 - Inflation

The Gold Standard The Gold Standard

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


Unit 7 - Inflation

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