How does the interest rate effect explain the slope of the aggregate demand (AD) curve?? 2. How does the wealth effect explain the slope of the

Chapter 8 The Price Level and Inflation

Review: • Unemployment rate

• Percentage of the labor force that would like to work who are unemployed

• Labor for participation rate • Percent of overall population in the labor force • Additional labor market indicator

• Gross domestic product • To get real GDP, we adjust nominal GDP for

inflation.

Question and Definition

1. What is inflation? Inflation: The growth in the overall level of prices in an economy.

2. How is inflation measured? 3. What problems does inflation bring? 4. What is the cause of inflation?

How inflation affect our life?

• If inflation rate is 100% each year, will you change your shopping and saving habits?

• What if prices double each day? • Zimbabwe

Inflation

• Inflation: The growth in the overall level of prices in an economy. • A continual rise in the general price level (the price of all goods) • not the price of a certain good going up due to a shift in demand or

supply for that good • By itself, will decrease the purchasing power of your dollars • Creates uncertainty, a problem for firms and workers • May cause consumers to change buying patterns due to

uncertainty

• Hyperinflation: An extremely high rate of inflation. • Deflation: Occurs when overall prices fall.

• It is the opposite of inflation. The price level falls or there is a negative percentage change in the price level

Bureau of Labor

Statistics

Bureau of Labor Statistics (BLS): Measures and reports inflation.

Its goals are: • Determine the prices of all the goods and services a

typical consumer buys. • Identify how much of a typical consumer’s budget is

spent on these particular items.

• Each month, the BLS collects price information • on over 8,000 goods and services each month • in 211 categories • for 38 geographic locations.

Question and Definition

1. What is CPI? Consumer Price Index (CPI): A measure of the price level based on the consumption pattern of a typical consumer.

2. How to calculate it? 3. The concerns that are caused by it?

Consumer Price Index

• Consumer Price Index (CPI): A measure of the price level based on the consumption pattern of a typical consumer.

• Goal: Measure the cost of living.

• Calculated by the Bureau of Labor Statistics (BLS).

• The weights are based on the spending patterns of a typical consumer in the United States.

Computing the CPI

• Calculating the price index:

• Using the price levels, we can find inflation with the percentage change formula:

𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 =   𝑏𝑎𝑠𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒

𝑏𝑎𝑠𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 × 100

𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 =   𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥1 − 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥0

𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥0

Computing the CPI

Computing the CPI Consider the previous figure. There are three goods, each given a price and quantity. • Cost in this case is the total amount of money expended on the item.

Given a base year of 2016, we purchased some goods and spent $40. • We purchased the same goods in 2017, and we spent a total of $44 for the same goods. • To create an index, we use our base year and give it an index of 100 as a figure to compare other years to. • To get the index for the other years, we divide the basket price in the new year divided by the basket price in

the base year.

When we multiply by 100 here this does not convert the number to a percentage; it simply indexes the price level. • Inflation is equal to 10%.

CPI and Inflation in the Long Run (1965–2018)

Price Movements

• Clearly, most prices rise over time (see the previous figure) • Travel • Education • Health care

• However, some prices fall over time • Consumer electronics • Usually due to a result of great

technological advancements • Tube TV 1997: $7,000

• Flat panel TV 2012: $500

Using the CPI to Compare Dollar

Values across Time

• Prices from different time periods can be misleading. • In 1924, you could buy a fully constructed

house for $1,969. • To compare prices over time, we can

transform past prices into a price in today’s dollars.

𝑃 𝑟𝑖𝑐𝑒 𝑇𝑜𝑑𝑎𝑦 = 𝑃 𝑟𝑖𝑐𝑒 𝐸𝑎𝑟𝑙𝑖𝑒𝑟 × 𝑃 𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙 𝑇𝑜𝑑𝑎𝑦

𝑃 𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙 𝐸𝑎𝑟𝑙𝑖𝑒𝑟

Costs of Inflation

1. Shoe-leather costs 2. Money illusion 3. Menu costs 4. Uncertainty over future price levels 5. Wealth redistribution 6. Price confusion 7. Tax distortions

Costs of Inflation

• As prices go up, it becomes more costly to hold money.

• Shoe-leather costs: Resources are wasted when people change behavior to avoid holding money.

• People bear time, effort, and fuel costs when they try to use more money.

Costs of Inflation

Money illusion: People interpret nominal wage or price changes as real changes.

If prices and wages all go up by 2%, there is no real change in purchasing power. People with money illusion think they are richer in this case.

Nominal wage: The wage in current dollars. Real wage: Nominal wage adjusted for inflation.

Another money illusion example: • Suppose nominal wages increase by 3% and prices go up by 5%. • Money illusion may cause you to think of yourself as wealthier, but

your real wages have actually decreased!

Costs of Inflation

• Menu costs: The costs of changing prices. • Wage and other input contracts often have

long-term commitments. • Example: Would you be willing to sign a contract

and be paid the same for the next five years? • Uncertainty about prices may make borrowing

riskier.

Costs of Inflation

• Wealth redistribution: Inflation can redistribute wealth between borrowers and lenders.

• Example: Suppose you borrow $50,000 and expect to pay back $60,000 in five years. • If unexpected inflation occurs, you are better off,

bank is worse off. • If the inflation was expected the bank would have

required more in return for the loan (i.e., you’d have to repay $75,000 in five years).

• If unexpected deflation occurs, you are worse off, bank is better off.

Costs of Inflation

• Prices act as signals for producers. • Higher prices signal producers to produce more, but

what if that is caused by inflation?

• If prices go up because of inflation but producers misinterpret this, their businesses can fail.

Price increase

No change in output All prices affected

Buy new resources Build factories Hire workers

Increase output

Increase in demand?

Inflation?

Costs of Inflation

Capital gains taxes are taxes on the gains realized by selling an asset for more than its purchase price.

Problem: often, the price rises due to inflation rather than an increase in the value of the good.

Example: If you buy a house in 1980 for $80,000 and sell the house in 2012 for $230,000:

• Capital gains = $150,000. • You have to pay taxes on this $150,000. • However, CPI rose from 80 to 230 in those years, so the

real value of the house is the same!

Costs of Inflation Summary

Cause of Inflation

• No debate on the cause of inflation.

• Inflation is caused by expansions in the nation’s money supply.

• Milton Friedman:“Inflation is always and everywhere a monetary phenomenon.”

Equation of Exchange

• Equation of exchange: Specifies the long-run relationship between the money supply, the price level, real GDP, and the velocity of money.

M: quantity of money V: velocity of money

P: price level Y: real GDP

𝑀 × 𝑉 = 𝑃 × 𝑌

Equation of Exchange

• In growth rates:

• If we assume that the velocity of money is constant: • %ΔP > 0 if %ΔM > %ΔY • %ΔP < 0 if %ΔY > %ΔM • %ΔP = 0 if %ΔM = %ΔY

• Conclusions: • Inflation (the percent change in the price level) is > 0 if the growth rate of the money

supply is greater than the growth rate of real GDP. • Inflation is < 0 if the growth rate of the money supply is less than the growth rate of real

GDP.

• Inflation is = 0 if the growth rate of the money supply is equal to the growth rate of real GDP.

%ΔM + %ΔV =%ΔP + %ΔY

Governments Inflate the

Money Supply

• Inflation can have significant costs but there are two reasons why governments inflate their money supply:

1. Large government debts often spur governments to choose to increase the money supply rapidly so they can pay off the debts.

2. Surprise increases in the money supply can temporarily stimulate an economy toward more rapid growth rates.

Conclusion

• CPI is the primary measure of the general price level • CPI uses prices from a basket of goods formed by the spending habits

of the typical consumer. • The inflation rate is the growth rate of the CPI, expressed in

percentage terms.

• CPI is also useful for equating monetary values (or prices) over time.

• There are several macroeconomic costs from inflation, including:

• signal extraction costs • future price level uncertainty • menu costs • money illusion

• Inflation is caused and controlled by expansions of a nation’s money supply.