Chapter 20 inflation - Summary Macroeconomics PDF

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Chapter 20: Inflation Article I. Definition of Inflation It is defined as a continuous and considerable rise in prices in general. It erodes the purchasing power over time (a) It is a neutral definition 1) Casual definitions define something as a result of a particular cause. (b) It is a process 1) ...

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Chapter 20: Inflation Article I. Definition of Inflation It is defined as a continuous and considerable rise in prices in general. It erodes the purchasing power over time (a) It is a neutral definition 1)

Casual definitions define something as a result of a particular cause.

(b) It is a process 1)

It is a continuous increase in prices

(c) It is concerned with a considerable increase in prices 1)

Some small price rises result from increases in quality of goods in which case it would be wrong to ascribe them to inflation

(d) Increase in prices IN GENERAL 1)

There is only inflation when the prices of most goods and services are increasing.

(e) It increases as rand depreciates

Price level is the level of prices that has increased from one period to another. It is the movement from year to year. It is measured by prices indices such as CPI or GDP deflator. These Indices are a means of expressing a change in the price level.

Article II. The measurement of inflation Section II.1 The consumer price index (CPI) 1)

When we were calculating real GDP, we kept prices constant (base year) and measured change in quantity. For CPI, we keep quantities constant and measure the change in prices.

2)

It is an index which reflects the cost of a representative basket of consumer goods and services. The unadjusted CPI for all urban areas is referred to headline CPI

3)

Inflation is always expressed as an annual rate

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(b) Methods of calculating inflation (i) Month on the same month during previous year- most common practice 1)

CPI ( March 2015) −CPI (March2014 ) CPI (March 2014)

*100= inflation rate

2)

Inflation rates calculated according to this method are subject to considerable fluctuations

3)

Another problem: not all prices are measured every month

(ii) Annual average on annual average 1)

Avg CPI for 2013−avg CPI for 2012 Avg CPI for 2012

2)

This helps negate short-term fluctuations in the index figures Thus it is a better indication of the inflation process over a longer period of time

3)

It is not restricted to calendar year. Can be any 12-month period

(c) Constructing CPI 1)

Choice of items or components (creating the basket)

2)

Choice of base year

3)

Assignment of weights to components

a)

To determine the weight of good X in the price index we need to look at the proportion of income spent on good X

4)

Collection of data

5)

Calculation of index numbers

6)

Price index= (cost of basket in current period/cost of basket in base year)*100

a)

7)

a)

NB! Keep the base-year quantities constant; multiply it with current year prices= cost of basket in current period

Extensive survey is done every 5 years since it is very expensive to conduct. But it has to be done regularly since products change over time. The weight of a product depends on the amount of money spent on it. Sometimes, the quantity and the quality changes and the base year has to account for it.

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8)

When interest payments on mortgage bonds are removed from the calculation of CPI, we get the CPIX inflation rate

(d) Bias in the CPI numbers 1)

New goods bias (also known as substitution bias)

a)

Newer goods come at a higher price and increase the CPI. E.g. radio replaced with LCD TV, it causes the CPI to increase a lot since LCD is much more expensive

b)

ALSO (and more importantly): new products are not introduced into the index until they become commonplace, so the dramatic price decrease often associated with new technology products are not reflected in the index

c)

Exam answer: new product prices often decrease after their initial introduction, and since the CPI is adjusted infrequently it overestimates the cost to consumers.

2) a)

3) a)

4) a)

5)

Quality change bias CPI does not account for changes in quality. If the prices of goods increase due to quality only, then CPI does not show this increase in CPI as an increase in quality Commodity substitution bias If prices of goods increase then the consumer substitutes away from it and buys more of the relatively cheaper good. However, CPI keeps quantities constant and only accounts for price changes. Therefore, CPI is still calculated on the fact the people still buy a lot of the ‘relatively’ expensive good. Outlet bias The consumer shifts to new outlets (shops) such as wholesale clubs and online retailers is not well-represented by the CPI Difference between actual and advertised prices

Section II.2 The producer price index (PPI) 1)

Measures prices at the level of first significant commercial transaction

2)

It also includes capital and intermediate goods but excludes services (which accounts for half of CPI)

3)

Imported prices measured when entering the country. Domestic output measured when leaving factory.

4)

Weights calculated according to value of SA production (excluding exports) but including imports

5)

Most prices collected in a 3-month interval Page 3 of 16

6)

It measures cost of production rather than the cost of living (CPI)

7)

PPI quoted in the media is the headline PPI which is the one for final manufactured goods.

8)

PPI exclude VAT while CPI includes VAT

Section II.3 Implicit GDP deflator 1)

It is called implicit since it is a side-effect of the calculation of economic growth while the CPI and PPI bare explicit indices that are indices that are specifically designed to measure price increases.

2)

Implicit deflator= ((GDP at current prices)/(GDP at base-period prices) ) *100

a)

Note: GDP at current prices is the nominal GDP while GDP at base-period prices is the Real GDP

3)

Difference between real GDP over the years indicates the economic growth while difference between nominal and real GDP for a given year shows the effect of inflation

4)

GDP deflator is a broader index than CPI since GDP includes exports and excludes imports. However, GDE deflator is preferable due to changes in prices of imports and exports

5) CPI measures the aggregate price of output consumed and not produced 6)

GDP deflator series is easy to calculate from real and nominal GDP

7)

Volatile resource prices have a much bigger impact on GDP deflator than on the CPI

Section II.4 Correcting Variables for Inflation 1)

Inflation makes it harder to compare rand amounts from different times

2)

Amount in today’s rand=

(Amount in year T rand) x (price level today/price level in year T) i)

Side note: (price level=CPI)

Article III. The effects of inflation

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Section III.1Distribution effects 1)

The basic rule is that inflation benefits the debtors at the expense of the creditors

2)

To find the real value/purchasing power of a certain amount of money; you multiply it by the CPI of the old month, then divide it by the new month CPI

3)

The difference between the nominal interest rate and the inflation rate is called the real interest rate:

a)

If real interest rate is positive then redistribution of income (interest) falls away and only wealth is redistributed

b)

If real interest rate is negative then the lender is prejudiced in 2 ways:

i)

The real value of his wealth declines

ii)

And the interest income he receives is also not sufficient to compensate him for inflation

real inflation rate=

nominal interest rate−inflation rate inflation rate 1+ 100

(

)

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4)

Since younger people are more likely to be net borrowers while old people tend to have relatively fixed nominal incomes (e.g. pensions and interest income), inflation tends to redistribute income and wealth from the elderly to the young

5) There is also a significant redistribution from the private sector to the government a)

During inflation the government therefore gains at the expense of the holders of the public debt (e.g. holders of government stock)

b)

The increased government revenue from taxation through inflation is also called fiscal dividend.

i)

6) a)

Bracket creep: redistribution of income from taxpayers to the government even though they are no better off since their NOMINAL income increases however, their REAL income is still the same BUT tax rates are based on NOMINAL income.

Inflation tends to affect poor households more than those who are better off Since all the purchases made by poor households are necessities and cannot afford to adjust their spending

Section III.2Economic effects (a) Anticipating inflation rather than seeking out profitable new production opportunities 1)

People seek to place their money in other forms of assets by speculating which of these assets will likely maintain their real value during inflation such speculative activity often occurs in place of productive investment

(b) It produces balance of payments problems 1)

Inflation increases the cost of export and import-competing industries

2)

Leads to the loss of international competitiveness

a)

This can be compensated for in the short-run by depreciation of the rand against foreign currency but such depreciation feeds back into the inflation process by raising the cost of imported goods. And since most goods we import are capital/intermediate goods production costs increase

b)

This will only happen as long as the inflation rate of SA > inflation rate of trading partners

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Section III.3Social and political effects 1)

The increase in prices causes social and political unrest, especially among the poor. This climate of conflict is not conducive to economic progress

Section III.4Expected inflation 1)

An increase in inflation often leads to people to expect that it will increase further.

2)

If more money is produced and GDP is not increased to the same degree then it leads to inflation

3)

They therefore try to be compensated for the expected higher inflation rate. If they succeed, this results in raising the actual rate of inflation  this may eventually lead to hyperinflation

4)

Hyperinflation:

a) 5)

Monthly inflation in excess of 50% Most economies aim for range of inflation: SA=3-6%; USA=2%; UK=2%

(b) Falling prices: A consumer’s heaven ? Also known as Deflation 1)

a)

When prices are falling continuously, firms find it hard to survive since they produce goods and by the time they sell it, the prices are too low to recover their cost of production. This leads to unemployment and a smaller GDP growth rate

2)

Everyone who ‘wins’ during inflation, loses during deflation

3)

NB! Note the difference between deflation and disinflation (which is when the prices are increasing but at a decreasing rate)

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Article IV. The causes of inflation There are 3 approaches to diagnosing (or explaining) inflation

Section IV.1 Demand-pull and cost-push inflation (a) Demand-pull inflation 1)

This is when AD increases but AS remains constant

2)

Causes:

a)

Increased consumption spending because of a greater availability of consumer credit or the availability of cheaper credit as a result of a drop in interest rates

b)

Increased investment spending as a result of lower interest rates or improvement in business sentiment and profit expectations

c)

Increased government spending to combat unemployment or to provide more or better services to the population at large

d)

Increased export earnings because of an improvement in economic conditions in the rest of the world

3)

All these causes tend to accompanied by increases in the money stock

4)

At Yf the increases in AD will only lead to an increase in price levels and not in employment since we are at full-employment

5)

To combat demand pull inflation:

a)

Apply restrictive monetary and fiscal policies

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i)

Restrictive monetary policy entails raising interest rates and limiting the increase in money stock  raises cost of credit and reduces availability of credit to various sectors of the economy

ii)

Restrictive fiscal policies: reduction in government spending and or increased taxation

iii)

The problem with these measures is that they may have costly side effects on AS curve  raise in production costs

(b) Cost-push inflation (i) Sources of cost-push inflation 1)

Increase in wages and salaries

2)

Cost of imported capital and intermediate goods

a)

This results from either a depreciating currency or price increases in the rest of the world

3)

Increases in profit margins

4)

Decreased productivity

5)

Natural disasters

(ii) General 1)

Remember a left shift of the AS curve results in stagflation reduction in production and increase in price

(iii) Combat 1)

Increases in productivity

2)

Apply income policy

3)

Cannot use restrictive fiscal or monetary policies since that affects AD curve and could result in even more unemployment (but reduce the price level)

(c) Drawbacks of Demand pull and cost push inflation 1)

It ignores the possible linkages between AD and AS in the economy

2)

It can only explain changes in the price level and does not deal with the dynamic process of inflation

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Section IV.2 Structuralist approach to inflation 1)

It still retains the distinction between demand and supply inflation but says that inflation is the result of the interaction between the following 3 factors

a)

The underlying factors:

b)

The initiating factors

c)

The propagating factors

(a) Underlying Factors (a.k.a structural factors) 2)

Provide the background against which the process of inflation occurs

3)

Shows how vulnerable an economy is to inflation (e.g. racial conflict in country means higher interest rates)

4)

The structures of labour and goods market has to be examined

a)

E.g. if market has a high concentration and no competition more likely to lead to high inflation

b)

Bargaining power of trade unions and the indexation of wages

(b) Initiating factors 1)

They are the immediate causes of such increases in inflation. Can be classified into 3 broad categories: demand-pull factors; cost-push factors; “other” price or cost increases

2)

“Other” price increases are called

a)

If rate of VAT were to increase higher CPI  trigger further increases in the economy

(c) Propagating Factors 1)

These increases in prices have to be transmitted to the rest of the economy and over time to generate or sustain an inflation process. There can be 3 sets of propagating factors, namely: (i) Various interrelationships that exist between prices, wages and profits in the economy 2)

Price-wage, price-price, wage-price, wage-wage spirals

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3)

a)

Suppose that a trade union is successful in getting a higher wage for its workers without an increase in productivity  this increases cost of production and firms try to pass this cost to the consumers by increasing selling price Workers in other industries will experience an increase in cost of consumer goods and will therefore demand a higher wage for this AND also since workers in the first industry got a raise. This cycle continues and can generate a process of inflation.

(ii) Interaction between domestic prices, the balance of payments and the exchange rate 1)

If initiating factor (such as a sharp increase in wages) causes price increases in the domestic economy consumers start substituting and exports decrease while imports increase this leads to depreciation of local currency and domestic inflation since many capital goods are imported and used in production process  increased costs of production leads to increase in selling prices of goods.

(iii) Increase in the money stock 1)

Inflation can only occur in a money economy and not a barter economy.

2)

According to the monetarists equation;

a)

3)

MV =PY

An increase in P(i.e. inflation) can only be sustained if quantity of money (M) and/or velocity of money increase with no changes in Y. In terms of the structuralist approach to inflation, this means that expansions in the money stock tend to be part of the inflation process (endogenous) rather than directly under the control of the monetary authorities (exogenous)

The general policy implication of the structural approach is that inflation can be combated only through a broad, coordinated anti-inflation strategy that is aimed at all three sets of factors in the inflation process. An important determinant of the strategy will be the nature of the underlying factors which vary from country to country.

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Section IV.3 The conflict approach to inflation 1)

According to this approach, inflation is a symptom of a fundamental disharmony in society which results in a continuous imbalance between the rate of growth in the real national income and the rate of growth of the total effective claims on this income

2)

The problem arises when the different economic and social groups together claim more income than is produced. Moreover, each group has the economic or political bargaining power to raise its money income.

a)

3)

These interest groups has a certain degree of economic and/or political power which governs its effective claim on the national income. If there is no mechanism which ensures the balance between the claims on national income and the contributions to the national income then there is no mechanism which guarantees ex ante (Before the fact) equilibrium between total effective claim and contributions at the existing price level.

IN this case, there are...