Sunday, October 26, 2008

Low Inflation - Questions for Further Study

QUESTIONS FOR FURTHER STUDY

1. Chile experienced hyperinflation in 2005. What was the inflation rate? What caused Chile’s hyperinflation?

2. Go to the web site for the Bureau of Labor Statistics (www.bls.gov) to find historical U.S. inflation data. Is there a correlation between high inflation rates of inflation and U.S. involvement is wars? What explanation does economic theory provided for this correlation?

3. Stagflation is the economic condition of having relatively high unemployment and inflation at the same time.
(a) Since cyclical unemployment is caused by insufficient aggregate demand and demand-pull inflation is caused by excessive aggregate demand, how is it possible to have stagflation?
(b) What remedies might you suggest for stagflation?
(c) Which is the greater concern: high unemployment or high inflation?
(d) When has the U.S. economy experienced stagflation? What were its causes? How was it remedied?

Friday, October 24, 2008

Important Definitions Related to the Macroeconomic Policy Goal of Low Inflation

· Inflation is a general increase in the level of most prices in an economy.

· The price level represents the prices of most products in an economy. It is approximated by a price index, such as the Consumer Price Index (CPI), Producer Price Index (PPI), or the GDP deflator.

· The inflation rate is a measurement of how quickly prices are rising in an economy. It is typically reported as the annual percentage increase in the price level.

· Deflation is a general decrease in the price level.

· Disinflation occurs when the inflation rate decreases, but remains positive.

· Hyperinflation is extreme inflation in which the inflation rate exceeds 50% per month.

· Nominal data have not been adjusted for inflation.

· Real data have been adjusted for inflation. They are reported using prices from a common base year.

· The shoe leather costs of inflation are the wasted time and inconveniences caused when inflation encourages people to reduce their holdings of currency.

· The menu costs of inflation are the costs associated with changing the prices of the products sold by a business.

· Purchasing power is the value of the products a person is able to buy with a given amount of money.

· Indexation refers to using a law or contract to automatically correct a dollar amount for the effects of inflation.

· Cost-of-living adjustments (COLAs) automatically increase Social Security benefits to compensate for the loss in purchasing power caused by inflation as measured by the Consumer Price Index (CPI).

· Cost-push inflation is an increase in the price level caused by higher costs of production.

· Demand-pull inflation is an increase in the price level caused by excess demand for newly produced goods and services. Society’s demand for new products exceeds its ability to produce them.

· "Too much money chasing too few goods" is an expression that describes demand-pull inflation, which is an increase in the price level caused by excess demand for newly produced goods and services. Society’s demand for new products exceeds its ability to produce them.

· The quantity theory of money suggests there is a relationship between the supply of money and the inflation rate. If the money supply increases faster than an economy’s output, a likely outcome is inflation.

· A price index is an estimate of the price level that is used to measure inflation. Three commonly used price indices in the United States are the Consumer Price Index (CPI), the Producer Price Index (PPI), and the GDP deflator.

· A basket of goods is a collection of products used to calculate a price index.

· The base year is the year that is used as the comparison year when calculating an index.

· The Consumer Price Index (CPI) is a measure of the price level based on a fixed basket of the goods and services purchased by a typical urban family. It is used to calculate the inflation rate.

· The Producer Price Index (PPI) is a family of indices that measures the price level based on a fixed basket of all goods and services produced and sold by American businesses. It includes consumer products and goods and services used as inputs in the production of other products.

· The GDP deflator is a measure of the price level based on all goods and services produced in a country in a particular year. Unlike the CPI and PPI, the GDP deflator is not based on a fixed basket of goods.

Wednesday, October 22, 2008

The Most Important Concepts about the Macroeconomic Policy Goal of Low Inflation

· Inflation imposes costs on society that generally result in reduced economic growth and lower present and future standards of living.

· Keeping inflation low is the primary macroeconomic policy goal in the most developed economies of the world.

· Inflation can be very hard to eliminate because expectations of future price increases contribute to continued inflation.

· Inflation is most commonly measured in the U.S. using the consumer price index (CPI). The measurement of inflation using the consumer price index (CPI) exaggerates the actual level of price increases in an economy. Consequently, even when the prices of consumer products are relatively stable, the CPI suggests there is 1-2% inflation in the economy. Thus, the macroeconomic policy goal is low inflation, rather than no inflation.

Monday, October 20, 2008

U.S. Inflation Rates Since 1956

U.S. INFLATION RATES SINCE 1956

YEARCPI (1982-1984 = 100)Annual Inflation Rate
195627.21.5%
195728.13.3%
195828.92.8%
195929.10.7%
196029.61.7%
196129.91.0%
196230.21.0%
196330.61.3%
196431.01.3%
196531.51.6%
196632.42.9%
196733.43.1%
196834.84.2%
196936.75.5%
197038.85.7%
197140.54.4%
197241.83.2%
197344.46.2%
197449.311.0%
197553.89.1%
197656.95.8%
197760.66.5%
197865.27.6%
197972.611.3%
198082.413.5%
198190.910.3%
198296.56.2%
198399.63.2%
1984103.94.3%
1985107.63.6%
1986109.61.9%
1987113.63.6%
1988118.34.1%
1989124.04.8%
1990130.75.4%
1991136.24.2%
1992140.33.0%
1993144.53.0%
1994148.22.6%
1995152.42.8%
1996156.93.0%
1997160.52.3%
1998163.01.6%
1999166.62.2%
2000172.23.4%
2001177.12.8%
2002179.91.6%
2003184.02.3%
2004188.92.7%
2005195.33.4%
2006201.63.2%
2007207.3422.8%
2008215.3033.8%
2009214.537-0.4%
2010218.0561.6%
2011224.9393.2%


Table. Historical data for the Consumer Price Index (CPI)
and the Inflation Rate.
Source: U.S. Bureau of Labor Statistics
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

Thursday, October 16, 2008

Limitations of Using the Consumer Price Index (CPI) to Measure Inflation

Limitations of Using the Consumer Price Index (CPI) to Measure Inflation

1. Prices of different products rise at different rates. Consumers tend to shift their consumption away from the more expensive products and substitute cheaper products. Because the CPI uses a fixed basket of goods, it will assume people are still buying the same amount of the relatively expensive products. In reality, however, they are buying less of the expensive products. So their overall expenses are not as large as the CPI suggests.

2. Price indexes have difficulty measuring changes in quality. Consumers benefit from higher quality products. When inflation calculations use a fixed basket of goods, however, the implicit assumption is the quality does not change. A product could be more expensive because it has improved in quality. The CPI would attribute the price rise to inflation.

3. Price indexes have difficulty including new technology. Consumers benefit from new technology, but the fixed basket of goods used in the CPI will not include the newest products and technology. Thus, the CPI is an inaccurate measure of the true cost of living of a typical urban consumer.

The CPI is the primary index used to calculate the inflation rate in the United States. Because of its shortcomings, most economists think the CPI overestimates the inflation rate by 1-2%. This is why the macroeconomic policy goal is low inflation, not no inflation. When the inflation rate is reported around 1.5%, economists feel there in very little real inflation.

Wednesday, October 15, 2008

Estimating the Inflation Rate from the Consumer Price Index

Estimating the Inflation Rate from the Consumer Price Index

Use the following hypothetical data to calculate the inflation rate between various years.


Year
2010
2011
2012
2013
2014
2015
CPI
100
101
105
113
120
126



Earlier Year
Later Year
Inflation Rate
Earlier Year
Later Year
Inflation Rate
2010
2011
1%
2011
2015
24.75%
2010
2012
5%
2012
2013
7.62%
2010
2013
13%
2012
2014
14.29%
2010
2014
20%
2012
2015
20%
2010
2015
26%
2013
2014
6.19%
2011
2012
3.96%
2013
2015
11.50%
2011
2013
11.88%
2014
2015
5%
2011
2014
18.81%

Tuesday, October 14, 2008

Using a Price Index to Measure Inflation for a Simple Economy with Three Products

Using a Price Index to Measure Inflation for a Simple Economy with Three Products

Consider a simple economy, Breakfastland, which only produces three products: milk (measured in gallons), bread (measured in loaves), and breakfast cereal (measured in boxes). The following tables contain relevant data for this economy.

Product
Price in 2003
Quantity Produced in 2003
Value of Output in 2003
Milk
$3.00 per gallon
20 gallons
$60.00
Bread
$2.00 per loaf
15 loaves
$30.00
Cereal
$5.00 per box
10 boxes
$50.00
Total Value of all Output produced in 2003 (GDP)
(Valued using 2003 prices)
$140.00
Table 6. Hypothetical data for 2003 in an economy with three products.

Product
Price in 2004
Quantity Produced in 2004
Value of Output in 2004
Milk
$6.00 per gallon
30 gallons
$180.00
Bread
$3.00 per loaf
20 loaves
$60.00
Cereal
$5.50 per box
10 boxes
$55.00
Total Value of all Output produced in 2004 (GDP)
(Valued using 2004 prices)
$295.00
Table 7. Hypothetical data for 2004 in an economy with three products.

Product
Price in 2005
Quantity Produced in 2005
Value of Output in 2005
Milk
$6.60 per gallon
35 gallons
$231.00
Bread
$3.50 per loaf
25 loaves
$87.50
Cereal
$6.00 per box
15 boxes
$90.00
Total Value of all Output produced in 2005 (GDP)
(Valued using 2005 prices)
$408.50
Table 6. Hypothetical data for 2005 in an economy with three products.

There are five steps to follow when using a price index to measure inflation.

Step 1. Choose the base year and determine the basket of goods.

Step 2. Find the price of each good in each year.

Step 3. Compute the cost of the basket of goods in each year.

Step 4. Compute the price index for each year.


Step 5. Use the price index to calculate the inflation rate.



Step 1. Choose the base year and determine the basket of goods.
Let 2003 be the base year. Let the basket of goods be the output in 2003. Thus, the basket of goods contains 20 gallons of milk, 15 loaves of bread, and 10 boxes of cereal. (Note: The basket of goods does not have to be the output in the base year.)

Step 2. Find the price of each good in each year. The prices of milk, bread, and cereal in 2003, 2004, and 2005 are given in the second column of the three tables above.

Step 3. Compute the cost of the basket of goods in each year.

The basket of goods valued at 2003 prices =
(20 gallons of milk)($3 per gallon) +
(15 loaves of bread)($2 per loaf) +
(10 boxes of cereal)($5 per box) = $140.000

The basket of goods valued at 2004 prices =
(20 gallons of milk)($6 per gallon) +
(15 loaves of bread)($3 per loaf) +
(10 boxes of cereal)($5.50 per box) = $220.00

The basket of goods valued at 2005 prices =
(20 gallons of milk)($6.60 per gallon) +
(15 loaves of bread)($3.50 per loaf) +
(10 boxes of cereal)($6.00 per box) = $244.50

Step 4. Compute the price index for each year.


Assume 2003 is the base year.




Thus, the price index for 2003 is 100. The value of an index in the base year is always 100.




Thus, the price index for 2004 is 157.




Thus, the price index for 2005 is 175.



Step 5. Use the price index to calculate the inflation rate.




Calculate the inflation rate between 2003 and 2004

The inflation rate between 2003 and 2004 for this simple economy can be calculated from the price indexes above.



Thus, the rate of inflation between 2003 and 2004 is 57% in Breakfastland.



Calculate the inflation rate between 2003 and 2005

The inflation rate between 2003 and 2005 for this simple economy can be calculated from the price indexes above.




Thus, the rate of inflation between 2003 and 2005 is 75 % in Breakfastland.


Calculate the inflation rate between 2004 and 2005

The inflation rate between 2004 and 2005 for this simple economy can be calculated from the price indexes above.


Thus, the rate of inflation between 2004 and 2005 is 11.46 % in Breakfastland.

Monday, October 13, 2008

Using a Price Index to Measure Inflation for a Simple Economy with One Product

Using a Price Index to Measure Inflation for a Simple Economy with One Product

Consider a simple economy that only produces one product, widgets. The following table contains relevant data for this economy.

Year
Price of Widgets (P)
Quantity of Widgets Produced (Q)
Gross Domestic Product
2003
$0.50
10
$5.00
2004
$0.80
20
$16.00
2005
$1.00
50
$50.00
Table 5. Hypothetical data for an economy that only produces one product, widgets.

There are five steps to follow when using a price index to measure inflation.

Step 1. Choose the base year and determine the basket of goods.
Let 2003 be the base year. Let the basket of goods be the output produced in the base year. Thus the basket of goods contains 10 widgets. (Note: The basket of goods does not have to be output in the base year.)


Step 2. Find the price of each good in each year.

The prices of the widgets are given in the second column of the table.



Step 3. Compute the cost of the basket of goods in each year.

The basket of goods from 2003 valued at 2003 prices =
(10 widgets) ($.50 per widget) = $5.00

The basket of goods from 2003 valued at 2004 prices =
(10 widgets) ($.80 per widget) = $8.00

The basket of goods from 2003 valued at 2005 prices =
(10 widgets) ($1.00 per widget) = $10.00



Step 4. Compute the price index for each year.


Price index for 2003





Thus, the price index for 2003 is 100. The value of an index in the base year is always 100.


Price index for 2004





Thus, the price index for 2004 is 160.



Price index for 2005





Thus, the price index for 2005 is 200.


Step 5. Use the price index to calculate the inflation rate.



Calculate the inflation rate between 2003 and 2004

The inflation rate between 2003 and 2004 for this simple economy can be calculated from the price indexes above.


Thus, the rate of inflation between 2003 and 2004 is 60%.


Calculate the inflation rate between 2004 and 2005

The inflation rate between 2004 and 2005 for this simple economy also can be calculated from the price indexes above.



Thus, the rate of inflation between 2004 and 2005 is 25%.

Calculate the inflation rate between 2003 and 2005

The inflation rate between 2003 and 2005 for this simple economy also can be calculated from the price indexes above.



Thus, the rate of inflation between 2003 and 2005 is 100%. Prices in this simple economy doubled between 2003 and 2005.

Sunday, October 12, 2008

Using the Consumer Price Index to Measure Inflation

The U.S. consumer price index (CPI) for the years 1990 to 2000 is listed below:
1990 - 130.7
1991 - 136.2
1992 - 140.3
1993 - 144.5
1994 - 148.2
1995 - 152.4
1996 - 156.9
1997 - 160.5
1998 - 163.0
1999 - 166.6
2000 - 172.2

To calculate the inflation rate between two years, divide the difference between the CPI in the two years by the value of the CPI in the earlier year and multiply the result by 100.

Inflation Rate = [(CPI in later year - CPI in earlier year) / (CPI in earlier year)] x 100

For example, the inflation rate between 1999 and 2000 was:

[(CPI in 2000 - CPI in 1999) / (CPI in 1999)] x 100 = [(172.2 - 166.6) / 166.6] x 100 = [5.6 / 166.6] x 100 = 3.4%

Measurement of Inflation

Measurement of Inflation

Inflation is measured using a basket of goods. A basket of goods is a collection of products used to calculate a price index.

The table below lists the three most commonly used price indexes for measuring inflation in the United States. Each index uses a different basket of goods.

Price Index
Basket of Goods
Consumer Price Index (CPI)
Products purchased by a typical urban household.
Producer Price Index (PPI)
Products produced and sold by U.S. businesses, including goods and services that are used as inputs in the production of other products.



Everything in Gross Domestic Product. Unlike the CPI and PPI, the GDP deflator is not based on a fixed basket of goods.
Table 4. The baskets of goods associated with three price indices used to measure U.S. inflation.

Could you measure price changes by examining the amount of money spent on weekly trips to the grocery store? Probably not, because most people buy at least a few different items each trip to the store. If you bought the same items each time, however, then you would have some indication of what is happening to prices. The CPI and PPI use fixed baskets of goods. They calculate price changes over time to the same collection of items.

The base year is the year that is used as the comparison year when calculating an index. In the following examples, output in the base year is the basket of goods used to calculate the price indexes.

There are five steps to follow when using a price index to measure inflation.
Step 1. Choose the base year and determine the basket of goods.
Step 2. Find the price of each good in each year.
Step 3. Compute the cost of the basket of goods in each year.
Step 4. Compute the price index for each year.


Step 5. Use the price index to calculate the inflation rate.


Table 5. The five steps to follow when using a price index to measure inflation.

Saturday, October 11, 2008

Strategies for Controlling Inflation

Strategies for Controlling Inflation

1. Break the cycle of expectations. This helps to control cost-push inflation.
2. Reduce the costs of production. This helps reduce cost-push inflation.
3. Reduce aggregate demand. This helps to control demand-pull inflation.

AD = C + I + G + X – M
where:
AD = aggregate demand
C = consumption
I = investment
G = government purchases
X – M = exports – imports = net exports = NE


Objective to help achieve low inflation
Fiscal policy
to achieve this objective
Monetary policy
to achieve this objective
Break the cycle of inflationary expectations.
Anything that convinces the public that the government is committed to reducing inflation.
Anything that convinces the public that the Federal Reserve System is committed to reducing inflation.
Decrease the costs of production.
Anything that reduces costs of production. Increasing the world supply of oil, for example, would reduce production costs for many industries.

Reduce aggregate demand.
Decrease government purchases or increase taxes. Since government purchases are a component of aggregate demand (and GDP), reduced government spending will reduce aggregate demand directly. Higher taxes leave workers and businesses with less disposable income. This leads to a reduction in consumption and investment spending, which are two of the components of aggregate demand.
Decrease the money supply to increase interest rates. Higher interest rates discourage borrowing. This causes a decrease in consumption and investment spending, which are two of the components of aggregate demand
Table 3. Using fiscal and monetary policies to achieve low inflation.

Friday, October 10, 2008

Types and Causes of Inflation

Types and Causes of Inflation

Cost-push inflation is an increase in the price level caused by higher costs of production. The world experienced a dramatic increase in inflation in the 1970s when the Organization of Petroleum Exporting Countries (OPEC) caused the price of oil to quadruple, practically overnight. Cost-push inflation also can be caused when the unemployment rate becomes too low. This is frequently referred to as a tight labor market. For example, when unemployment is low, businesses may need to pay higher wages to attract new workers. Higher labor costs can lead to higher prices. This is one of the chief concerns of Alan Greenspan, the chairman of the Board of Governors of the Federal Reserve System.

A factor that contributes to cost-push inflation is the expectation of further inflation. For example, if the prices of most consumer products (e.g., groceries, clothing, rent) are increasing and people expect the inflation to continue, there is a natural tendency for people to ask for wage and salary raises to cover their increased living costs. Wage and salary increases, however, are increased labor costs for businesses. Higher costs of production lead to even higher prices for the consumer products and the expectation that the inflation will continue. Once inflation becomes entrenched in an economy, it tends to be self-perpetuating. Businesses seek higher prices for their products to cover increasing costs. In turn, workers seek higher wages & salaries to cover their increased cost of living. A key to reducing cost-push inflation is to break the cycle of expectations that the price level will continue to rise.

Demand-pull inflation is an increase in the price level caused by excess demand. It is often referred to as "too much money chasing too few goods." The link between the supply of money and the inflation rate is often made using the quantity theory of money. The quantity theory of money is based on the following axiom:




where:
M = the supply of money (influenced by the Fed)
V = the velocity of money (the number of times a unit of money is typically spent)
P = the price level
Q = the quantity of output produced and sold

The left side of this equation measures the value of the products purchased in the economy. The right side of this equation measures the value of the goods and services produced and sold in the economy. The above equation is a truism because it states that the value of the goods and services purchased in an economy is equal to the value of the goods and services produced and sold in the economy. The quantity theory of money adds two assumptions to this equation. The first assumption is that the velocity of money is relatively constant. Measurements of the velocity of money indicate this is a fair assumption. The second assumption is that is that the quantity of output is relatively constant over time. This assumption is less realistic. If it were true, however, then the quantity theory of money predicts that any changes the price level (P) are caused by changes in the money supply (M). According to the quantity theory of money, the way to prevent demand-pull inflation is to keep the money supply (M) from increasing. This theory suggests a different conclusion if the assumption about the quantity of output (Q) remaining constant is relaxed. In order to keep inflation low, the price level (P) needs to remain fairly constant. If the economy’s quantity of output (Q) changes [and if the velocity of money (V) is relatively constant], then the way to keep the price level (P) constant is to change the money supply (M) in proportion to changes in output (Q). If real GDP increases by 3%, for example, then the money supply should also grow by 3%. Thus, if monetary policy is used to keep inflation low, it should try to increase the supply the money at the same rate as the growth of the economy’s real GDP.

Thursday, October 9, 2008

The Importance of Low Inflation when price changes are unexpected and unpredictable.

Type 3: Price changes that are unexpected and unpredicted

Unexpected inflation redistributes income from lenders to borrowers.

There is an additional cost of inflation if the price changes are unexpected. Unexpected inflation redistributes income from lenders to borrowers. Unexpected deflation, by contrast, redistributes income from borrowers to lenders. Loans charge an interest rate that is variable or fixed. Variable rate loans allow the lender to periodically adjust the nominal interest rate to correct for changes in the inflation rate. Fixed rate loans, however, commit the lender to pay the stated nominal rate of interest for the life of the loan. If lenders expect inflation to occur, they include it in the nominal interest rates charged to borrowers. Unexpected inflation reduces the real rate of return, however. In October 2003, a typical interest rate on a 30-year fixed-rate mortgage loan was around 6% per year. The inflation rate during that month was estimated to be about 2% per year. Thus, the real interest rate was about 4% per year. (real interest rate = nominal interest rate – inflation rate) If the inflation rate increases unexpectedly to 5% per year, then the real rate of interest drops to only 1% per year. The borrower is paying a smaller real interest rate than the lender had expected. Thus, borrowers tend to benefit from unexpected inflation, while lenders lose from it. Borrowers pay back the loan with dollars that have less purchasing power than the lender had expected.

When lenders are burned by unexpected inflation, they may attempt to create a larger cushion between the nominal and real interest rates. This is sometimes referred to as a risk premium. Thus inflation can cause real interest rates to rise. This discourages businesses and households from borrowing money for investment projects. Reduced investment leads to lower productivity and reduced economic growth.

Inflation creates uncertainty that discourages long-term investment

The largest cost of inflation may be the effect it has on investment in the economy. Inflation creates an environment of uncertainty, especially when the inflation rate fluctuates. Historically, high inflation rates are rarely constant and predictable. This may make businesses reluctant to proceed with some investment projects (e.g., new factories).

If businesses expect prices to remain steady over the upcoming decade or two, they will be much more inclined to engage in a long-term investment project. Suppose analysts tell the Trek bicycle executives that the company could earn an additional $1 million in each of the next 10 years if they build a new bicycle manufacturing plant in Jacksonville, Florida. If inflation causes erratic changes in the price level, however, Trek executives may have difficulty determining if $1 million per year will be a good rate of return 10 years from now. This uncertainty may make them less inclined to build the new factory.

Since investment (in physical capital, human capital, and technology) is the key to increased productivity and economic growth, inflation can reduce the future standard of living if it causes a reduction in investment.

To illustrate how inflation creates uncertainty, consider two scenarios. In one scenario, imagine that inflation was low and persistent throughout the twentieth century. This would lead most people to predict that inflation will stay low in the coming decades. In the second scenario, imagine that the price level fluctuated wildly throughout the twentieth century. This makes it difficult to reach a consensus on the expected price level in the future. The price level could rise quickly, rise slowly, stay relatively constant, or even fall.




Price
? Level
Unpredictable inflation



Persistent low inflation
?
?
?













Year

Figure 2. Hypothetical inflation rates.
Persistent low inflation leads to more confidence about future price levels than unpredictable inflation.



Inflation is bad because it imposes costs on society that could be avoided in the absence of inflation. These costs generally result in reduced economic growth and lower present and future standards of living. These costs can be minimized if the economy maintains a low inflation rate.

In order to keep inflation low, it helps to understand the types of inflation and their causes. The appropriate policy prescription depends upon the source of the inflation.

Wednesday, October 8, 2008

The Importance of Low Inflation when price changes are expected and predictable, but not uniform.

Type 2: Expected & predictable price changes that are not uniform

Wages & salaries rise less frequently than the prices of goods & services

A bigger problem with inflation is that prices do not rise uniformly. Inflation causes most people to lose purchasing power because their income lags behind increases in the prices of goods and services. Purchasing power refers to the value of the products a person is able to buy with a given amount of money. People are not able to purchase as many goods and services with their income as prices rise.




How Purchasing Power Has Changed in the Last Century
$100 in 1915 had the same purchasing power as $1913.86 in 2005
$100 in 1920 had the same purchasing power as $ 966.50 in 2005
$100 in 1925 had the same purchasing power as $1104.57 in 2005
$100 in 1930 had the same purchasing power as $1157.49 in 2005
$100 in 1935 had the same purchasing power as $1410.95 in 2005
$100 in 1940 had the same purchasing power as $1380.71 in 2005
$100 in 1945 had the same purchasing power as $1073.89 in 2005
$100 in 1950 had the same purchasing power as $ 802.07 in 2005
$100 in 1955 had the same purchasing power as $ 721.27 in 2005
$100 in 1960 had the same purchasing power as $ 653.04 in 2005
$100 in 1965 had the same purchasing power as $ 613.65 in 2005
$100 in 1970 had the same purchasing power as $ 498.20 in 2005
$100 in 1975 had the same purchasing power as $ 359.29 in 2005
$100 in 1980 had the same purchasing power as $ 234.59 in 2005
$100 in 1985 had the same purchasing power as $ 179.65 in 2005
$100 in 1990 had the same purchasing power as $ 147.90 in 2005
$100 in 1995 had the same purchasing power as $ 126.84 in 2005
$100 in 2000 had the same purchasing power as $ 112.25 in 2005
$100 in 2005 had the same purchasing power as $ 100.00 in 2005
Table . Inflation causes a significant loss of purchasing power.
Source: U.S. Bureau of Labor Statistics
http://data.bls.gov/cgi-bin/cpicalc.pl




People do not lose purchasing power if their incomes are indexed. Indexation is using a law or contract to automatically correct a dollar amount for the effects of inflation. For example, Social Security benefits use cost-of-living adjustments (COLAs), which are indexed to the Consumer Price Index (CPI) and automatically increase with increases in inflation.

Year
COLA
Year
COLA
1975
8.0%
1991
3.7%
1976
6.4%
1992
3.0%
1977
5.9%
1993
2.6%
1978
6.5%
1994
2.8%
1979
9.9%
1995
2.6%
1980
14.3%
1996
2.9%
1981
11.2%
1997
2.1%
1982
7.4%
1998
1.3%
1983
3.5%
1999
2.5%*
1984
3.5%
2000
3.5%
1985
3.1%
2001
2.6%
1986
1.3%
2002
1.4%
1987
4.2%
2003
2.1%
1988
4.0%
2004
2.7%
1989
4.7%
2005

1990
5.4%
2006

Table . Cost-of-living adjustments (COLAs) automatically increase Social Security benefits to compensate for the loss in purchasing power caused by inflation as measured by the Consumer Price Index (CPI).
Source: The Social Security Administration
http://www.ssa.gov/OACT/COLA/colaseries.html

*The COLA for December 1999 was originally determined as 2.4 percent based on CPIs published by the Bureau of Labor Statistics. Pursuant to Public Law 106-554, however, this COLA is effectively now 2.5 percent.

Most people's incomes are not indexed, however. Consequently inflation harms most people by reducing their purchasing power, at least temporarily.




Expectations of future price increases

Another damaging component of inflation is its effect on expectations. If people think the prices of goods and services will increase before their incomes rise, then workers may push for higher wages and salaries now in anticipation of higher prices of goods and services in the future. Higher labor costs represent higher costs of production for businesses. These companies are then forced to raise product prices to cover these higher labor costs. This pushes inflation even higher, forcing another round of expectations of higher prices. Expectations of higher prices cause the price level to rise more rapidly than it would otherwise.

Inflation creates confusion that leads to inefficient purchasing decisions

Inflation also creates confusion and makes if difficult for people to have accurate price information when making purchasing decisions. When inflation is low, prices remain relatively constant. This allows people to develop a sense of the appropriate prices of products. Is one dollar per pound a good price for bananas? How about two dollars per gallon of gasoline? Is five dollars per gallon of milk a bargain price? During periods of high inflation, prices change rapidly so it is difficult for people to learn appropriate prices. People may not know if the price of a product has gone up because the seller is seeking excess profits or just because it reflects current inflation.


In the real world, prices do not change uniformly. Individual companies make decisions about when to change prices and by how much. These changes are usually in response to market conditions. Nonetheless, prices in various markets do not change by the same amount every day. This can lead to a misallocation of resources.

Tuesday, October 7, 2008

The Importance of Low Inflation when price changes are expected, predictable, and uniform.

The Importance of Low Inflation when price changes are expected, predictable, and uniform.

Type 1: Expected, predictable, uniform price changes.

If price changes are expected, predictable, and uniform, then their effects are relatively small. If inflation caused the prices of everything to rise at the same rate, inflation would not be so bad. It would create a few inefficiencies, however, such as the shoe leather and menu costs of inflation and an increase in the tax burden on personal investments. These costs occur with any type of inflation. What makes these costs unique, however, is that they occur even when inflation is expected, predictable and uniform.

Suppose the prices of everything in the economy double each year. Suppose wages and prices double on January 1st and remain at that level throughout the year. The week after January 1st, everyone’s income is twice as big as it was the week before. Are people better off? Because prices have also doubled, everyone’s purchasing power has stayed the same. For example, if you have $1 and a Coke costs 50 cents, then you can buy two of them. If you have $2 and a Coke costs $1, you still can buy only two of them. Your purchasing power has not changed.

The shoe leather costs of inflation

Inflation does cause people to alter their behavior, however. One form of altered behavior creates the shoe leather costs of inflation. Inflation causes people to hold less cash than in the absence of inflation. Consider the extremely high rates of inflation known as hyperinflation. If prices are increasing at a rate of 50% per month, then any cash a person carries around loses purchasing power at the same rate. If a pair of shoes costs $100 at the beginning of the month, then its price rises to $150 at the end of the month. In order to avoid the loss of purchasing power, people will tend to leave money in savings accounts where it will earn a nominal rate of interest that will keep up with the inflation rate. (Remember that nominal interest rates increase with the inflation rate.) Money loses its power as a store of value during periods of high inflation. In periods of high inflation, people have an incentive to carry less cash. This may cause them to make more frequent trips to the bank. The shoe leather costs of inflation are the wasted time and inconveniences caused when inflation encourages people to reduce their holdings of currency. The name is derived from the extra wear that would occur to people’s shoes if they walked to the bank every time they needed to withdraw cash to buy something. Modern banking conveniences, such as debit cards, have reduced the significance of the shoe leather costs of inflation.

The menu costs of inflation

Inflation also causes businesses to pay increased menu costs. The menu costs of inflation are the costs associated with changing the prices of the products sold by a business. These include the resources devoted to recalculating prices and publicizing the new prices to potential customers. The name is derived from the additional cost of printing new menus more frequently during periods of high inflation. If inflation is low, a restaurant might print new menus once or twice per year. During periods of hyperinflation, however, the restaurant might print new menus several times per week. Menu costs are significant for some businesses, such as those that rely on catalogs to generate sales.

Monday, October 6, 2008

The Importance of Low Inflation

The Importance of Low Inflation

Inflation is bad because it imposes costs on society that could be avoided in the absence of inflation. These costs generally result in reduced economic growth and lower present and future standards of living. These costs can be minimized if the economy maintains a low inflation rate.

To understand the importance of low inflation, it helps to consider three types of changes in the price level: (1) expected, predictable, uniform price changes; (2) expected and predictable price changes that are not uniform; and (3) price changes that are unexpected and unpredicted.

Sunday, October 5, 2008

The U.S. National Debt - Measured in Pennies ...

According to the October 5, 2008 Newsprism article "National Debt Surpasses $10,000,000,000,000.00—Charlton Heston Reacts:
Lily Tomlin famously said, “No matter how cynical you get, you can’t keep up.”

By at least one measure—the National Debt Clock in downtown New York City (video)—our collective debt has just surpassed $10 trillion. In fact, a fourteenth digit must be added to the Clock to keep up with the (with our) debt.

Here’s a nice way to visualize $10 trillion:
One Quadrillion Pennies
Image copyright 2001, kokogiak media

$10 trillion dollars equals one quadrillion pennies, which would fill a cube roughly half a mile tall, deep and wide…dwarfing the Washington Monument and the Sears Tower.

Those responsible for this burden, including Democrats and Republicans in both the Executive and Legislative Branches over the last three decades, have put our national security at risk with their out-of-control spending. Our economic supremacy is at risk as the global financial system lurches into a paradigm shift at a time when we’re trillions of dollars in debt to our main economic competitor, China, and to our economic overlords in the Middle East.

As Charlton Heston said at the end of “Planet of the Apes”, kneeling before the remains of the Statue of Liberty, “Damn you…God damn you all to Hell.”

And that’s putting it mildly.

The Difference Between Nominal and Real Variables is the Inflation Rate

The Difference Between Nominal and Real Variables

The difference between nominal and real variables is the inflation rate. For example, the difference between the nominal interest rate and the real interest rate is the inflation rate. The nominal interest rate is the stated rate of return on a financial asset, such as the interest rate a bank pays on a certificate of deposit. The real interest rate is the nominal rate of return adjusted for inflation.

real interest rate = nominal interest rate - inflation rate

nominal interest rate = real interest rate + inflation rate

inflation rate = nominal interest rate - real interest rate


Table 2 provides examples of the relationship between the nominal interest rate, the real interest rate, and the inflation rate. The real interest rate is kept constant at 1%. This reflects the rate of return on a financial asset with low risk, such as a certificate of deposit.

nominal interest rate
real interest rate
inflation rate
1%
1%
0%
2%
1%
1%
3%
1%
2%
4%
1%
3%
5%
1%
4%
6%
1%
5%
7%
1%
6%
8%
1%
7%
9%
1%
8%
10%
1%
9%
11%
1%
10%
12%
1%
11%
...
...
...
51%
1%
50%
Table 2. The difference between nominal variables and real variables is the inflation rate.

Saturday, October 4, 2008

Zimbabwe hyperinflation 'will set world record within six weeks'


A 13 November 2008 article in United Kingdom´s Telegraph newspaper claimed:
Inflation levels in Zimbabwe are running at 13.2 billion per cent a month and could reach an all-time world record within weeks.

The latest figures put the country's annual rate at 516 quintillion per cent – 516 followed by 18 zeros – overtaking Yugoslavia in 1994 and putting it behind only Hungary in 1946.

With goods unavailable and official statistics widely distrusted, the Cato Institute in Washington calculated the figures based on exchange rate movements and market data.

In post Second World War Hungary monthly inflation reached 12,950,000,000,000,000 per cent, with prices doubling every 15.6 hours – Zimbabwean prices are currently doubling every 1.3 days.

The most famous hyperinflation, Weimar Germany in 1923, is in a distant fourth place, at 29,525 per cent a month with prices doubling every 3.7 days.

Prof Steve Hanke said: "They still have a way to go to catch Hungary, but they are getting there. This is conjecture, but if they keep going at this pace, they have a shot at it within a month or maybe a month-and-a-half at the outside."

For ordinary Zimbabweans, the consequences are appalling and they must spend money as soon as they get it before it loses its value.

But the dysfunctional economy means that goods are in desperately short supply, and they must spend hours foraging to find things to buy.

There comes a point, though, where the inflation rate makes little practical difference.

"The economy just stops functioning or slows down very much," said Prof Hanke. "A lot of barter takes place. Money is not used as much or if it is, it's all foreign exchange." Supermarkets in Harare are accepting only US dollars and South African rands, leaving those Zimbabweans without access to foreign currency in dire straits.

The latest official figure for inflation in Zimbabwe – dating back to July – is 231 million per cent a year. Robert Mugabe's government blames foreign sanctions for the economic turmoil.

Prof Hanke said the only way to stop the rise was to abolish the Reserve Bank of Zimbabwe – which is a key tool of the regime.

"At the end of the day, people will just refuse to use the money. It will be just worthless and the Reserve Bank will be useless too. The only way you can change expectations about inflation in hyper-inflating countries is completely get rid of the old system."

Announcing a range of measures this week, that only tinker with symptoms of the problem, Gideon Gono, the governor of the reserve bank, blamed a “breed of selfish and unrelenting money launderers and speculators” for the crisis.

“The nation has to appreciate the magnitude of the 'sanctions’ and the mightiness of the enemies who are at play in order to understand that we are at war,” he said.

For years, analysts and opposition politicians have predicted that the economy would prove to be Mr Mugabe's downfall, but Prof Hanke, who is professor of applied economics at Johns Hopkins University, said that Slobodan Milosevic survived for almost eight years in Yugoslavia after hyperinflation peaked.

"The idea hyperinflation is going to blow Mugabe out of there isn't based on historical experience.

"Milosevic and Mugabe are similar in more ways than one: the restrictions on liberty of all sorts; Milosevic carrying on just like Mugabe that it was the foreign sanctions that were ruining the economy. It's very similar."

http://www.telegraph.co.uk

Zimbabwe inflation passes 100,000%, officials say

A February 22, 2008 article by Associate Press writer Angus Shaw highlighted the hyperinflation in Zimbabwe:

The official rate of annual inflation in Zimbabwe has rocketed past the 100,000% barrier, by far the highest in the world, the state central statistical office said yesterday. Second-placed Iraq has inflation of 60%, according to international estimates.

In a brief statement, the statistics office said inflation rose to 100,580% in January, up from 66,212% in December.

The new official figure was still well below the rate calculated by independent analysts. They estimate the real inflation is closer to 150,000%, citing supermarket receipts showing that the price of chicken rose more than 236,000% to 15m Zimbabwe dollars a kilogram between January 2007 and January 2008. Slower increases in prices of sugar, tea and other basics bring down the average to around 150,000%.

Zimbabwe, a former regional breadbasket, is facing acute shortages of food, hard currency, gasoline and most basic goods in an economic meltdown blamed on disruptions in the agriculture-based economy after the seizures of thousands of white-owned commercial farms began in 2000, accompanied by political violence and turmoil.

Economic hardship is a key issue in national elections scheduled for March 29 in which President Robert Mugabe, who turns 84 on Friday, is facing the biggest challenge to his hold on power since he led the nation to independence in 1980.

Inflation, food shortages and the crumbling of power, water, sanitation, roads, phones and communications and other utilities have fuelled deep divisions in the ruling Zanu-PF party.

In early October the state central statistical office gave official inflation at just below 8,000%. It then suspended its monthly updates because there was not enough in the shortage-stricken shops to calculate a regular basket of goods.

November's already dizzying rate of 24,470% was announced in January and earlier this month the official rate for December was given as 66,212%, a dramatic escalation in the space of a month.

The National Incomes and Prices Commission, the government's price control body, this month allowed sharp increases in the prices of the corn meal staple, sugar, bread and other basics in a bid to restore viable operations by producers and return the goods to empty shelves.

But the new prices were still roughly half the price demanded on the black market and were unlikely to guarantee regular supplies to food stores.

Executives at a milling company producing corn meal said the price increase allowed by the government was already overtaken by soaring production costs and gasoline prices and the National Bakers Association said bread shortages were set to worsen unless the price of a loaf was nearly doubled to more than 5m Zimbabwe dollars for a regular loaf.

Gross domestic product in Zimbabwe fell from about $200 in 1996 to about $9 a head last year.

Zimbabwe inflation now over 1 million percent

A May 21, 2008 article by Associate Press writer Angus Shaw says the hyperinflation in Zimbabwe is escalating:

HARARE, Zimbabwe --Weary Zimbabweans are facing a new wave of price increases that will put many basic goods even further out of their reach: A loaf of bread now costs what 12 new cars did a decade ago.

Independent finance houses said in an assessment Tuesday that annual inflation rose this month to 1,063,572 percent based on prices of a basket of basic foodstuffs. Economic analysts say unless the rate of inflation is slowed, annual inflation will likely reach about 5 million percent by October.

As stores opened for business Wednesday, a small pack of locally produced coffee beans cost just short of 1 billion Zimbabwe dollars. A decade ago, that sum would have bought 60 new cars.

And fresh price rises were expected after the state Grain Marketing Board announced up to 25-fold increases in its prices to commercial millers for wheat and the corn meal staple.

The economy was on shop clerk Jessica Rukuni's mind as she left the public swimming pool in downtown Harare's central park with three disappointed children. She found the new admission price of 100 million Zimbabwe dollars -- 30 U.S. cents -- out of reach.

"The point is that it's far too much for most people who don't get U.S. dollars," she said.

Her income is the equivalent of about one U.S. dollar a day, and her family has one basic meal daily.

The collapsing economy was a major concern of voters who dealt longtime President Robert Mugabe a defeat in March 29 elections. His challenger, Morgan Tsvangirai, topped the poll but did not win the simple majority needed to avoid a runoff. The two face each other in a second round June 27.

Mugabe was to officially launch his runoff campaign with a rally at his party's headquarters in Harare on Sunday, the state-run Herald newspaper reported Wednesday.

The opposition's campaigning has been hampered by violence blamed on Mugabe's government and party. The opposition claims Tsvangirai is the target of a government assassination plot and he has been out of Zimbabwe since shortly after the March 29 first round. He plans to return to Zimbabwe to campaign for the runoff once security measures are in place, his aides have said.

Mugabe, speaking as he reviewed graduating police cadets Wednesday, said the opposition was fanning violence. Independent observers have said that while there have been some retaliatory attacks by the opposition, the vast majority of the attacks have been carried out by Mugabe supporters.

Mugabe accuses the United States, the European Union and especially former colonial ruler Britain of using their economic influence to back his opponents and bring about his ouster. He has severed ties with the International Monetary Fund, the World Bank and other financial organizations.

Zimbabwe's official annual inflation was given by the government as 165,000 percent in February, already by far the highest in the world. The government has not updated that -- the state statistical service has said there were not enough goods in the shortages-stricken shops to calculate new figures.

The economic decline has been blamed on the collapse of the key agriculture sector following the often violent seizures of farmland from whites. Mugabe claimed the seizures begun in 2002 were to benefit poor blacks, but many of the farms went to his loyalists.

"The crunch is going to come when local money is eroded to the point it is no longer acceptable" in commercial activities or as earnings, especially by longtime ruler Mugabe's loyalists, said independent Harare economist John Robertson.

Already, more transactions are being done in U.S. dollars, both openly and in secret.

Manufacturing industries, running at below 30 percent of their capacity, reported growing absenteeism by workers facing soaring commuter bus fares.

German Hyperinflation


Children use notes of German money as building blocks during the country's inflation crisis in 1923. (Three Lions/Getty Images)

See "Will Overstimulating Economy Bring Inflation?"

Hyperinflation

Hyperinflation is extreme inflation in which the inflation rate exceeds 50% per month. Because the United States has never experienced hyperinflation, many Americans might think it is a theoretical curiosity. In the 20th century, however, there were more than a dozen instances of hyperinflation in the world.

Examples of hyperinflation in the 20th Century

HYPERINFLATION in the 20th Century

CountryYears
Russia1911-1916
Germany1923
Hungary1939-1945
China1946-1948
Indonesia1959-1965
Israel1982-1984
Brazil1984-1994
Bolivia1985
Peru1987
Poland1989-1990
Argentina1990-1991
Peru1990-1992
Russia1992-1995
Table 1. Examples of hyperinflation in the 20th century.

Hyperinflation is typically caused by the government creating too much money.

A Zimbabwean man holds a new five hundred million dollar note in Harare on May 16, 2008. Zimbabwe was grappling with a record 2.2 million percent inflation rate.


Figure 1. This is a 20 million mark note used during Germany’s hyperinflation in 1923. Even with large denomination notes, it was not uncommon to see people carrying large amounts of currency in a wheelbarrow.

Friday, October 3, 2008

The Difference Between Inflation, Deflation, and Disinflation

The Difference Between Inflation, Deflation, and Disinflation

Inflation is a general increase in the price level. The price level represents the prices of most products in an economy. Thus, the prices of most products are increasing during periods of inflation. The forces of supply and demand still determine prices in individual markets. Yet, inflation creates a tendency for prices to rise throughout the economy.

The inflation rate measures how quickly the price level changes. It is usually reported on an annual basis. In October 2003, for example, the inflation rate was 2.04%. This means that if prices rose at this same rate for an entire year, then they would be 2.04% higher on October 1, 2004 than they were on October 1, 2003. (The price index was actually 0.17% higher on October 31, 2003 than it was on October 1, 2003. Twelve months multiplied by 0.17% yields an annual rate of 2.04% per year.)

Deflation is a general decrease in the price level. During periods of deflation, the prices of most products are decreasing. Deflation is undesirable because it usually causes a significant decrease in overall spending (i.e., aggregate demand) in an economy and is most likely to occur when the economy is already stagnant. For example, deflation occurred in the United States during the Great Depression. Deflation occurs when the inflation rate is negative.

Disinflation occurs when the inflation rate decreases, but remains positive. For example, if the inflation rate changes from 6% in January to 5.5% in February to 5.2% in March, economists would say there is disinflation in the economy during the first quarter of the year (i.e., during January, February and March).

Thursday, October 2, 2008

Low Inflation - Learning Objectives

After studying the portion of this blog devoted to the macroeconomic policy goal of low inflation, you should be able to:

· define inflation and the inflation rate.
· define and explain the difference between deflation and disinflation.
· define hyperinflation and provide examples of its occurrence in the 20th century.
· explain the relationship between nominal variables, real variables, and the inflation rate.
· use nominal and real interest rate data to calculate inflation rates.
· use inflation and nominal interest rate data to calculate real interest rates.
· use inflation and real interest rate data to calculate nominal interest rates.
· explain why low inflation is an important macroeconomic goal.
· explain the effects of expected, predictable, uniform price changes.
· define and explain the significance of the shoe leather and menu costs of inflation.
· explain the effects of expected and predictable price changes that are not uniform.
· explain the effects of price changes that are unexpected and unpredictable.
· define purchasing power and indexation, and explain their relationships to inflation.
· define and explain the causes of cost-push and demand-pull inflation.
· list and explain the strategies for controlling inflation.
· explain why the goal is low inflation instead of no inflation.
· explain why the consumer price index (CPI) overestimates actual inflation.
· explain the effect of inflation on borrowers and lenders.
· explain the effect of inflation on people with indexed and non-indexed incomes.
· explain the effect of inflation on investment decisions by businesses.
· explain why inflation leads consumers to make inefficient decisions

Wednesday, October 1, 2008