Lecture 5 : Inflation

Lecture Inflation Dr.Do Xuan Luan Faculty of economics and rural development (FERD), Thai Nguyen University of Agriculture and Forestry (TUAF) All lectures of the course Introduction to macroeconomics; Gross Domestic Product (GDP); Economic growth; Unemployment Inflation; Aggregate Demand & Aggregate Supply (AS-AD model); Fiscal Policy; Monetary Policy; Combined effects of monetary and fiscal policy; 10 Trading with the world; Contents Definition of inflation Methods of measuring inflation Causes and effects of inflation How to control inflation? Definition of inflation • Inflation is a process in which the average level of prices rises and the value of money falls • Notes:  money is losing value  not prices of all goods and services increase, but the average price rises  some price changes are more important than others  the inflation rate and the price level: the inflation rate is the percentage change in the price level Measuring inflation • In comparison to the previous year 𝑃𝑡 − 𝑃𝑡−1 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑃𝑡−1 • In comparison to the base year 𝑃𝑡 − 𝑃0 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑃0 • Average for a period of time 𝑛 𝑡=1 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑡 𝐼𝑛𝑓𝑙𝑎𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑛−1 Where: 𝑃𝑡 : 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑡 𝑃𝑡−1 : 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟 (𝑡 − 1) 𝑃0 : price index of the base year n: number of years An example of inflation measurement 𝑃𝑡 − 𝑃𝑡−1 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑃𝑡−1 • the price index in June 2015 was 218.0, • and the price index in June 2014 was 215.7 • Then, the inflation rate during the twelve months to June 2015 was 218.0−215.7 Inflation rate = 215.7 ∗ 100 = 1.1% • Interpretation: the price index in June 2015 increased by 1.1% compared to June 2014 • Question?: how price index is measured? Price index measurement Two common methods GDP deflator GDP deflator measures the average level of prices of all goods and services that make up GDP The Consumer Price Index (CPI) is a price index based on the consumption expenditures of a basket of goods & services The consumer price index (CPI) • CPI is calculated as the ratio of the value of a basket in the current period to its value in the base period (multiplied by 100) • CPI= • 𝐶𝑃𝐼 𝑡 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑃𝐼 𝑏𝑎𝑠𝑘𝑒𝑡 𝑎𝑡 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒𝑠 𝐶𝑜𝑠𝑡𝑠 𝑜𝑓 𝐶𝑃𝐼 𝑏𝑎𝑠𝑘𝑒𝑡 𝑎𝑡 𝑏𝑎𝑠𝑒𝑑−𝑝𝑒𝑟𝑖𝑜𝑑 𝑝𝑟𝑖𝑐𝑒𝑠 = 𝑝𝑖𝑡 𝑞𝑖0 𝑝𝑖0 𝑞𝑖0 × 100 ×100 Of which: • 𝑖 𝑖𝑠 𝑡ℎ𝑒 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑜𝑟 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 𝑖 • 𝑞 𝑖𝑠 𝑡ℎ𝑒 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑎𝑛𝑑 𝑝 𝑖𝑠 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 • 𝑡: 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡, 0: 𝑡ℎ𝑒 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 • CPI tells us a percentage increase in the average price level of all commodities and services in the basket • Inflation rate = CPIt −CPIt−1 CPIt−1 A basket of goods: an example Fish Rice A typical basket of goods & services should represent common choices of a majority of households An example of calculating CPI and inflation rate Suppose that a basket of final good s and services has two goods namely rice and fish (10 kg of rice and kg of fish) Year Price of rice(1000 đ/kg) Price of fish Expenditure (1.000 (1000 đ) đ/kg) 2013 10 15 2014 12 2015 15 CPI Inflation rate % ?a ?d ?g 23 ?b ?e ?h 30 ?c ?f ?k Calculate expenditure and inflation rates (the base year: 2013) Make interpretation of results GDP deflator: an example Suppose, we have data of real and nominal GDP of Vietnam • 𝐺𝐷𝑃𝑟 2015 = 𝑘 𝑃2000 ∗ 𝑄2015 = 64.64 billion US • 𝐺𝐷𝑃𝑛 2015 = 𝑘 𝑃2015 ∗ 𝑄2015 =193.60 billion US • 𝐺𝐷𝑃𝐷 = 𝐺𝐷𝑃𝑛 𝐺𝐷𝑃𝑟 ∗ 100= 193.60 ∗ 64.64 100= 299.50 Interpretation: the average price level in the economy increased by 199.5% percent from 2000 (the base period for estimating real GDP) to 2015 GDP deflator & inflation: an exercise • Assume that an economy produces two final goods including rice and fish sauce Price and quantity of each good is provided as follows: Rice Year Fish sauce Price Quantity Price Quantity (1000d/kg) (kg) (1000đ/l) (liters) 2013 10 1.000 2014 12 1.200 2015 15 1.350 Indicator GDPn GDPr 180 ? ? ? - 10 190 ? ? ? ? 12 210 ? ? ? ? Calculate real, nominal GDP, GDP deflator and inflation rate (the base year: 2013) Make interpretation of results DGDP Inflation CPI vs GDP deflator Difference CPI points GDP deflator includes anything bought by includes only domestic consumers including foreign goods and not anything goods that is imported is a measure of only goods bought by consumers is a measure of the prices of all goods and services Commonly used to measure inflation Less common to measure inflation Causes of inflation An increase in aggregate demanddemand pull inflation (money supply, government purchases) a decrease in aggregate supply – Stagflation (wage rates+, prices of raw materials+) Inflation over the business cycle (the Phillips Curve) Inflation Causes of inflation: Demand pull inflation Price index (CPI, GDP deflator) AS0 Inflation Demand+: C+ I+ G+ X+ IM- P1 P0 AD1 AD0 Qa ∆Y Qp Value of quantities of final goods and services Causes of inflation: A decrease in aggregate supply – stagflation Inflation AS1 Price index AS0 Inflation AS(-): P1 P0 AD0 Qa ∆Y Qp Prices of materials(+) Wage (+) Rent (+) Interest rate (+) Technology(-) Weather (-) Value of quantities of final goods and services Causes of inflation: cycles tend to change cyclically BusinessBusiness cycle: inflation over time Causes of business cycles: Inflation high Inflation rise Inflation low • Economic Disturbances (i.e: war); • Economic policies (i.e: interest rate…); • Supply shocks (i.e: flood, drought, earthquake…); Effects of inflation on redistribution of income and wealth • Debtors gain and Creditors lose Why? Price (+) Money(-) Goods and services (-) • Salaried Persons (white collar persons) lose Why? Salaries are slow to adjust when prices are rising • Wage Earners may gain or lose Why? • Depending upon the speed with which their wages adjust to rising prices • And also depends on their unions’ power • Fixed Income Group loses Why? • The recipients of transfer payments such as pensions, unemployment insurance, social security, etc and recipients of interest and rent live on fixed incomes Effects of inflation on redistribution of income and wealth • Equity Holders or Investors Persons who hold shares or stocks of companies gain during inflation Why? Price (+)  Business activities (+)  Profits (+)  Dividends (+) • But those who invest in debentures, securities, bonds, etc which carry a fixed interest rate lose during inflation because they receive a fixed sum while the purchasing power is falling • Businessmen of all types (producers, traders and real estate holders) gain during periods of rising prices Price (+)  Business activities (+)  Profits (+) Effects of inflation on redistribution of income and wealth • Agriculturists: • Landlords lose during rising prices because they get fixed rents • Peasant proprietors who own and cultivate their farms gain Prices of farm products increase more than the cost of production • The landless agricultural workers are hit hard by rising prices Their wages are not raised by the farm owners, because trade unionism is absent among them Effects of inflation on savings and investment • Less saving: High rate of inflation will have an adverse effect on the savings in the economy Why? • As people spend more to sustain their present standard of living, less is being saved • This will result in less loanable funds being available to firms for investment • Inflation tends to discourage investment and long term economic growth Why? • The uncertainty and confusion are more likely to occur during periods of high inflation • High inflation is said to discourage stability and discourage firms to take risks and invest Conclusion on effects of inflation Title Add your text Thus inflation redistributes income from wage earners and fixed income groups to profit recipients, and from creditors to debtors The very poor and the very rich are more likely to lose than middle income groups How to control inflation? Monetary measures  Monetary policy to control money supply  Control credits Fiscal measures:  Unnecessary expenditure (-);  Taxes (+);  Savings (+);  Surplus budgets  Public debt to reduce money supply Other measures: • To increase production; • Rational wage policy; • Price control; Assigment Find the latest inflation figures of Vietnam/Laos for the last five year (20102015); Compare inflation rates of two countries and make comments on resutls www.themegallery.com Add your company slogan www.themegallery.com