Lecture Principles of economics (Asia Global Edition) - Chapter 16

After completing this chapter, students will be able to: See why inflation results from rapid growth in the money supply, learn the meaning of the classical dichotomy and monetary neutrality, see why some countries print so much money that they experience hyperinflation, examine how the nominal interest rate responds to the inflation rate, consider the various costs that inflation imposes on society.

Inflation and the Price Level Chapter 16 McGraw­Hill/Irwin Copyright © 2015 by McGraw­Hill Education (Asia). All rights reserved.16­1 Learning Objectives Explain how the consumer price index (CPI) is constructed and use it to calculate the inflation rate Show how the CPI is used to adjust dollar amounts to eliminate the effects of inflation Discuss the two most important biases in the CPI Distinguish between inflation and relative price changes to find the true costs of inflation Summarize the connections among inflation, nominal interest rates, and real interest rates 16­2 Keeping up with Grandpa • Prices of goods change over time – – • Baseball salaries – – • • Adjust values, incomes, or spending for change in prices Constant purchasing power Bruce Lee earned US$500,000 in 1973 Jackie Chan earned US$15 million in 2007 Inflation increases uncertainty when planning for the future Consider costs of inflation 16­3 Measuring the Price Level • • The Consumer Price Index (CPI) is a measure of the cost of living during a particular period The CPI measures – – • The cost of a standard basket of goods and services in a given year relative to the cost of the same basket of goods and services in the base year Base year for the CPI changes periodically, normally it changes every five years 16­4 Calculating the CPI 2013 Spending Monthly Cost in 2013 Rent (2 bedroom apartment) $500 Hamburgers (60 at $2 each) 120 Movie tickets (10 at $6 each) 60 Monthly expenditures 2018 Spending Rent (2 bedroom apartment) Hamburgers (60 at $2.50 each) Movie tickets (10 at $7 each) Monthly expenditures $680 Monthly Cost in 2018 $630 150 70 $850 16­5 Calculating the CPI • CPI is the ratio of the cost of the basket of goods in the current year to the cost in the base year – – • Base year cost $680 2018 cost $850 CPI = (850 / 680) (100) = 1.25 Cost of living in 2018 is 25% higher than in 2013 – – – CPI for the base year is always CPI for a given period is the cost of living in that period relative to what it was in the base year Statistical authorities around the world use CPI as a percentage – the ratio times 100 16­6 Cost of Living CPI = 1050 / 800 = 1.31 2013 Spending Monthly Cost in 2013 Rent (2 bedroom apartment) $500 Hamburgers (60 at $2 each) 120 Movie tickets (10 at $6 each) 60 Sweaters (4 at $30) Monthly expenditures 2018 Spending Rent (2 bedroom apartment) Hamburgers (60 at $2.50 each) Movie tickets (10 at $7 each) Sweaters (4 at $50) Monthly expenditures 120 $800 Monthly Cost in 2018 $630 150 70 200 $1,050 16­7 Price Index • • • A price index measures the average price of a given class of goods and services relative to the price of the same goods and services in a base year CPI measures the change in consumer prices Other indices – – – Core inflation is CPI without energy and food Producer price index Import / export price index 16­8 • • • Inflation The rate of inflation is the annual percentage change in the price level Inflation of China in 2012 = (2.68–2.61)/2.61 = 0.0268 = 2.7% When inflation rates are negative there is deflation CPI of Selected Countries United  Japan  Singapore  Thailand  States Year  China 2008 2.41 1.02 0.99 0.94 2.15 2009 2.40 1.01 1.00 0.93 2.15 2010 2.48 1.00 1.03 0.96 2.18 2011 2.61 1.00 1.08 1.00 2.25 2012 2.68 1.00 1.13 1.03 2.30 16­9 Adjusting for Inflation • • A nominal quantity is measured in terms of its current dollar value A real quantity is measured in physical terms – • Quantities of goods and services To compare values over time, use real quantities – Deflating a nominal quantity converts it to a real quantity • Divide a nominal quantity by its price index to express the quantity in real terms 16­10 Inflation and Relative Prices Year CPI Inflation 2013 2014 1.20 1.32 10% 2015 1.40 6% Oil Price Change Relative Price of Oil 8% 8% -2% 2% 16­25 Noisy Prices • Prices transmit information about – – • The cost of production and The value buyers place on buying an additional unit Inflation creates static in the communication – Buyers and sellers can't easily tell whether • • – – The relative price of this good is increasing OR Inflation is increasing the price of this good and all others Deciding these issues requires market participants gather information – at a cost Response to changing prices is tentative and slow 16­26 Indexing Avoids Distortions • Income taxes have been indexed to avoid bracket creep – Bracket creep occurs when a household is moved into a higher tax bracket due to increases in nominal but not real income • • Higher tax brackets have a higher tax rate Indexing income taxes matches tax rates to the real income level – – – Suppose the tax rate on $50,000 is 25% in 2010 CPI is for 2010, 1.25 for 2015 Nominal income of $62,500 is taxed 25% in 2015 16­27 Distortions Caused by Taxes • • Not all taxes are indexed Capital depreciation allowance encourages purchase of capital goods – – Allows firms to deduct a share of the purchase price as a business expense Machine cost is $1,000 and its useful life is 10 years • • • Capital depreciation allowance of $100 per year $100 in year is worth more than $100 in year 10 because of inflation In times of high inflation, investment in plant and equipment decreases 16­28 Distortions Caused by Taxes • US tax system is complex – – • Taxes are collected at the federal, state, and city levels Conflicting incentives Taxes that are not indexed distort the tax incentives for people to work, save, and invest – Lower savings and investment means lower economic growth – a real cost of inflation 16­29 Inflation Increases the Cost of Cash • If there is no inflation, cash holds its value over time – • • Some cash will be held for convenience When inflation is high, cash loses value over time Manage cash balances to limit losses – – – More frequent, smaller withdrawals cost consumers and businesses time, travel – a real cost of inflation Banks process more transactions, increasing costs – another real cost of inflation Costs of managing cash holding are called "shoe leather" costs, referring to the cost of frequent trips to the bank 16­30 Unexpected Redistribution of Wealth • • Unexpected inflation redistributes wealth Suppose workers' salaries are not indexed and inflation is higher than anticipated – – • Similarly, unexpectedly high inflation benefits borrowers at the expense of lenders – • Salaries lose purchasing power Employers gain at the expense of workers Borrowers repay with dollars worth less than anticipated Unexpected inflation confuses incentives 16­31 Interference with Long-Term Planning • Some decisions have a long time horizon – • Retirement planning requires an estimated cost for your desired life-style – – • Erratic inflation makes planning risky Save too little and you live less well in the future Save too much and you live less well now Given the costs of inflation, most economists agree that low and stable inflation promotes a healthy economy 16­32 Hyperinflation • Hyperinflation is an extremely high rate of inflation – – – • In 1923, German employers paid workers twice a day Magnifies the costs of inflation Minimize your cash holding A study of market economies, 1960 – 1996 showed 45 episodes of high inflation (100+%) in 25 countries – – – Real GDP/person fell by an average of 1.6% per year Real consumption/ person fell by an average of 1.3% per year Real investment per person fell by an average of 3.3% per year 16­33 Inflation and Interest Rates • • Unanticipated inflation helps borrowers and hurts lenders The real interest rate is the annual percentage increase in the purchasing power of financial assets – Real interest rate = nominal interest rate – inflation r=i• The nominal interest rate is the annual percentage increase in the dollar value of an asset – Nominal interest rates are the most commonly stated rates 16­34 Inflation and Interest Rates Nominal interest rates and inflation vary • Nominal interest rate range is 3.2% to 11.4% • Inflation rate range is 1.6% to 13.5% Real interest rate is nominal interest rate minus inflation • Real interest rate was highest in 1985, 7.0% • Real interest rate was lowest in 1980, – 2.1% • – Year Interest Rate (%) Inflation Rate (%) 1975 8.0% 9.1 1980 11.4 13.5 1985 10.6 3.6 1990 8.6 5.4 1995 6.6 2.8 2000 6.0 3.4 2005 4.3 3.4 2010 3.2 1.6 2012 1.8 2.1 16­35 U.S Real Interest Rates, 1960 - 2012 -1 -2 2010 2005 2000 1995 1990 1985 1980 -4 1975 -3 1970 Real interest rate (%/year) Year 16­36 Inflation and Interest Rates • Unexpected inflation benefits borrowers and hurts lenders – • Expected inflation may not hurt lenders if they can adjust the nominal interest rates – • For a given nominal interest rate, the higher the inflation rate, the lower the real interest rate Inflation-protected bonds pay a real rate of interest plus the inflation rate The Fisher effect is the tendency for nominal interest rates to be high when inflation is high and low when inflation is low 16­37 US Inflation and Interest Rates, 1960 - 2012 12 Nominal interest rate 10 Inflation rate 2010 2005 2000 1995 1990 1985 1980 1975 -2 1970 Inflation and interest rates (%/year) 14 Year 16­38 Inflation and Price Levels 16­39 ... Consider costs of inflation 16 3 Measuring the Price Level • • The Consumer Price Index (CPI) is a measure of the cost of living during a particular period The CPI measures – – • The cost of a standard... Monthly expenditures $680 Monthly Cost in 2018 $630 150 70 $850 16 5 Calculating the CPI • CPI is the ratio of the cost of the basket of goods in the current year to the cost in the base year – –... Cost in 2018 $630 150 70 200 $1,050 16 7 Price Index • • • A price index measures the average price of a given class of goods and services relative to the price of the same goods and services in