LvD

1
INFLATION
2
Definitions

• Inflation a sustained increase in all money
  prices
• Deflation a sustained decrease in all money
  prices
• Anticipated inflation inflation which is
  correctly foreseen
• Unanticipated inflation inflation which is
  unforeseen or incorrectly foreseen as to its
  timing, rate or duration

3
Question for Discussion
1. Are the following examples of
inflation? (a) There is a rise in the price of
only single good. (b) There is a once-and-for-all
rise in the price level. (c) There is a temporary
rise in the price level, like the price of
vegetables rises after typhoon or flood.
All the 3 cases are not examples of inflation.
Inflation is a general and continuous rise in the
money prices of goods and services. The 3 cases
do not fit in the definition of inflation.
4
Answer
(a) A rise in the price of only one good is not a
general rise in the price level. (b) A
once-and-for-all increase in general price level
is not a continuous rise in price level. (c) A
temporary increase in the price level(e.g., a
rise in the price of fruit and vegetables after a
typhoon) is not a persistent and continuous rise
in price level.
5
Measurement of Inflation
1. Meaning of price indexes
A price index is a series of indexed numbers
constructed according to the change in the prices
of goods and services over a period of time.
6
How is the CPI computed?

• Current year prices are compared to prices of a
  similar basket of goods and services in a base
  year

7
What is a Base Year?

• A year chosen as a reference point for comparison
  with some earlier or later year

8
Why is the CPI always 100 in the Base Year?

• The numerator and the denominator of the CPI
  formula are the same in the base year

9
CYP cost of the market basket of products at
current-year prices BYP cost of the market
basket of products at base-year prices
CYP BYP

• CPI

X 100
10

• 3. Consider an economy with only two goods bread
  and wine. In 1982, the the typical family bought
  4 loaves of bread at 50 cents per loaf and two
  bottles of wine for 9 per bottle. In 1996, bread
  cost 75 cents per loaf, and wine cost 10 per
  bottle. The CPI for 1996 (using a 1982 base year)
  is
• a. 100.
• b. 115.
• c. 126.
• d. 130.

B.
11
CYP cost of the market basket of products at
current-year prices BYP cost of the market
basket of products at base-year prices
CYP BYP

• CPI

X 100
23 20
X 100
115
What about HKSAR CPI?
12
How is theInflation Rate computed?

• The annual inflation rate is computed as the
  percentage change in the official CPI from one
  year to the next

13
Calculation of inflation rate
14
Exhibit 5
15

• 4. As shown in Exhibit 5, the rate of inflation
  for Year 2 is
• a. 5 percent.
• b. 10 percent.
• c. 20 percent.
• d. 25 percent.

B. A percent increase or decrease between two
numbers is the difference divided by the original
number. In this case, it is 10 / 100 10
16

• 5. As shown in Exhibit 5, the rate of inflation
  for Year 5 is
• a. 4.2 percent.
• b. 5 percent.
• c. 20 percent.
• d. 25 percent.

A. A percent increase or decrease between two
numbers is the difference divided by the original
number. In this case, it is 5 / 120 4.2
17
Question for Discussion
2. Read the following table and answer the
questions. Annual Average of CPI(A) Base
Year 1988 1989 1990 1991 1992
1993 1984-85 117.5 129.4 142.0 159.1 174
188.8 1989-90 84.6 93.1 102.2 114.5
125.2 135.9
(a) Compute the inflation rate in 1989 and 1993
respectively, taking 1989-90 as the base year.
18
Ans.
The inflation rate in 1989 is
(93.1-84.6)/84.610010.05
The inflation rate in 1993 is
(135.9-125.2)/125.21008.55
19
95C6
Refer to the following CPIs A B of Hong Kong.
Year
Index A
Index B
1992
125.2
125.1
1993
135.9
136.1
(a) Calculate the inflation rates in 1993 as
measured by the two CPIs respectively. Give TWO
reasons to explain why the two inflation rates
are different. (6 marks)
20
Implicit GNP deflator
93B1
The GDP figures (in HK millions) for the last 3
years as follows
1989
1990
1991
At current market prices
499,157
555,856
633,023
At constant 1980 prices
254,434
262,189
272,480
(a) What are the GDP implicit price deflators for
all 3 years? (1980100) Show your working.
21
93B1
The GDP figures (in HK millions) for the last 3
years as follows
1989
1990
1991
At current market prices
499,157
555,856
633,023
At constant 1980 prices
254,434
262,189
272,480
(b) What are the inflation rates as measured by
the GDP deflators for 1990 and 1991? Show your
working.
22
Functions of Price Indexes
to measure the value or purchasing power of money
to show the cost of living
to reflect on the economic situation (the
intensity of inflation/deflation) and facilitate
the formulation of policies
to estimate the state of a country in
international trade
23
Problems of Using PIs
A. Sample bias CPI covers only some selected
consumer goods in the economy. Such consumption
basket may not be a representative one. (Does GDP
deflator have the same problem?)
B. Change in Quality Since the price indexes do
not consider changes in the quality of goods,
they may overstate the inflation rate
24

• 8. Suppose a typical automobile tire cost 50 in
  1982 and had a useful life of 40,000 miles. In
  1995, the typical automobile tire cost 75 and
  had a useful life of 75,000 miles. If no
  adjustment is made for mileage, the CPI would
• a. underestimate inflation between the two
• years.
• b. overestimate inflation between the two years.
• c. accurately measure inflation between the two
  years.
• d. not measure inflation in this case.

b. Quality changes are difficult to measure.
When the quality of items improves, increases in
the CPI overstate the change in prices.
25
Problems of Using PIs
C. Substitution Effect Price index does not
consider people making substitutions from
relatively higher priced goods to lower priced
goods
D. Changing spending pattern As fixed weights
are used in constructing the indexes, changes in
spending pattern may not be represented.
E. Omission of capital goods CPI does not
consider the changes in the prices of capital
goods. ( Does GDP deflator have the same problem?)
26
Does the makeup of the CPI change?

• As peoples tastes and preferences change, some
  of the goods and services that go into the basket
  change

27
Causes of Inflation
P
AS
AS
AS
AD
AD
AD
0
Q
(b)
28
Equation of Exchange

• The nominal money supply (M) is the total dollar
  value of all paper money and coins in the economy.

29
Equation of Exchange

• The equation of exchange says that the nominal
  quantity of money multiplied by the velocity of
  money equals nominal GDP, (PY).
• MVPY

30
Equation of Exchange

• The price level equals the nominal money supplied
  multiplied by velocity divided by real GDP.
• PMV/Y

31
What Affects/Causes Inflation?

• Any one of the following raises inflation
• Increases in the growth rate of the money
  supply.
• Increases in the growth rate of velocity.
• Reductions in the growth rate of real GDP.

32
Equilibrium Inflation

• The equilibrium rate of inflation is the growth
  rate of the equilibrium price level.
• Solving for the equilibrium rate of inflation

33
The Ultimate Cause of Inflation
According to Q.T.M. MV PY
DM/MDV/VDP/PDY/Y Since DV/V 0,
DM/M - DY/Y DP/P
34
The Ultimate Cause of Inflation
Inflation (i.e. DP/P gt 0) occurs when a. the
stock of money increases at a rate faster than
the supply of real output (i.e. DM / M gt DY / Y)
OR b. the quantity of goods is reduced (i.e. DY /
Y lt 0) without an equivalent reduction in the
money supply (i.e. DM / M 0)
35
Inflation is a monetary phenomenon.
1. Can inflation also exist in a barter economy?
36
Short- and Long-Run Inflation and Money Supply
Growth

• Generally, inflation reflects the growth rate of
  the money supply.
• Because of changes in velocity (V) and real
  GDP (Y), they are not closely related in the
  short run.
• Over long periods of time, money growth and
  inflation move closely together.

37
U.S. Inflation and Monetary Growth Rate by Decades
38
Inflation and Money Supply Growth in the United
States
39
Figure 7.2 The relationship between money growth
and inflation
40
The Ultimate Cause of Inflation
Therefore, inflation is only a monetary
phenomenon. It will not last for a long time
unless there is a sustained increase in the money
stock relative (in ) to the real output.
41
Question for Discussion
3. Can inflation also exist in a barter economy?
Ans. Inflation can only exist in monetary
economies but not in barter economies. This is
because when the price of e.g. good X relative to
the price of good Y increases, then the price of
good Y relative to the price of good X will fall.
It is impossible for a sustained increase in the
prices of all goods.
42
Effects of Inflation Redistributive effect

• Monetary assets claims to fixed amount of money
  in the future, e.g. money, bonds
• Monetary liabilities obligations to pay those
  fixed amounts of money
• Real assets claims to goods and services whose
  real values remain unchanged by inflation, e.g.
  cake coupons
• Real liabilities obligations to deliver goods
  and services whose value remain unchanged by
  inflation.

43
Redistributive effect

• Net monetary creditors monetary assets gt
  monetary liabilities
• Net monetary debtors monetary liabilities gt
  monetary assets

44
Inflation causes wealth redistribution
45
Redistributive effect
Real assets liabilities no redistributive
effect
Monetary assets liabilities
Anticipated inflation no redistributive effect
Unanticipated inflation
46
Table 1 Balance sheets before and after
unanticipated inflation for a net monetary
debtor, showing real increase in equity
47
Question for Discussion
4. Decide who are the gainers and losers during
inflation.
Ans. If the monetary creditors do not foresee
inflation correctly (i.e. underanticipated as the
actual inflation rate is greater than the
expected inflation rate), they may ask for an
interest rate that cannot compensate the loss of
the moneys purchasing power when the monetary
debtors repay the money in the future. Thus,
there is an income redistribution from the
lenders to the borrowers net monetary creditors
lose and net monetary debtors gain during
underanticipated inflation. Fixed money income
earners lose and the government gains during
underanticipated inflation.
48
Losers during underanticipated inflation

• Underanticipated inflation net monetary
  creditors e.g. lender
• Fixed income earners, e.g. bond holders,
  pensioners
• Public
• Anyone whose growth rate of money income lt
  inflation rate

49

• Last year the Harrison family earned 50,000.
  This year their income is 52,000. In an economy
  with an inflation rate of 5 per cent, which of
  the following is correct?
• a. The Harrisons nominal income and real income
  have both risen.
• b. The Harrisons nominal income and real income
  have both fallen.
• c. The Harrisons nominal income has fallen, and
  their real income has risen. .
• d. The Harrisons nominal income has risen, and
  their real income has fallen.

52,000 - 50,00050,000
d. change real income
- 5,
-1
4 - 5
50
Gainers during underanticipated inflation

• Underanticipated inflation Net monetary debtors
  e.g. borrower
• Government
• Anyone whose growth rate of money income gt
  Inflation rate

51
98B5
Discuss how inflation affects the wealth of
creditors and debtors when
(a) the inflation rate is correctly anticipated.
(4 marks)
When inflation is correctly anticipated, both
creditors and debtors will adjust the nominal
interest rates by the inflation rate in the
absence of excessive adjustment cost. The real
interest rate creditors receive and debtors pay
is the same as the expected amount. Wealth
redistribution described above does not occur.
52
98B5
Discuss how inflation affects the wealth of
creditors and debtors when
(b) the inflation rate is completely
unanticipated. (4 marks)
When inflation is completely underanticipated,
the nominal interest rate does not take into
account sufficiently the inflation rate. As a
result, the real interest rate creditors receive
debtors pay will be less than the expected
amount. There is a redistribution of wealth from
creditors to debtors.
53
Effects of Inflation
Inflation is a TAX Inflation tends to
redistribute income from the public to the
government. It is a kind of tax without
legislation.
progressive income tax
Tax allowances
Government bonds
Tax on cash balances
54
Tax allowance 100,000
Taxable income
Tax rate
1st 100,000
10
15
2nd 100,000
20
3rd 100,000
Inflation raises money income
Person A 90,000 -gt 110,000
Person B 200,000 -gt 220,000
55
Inflation tax proportionately more money income
are taxable
56
Costs of Inflation

• Misallocation of resources
• encourages speculation
• discouraged from carrying out long-term
  investment
• unwilling to accept money insist on trading
  goods or services directly for other goods
  services

57
Costs of Inflation
Higher transaction costs in finding ways to hedge
against inflation
Higher inflation rate gt greater variability in
relative price movements gt greater uncertainties
Inflation encourages speculation rather than a
productive use of saving, and discourages
long-term investment projects
58
Costs of Inflation

• Transaction costs
• Anticipated inflation hedge against inflation
• Unanticipated inflation obtain information
  about future prices
• Higher unanticipated inflation causes
  uncertainties
• reduce the willingness to lend borrow
• reduce the willingness to invest

59
Effects of Inflation
Real and nominal rates of interest Nominal
interest rate Real interest rate Expected
rate of inflation
Actual real Nominal interest - Actual
rate interest rate rate
of inflation
60

• If the nominal rate of interest is less than the
  inflation rate,
• a. lenders win.
• b. savers win.
• c. the real interest rate is negative.
• d. the economy is at full employment.

C. The real rate of interest is negative because
the lender is receiving less money back, in real
terms, than was lent out.
61
What is a Wage-price Spiral?

• A situation (vicious circle/ve feedback) that
  occurs when increases in nominal wage rates are
  passed on in higher prices, which, in turn,
  result in even higher nominal wages and prices

62
Do peoples Expectations affect Inflation?

• Yes, expectations can influence both demand-pull
  and cost-push inflation

63
Issues and ApplicationsIs the World Facing the
Danger of Deflation?

• Inflation rates have declined worldwide
• Some countries such as Japan and China have
  deflation
• Some causes for concern
• Lower commodity prices could devastate emerging
  economies
• Unions might not anticipate falling prices
• Dont confuse deflation with falling relative
  prices

64
9.3 Inflation and the Nominal Interest Rate

• The Fisher equation says that the nominal
  interest rate (R) equals the real interest rate
  (r) plus the expected rate of inflation (pe).
• R r pe

65
Inflation and the Nominal Interest Rate
20
Inflation Rate Nominal Interest Rate
16
Inflation and Nominal Interest Rate (percent per
year)
12
8
4
1995
1998
1990
1985
1980
1975
1970
1965