Unit 7 - Inflation

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Unit 7 - Inflation

• Inflation Measures
• Common inflation measures are
• Consumer Price Index
• Producer Price Index
• GDP deflator

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Unit 7 - Inflation

• The Consumer Price Index (CPI)
• is the most common inflation measure.
• measures consumer goods only.
• is a weighted index (an increase in the price
  of eggs is more important than an increase in
  the price of black-and-white televisions).

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Unit 7 - Inflation

• The Producer Price Index (PPI)
• measures business goods only.
• is a weighted index.

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Unit 7 - Inflation

• The GDP Deflator
• measures price increases of all goods and
  services based on real and nominal GDP
  calculations
• Equals nominal GDP divided by real GDP.
• Example nominal GDP120, and real GDP100.
• GDP deflator 120/1001.2.

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Unit 7 - Inflation

• United States CPI-U History for selected years
  (average percentage change)

1914 1 2000 3.4
1918 18 2001 2.8
1942 10.9 2006 3.2
1946 8.3 2007 2.8
1980 13.5 2008 3.8
1985 3.6 2009 -.4
1990 5.4 2010 1.6
Source ftp//ftp.bls.gov/pub/special.requests/cpi
/cpiai.txt
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For a United States consumer, 100 in 1990 bought
the same as _____ in 2010.

1. 93
2. 100
3. 142
4. 166
5. 196
6. 223

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Unit 7 - Inflation

• For an inflation calculator, visit
• http//www.bls.gov/data/inflation_calculator.htm

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What causes steady price increases in the long
run

1. Too much demand
2. Too little demand
3. Too much government spending
4. Steady increases in the money supply
5. Trade deficits

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Unit 7 - Inflation

• The Cause of Inflation
• In the long run, a steady increase in the
  nations money supply is the only cause of
  constantly rising prices.

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Unit 7 - Inflation

• The Cause of Inflation
• Lets look at a very simplified economy with
  only two products to understand the cause of
  price changes.

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Unit 7 - Inflation

• Assume, for simplicity, that in year 1, an
  economy produces only 2 products oranges and
  hammers.

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Unit 7 - Inflation

• Assume that there are 10 orange producers.
• Each producer makes 2 oranges, so total
  production of oranges is 20.

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Unit 7 - Inflation

• Assume that there are 5 hammer producers.
• Each producer makes 1 hammer, so total
  production of hammers is 5.

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Unit 7 - Inflation

• Assume that the countrys money supply is 100.

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Unit 7 - Inflation

• Assume that the price of an orange is the same
  as the price of a hammer and that consumers spend
  their entire income (no savings) on oranges and
  hammers.
• Then what is the average equilibrium price per
  product?

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Unit 7 - Inflation

• Answer
• Money supply is 100.Total production is 25 (20
  oranges and 5 hammers).
• The equilibrium price is 100 / 25, or 4.
• If the price is less than 4, there is a
  surplus of money.
• If the price is more than 4, there is a surplus
  of products.

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Unit 7 - Inflation

• Assume that in year 2, the money supply
  increases to 200.Now what is the equilibrium
  price per product?

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Unit 7 - Inflation

• Year 2 money supply is 200.Total production
  is 25.Equilibrium price is 200 / 25, or 8.
• If the price is less than 8, there is a
  surplus of money.
• If the price is more than 8, there is a surplus
  of products.

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Unit 7 - Inflation

• Without an increase in production, an increase
  in the money supply causes average prices to
  increase.

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Unit 7 - Inflation

• What does it take for production to increase?
• Is it necessary to increase the money supply in
  order to experience economic growth and make
  incomes increase?

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Unit 7 - Inflation

• Lets assume a constant money supply.
• Will technological progress occur?
• What will happen to profits and average incomes?

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Unit 7 - Inflation

• Consider the orange and hammer example.One
  orange and one hammer producer improve their
  technology and double their production.

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Unit 7 - Inflation

• What is total production now?
• What is the average equilibrium price of an
  orange and a hammer?

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Unit 7 - Inflation

• Total production is 28 products22 oranges (9
  times 2, plus 4) 6 (4 times 1, plus 2) hammers.
• Average price per product 100/28 3.57.

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Unit 7 - Inflation

• Revenue of the orange producer that doubled its
  production is 4 times 3.57, or
• 14.28 (compared to 8 in year 1).
• Revenue of the hammer producer that doubled its
  production is 2 times 3.57, or 7.15 (compared
  to 4 in year 1).

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Unit 7 - Inflation

• Both innovative producers are better off.
• Innovation pays.

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Unit 7 - Inflation

• But what happens if the technology is shared and
  all producers adopt the improved technology?
• What is total production and what will be the
  average equilibrium price?

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Unit 7 - Inflation

• Total orange production is 40 (10 times 4).
• Total hammer production is 10 (5 times 2).
• Equilibrium price per product is 2 (100
  divided by 50).
• What is the revenue per producer?

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Unit 7 - Inflation

• Revenue per orange producer 8 (4 times 2).
• Revenue per hammer maker 4 (2 times 2).
• This is the same revenue as in year 1, before
  the technology improvements. Is anyone better
  off? Does innovation really pay in a constant
  money supply economy?

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Unit 7 - Inflation

• How many oranges does 8 buy in year 1?
• How many hammers does 8 buy in year 1?
• How many oranges does 8 buy after the
  technology improvements?
• How many oranges does 8 buy after the
  technology improvements?
• Lower prices means greater purchasing power and
  increased real incomes.

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Unit 7 - Inflation

• Falling Prices
• Are falling pricesharmful to the economy?

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Unit 7 - Inflation

• Falling Prices
• Why are some peopleconcerned about falling
  prices?

Large pizza 2.50
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Unit 7 - Inflation
S
Average Price Level
30
20
D1
D2
Quantity Demanded/Quantity Supplied
578
496
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Unit 7 - Inflation

• Falling Prices
• Falling prices due to a decrease in demandis
  harmful.

Jacket 20
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Unit 7 - Inflation
S1
Average Price Level
S2
35
25
D
Quantity Demanded/Quantity Supplied
296
379
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Unit 7 - Inflation

• Falling Prices
• Falling prices due to an increase in supplyis
  beneficial.

Ipod 25
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Unit 7 - Inflation

Understanding economics priceless
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Unit 7 - Inflation

• Harmful Consequences of Inflation
• Inflation leads to
• Increases in long-term interest rates
• Decreases in exports
• Decreases in savings
• Mal-investments (people buy houses instead of
  investing in new businesses)
• Higher taxes (COLAS increase nominal, not real
  income)
• Inefficient government spending (government is
  not accountable for printed money)

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Unit 7 - Inflation

• Short-run versus Long-run Consequences of
  Inflation
• In the short run, an increase in the money
  supply decreases interest rates and stimulates
  spending.
• In the long run, an increase in the money supply
  increases prices, increases long-term interest
  rates, and slows down the economy.

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Unit 7 - Inflation

• A Constant Money Supply System
• In a constant money supply system
• The quantity of money in circulation is
  constant or nearly constant.
• Average prices decrease with increases in
  production.
• Purchasing power, profits, wealth and incomes
  increase.

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Unit 7 - Inflation

• The Gold Standard
• The Gold Standard is an example of a system with
  an constant (or nearly constant) money supply.
• In a gold standard, the supply of money is only
  allowed to grow as much as the supply of gold
  grows each year. Historically this has been
  between 1 and 2 per year.

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Unit 7 - Inflation

• The Gold Standard
• An appropriately applied gold standard forces
  the Federal Reserve System to keep the money
  supply limited to the growth of the gold supply.
• In a growing economy and an appropriately
  applied gold standard, prices will fall.
• The Gold Standard failed in the 1960s, because
  the Fed was not disciplined enough to limit the
  money supply.

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Unit 7 - Inflation

• The Gold Standard
• If the Fed is disciplined to keep the money
  supply constant without a gold standard, then we
  would not need a gold standard. This is actually
  preferable, because the supply of gold in some
  years fluctuates more than 1-2.

Macroeconomics