The Monetary System, Prices, and Inflation

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Chapter 18

• The Monetary System, Prices, and Inflation

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The Monetary System

• A monetary system establishes two different types
  of standardization in the economy
• Unit of valuea common unit for measuring how
  much something is worth
• Means of paymentthings we can use as payment
  when we buy goods and services
• examples dollar bills, personal checks, money
  orders, credit cards

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History of Currency

• In a barter economy, where there is no commonly
  accepted currency cows, sheep, fish
• Commodity money (with intrinsic value) like
  precious metals gold, silver
• Paper currency
• used to be backed by physical commodity
• Now, we have fiat money, i.e. a means of
  payment by government declaration.
• Legal tender payment that cannot be refused
  in settlement of a debt denominated in the same
  currency by virtue of law.

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Price Level and Inflation

• Price level
• Average level of dollar prices in the economy
• Index numbers
• Series of numbers used to track the change of a
  variable over time crime index, air pollution
  index
• Most measures of the price level are reported in
  the form of an index
• Dow Jones Index, SP 500, Consumer Price Index

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Index Numbers

• In general, an index number for any measure is
  calculated as

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Index Numbers

• Create index numbers
• Example the number of traffic accidents in
  Youngstown, Ohio
•  

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The Consumer Price Index

• An index of the cost, through time, of a fixed
  market basket of goods and services purchased by
  a typical household in some base period (1983).
• The market basket does not include goods and
  services purchased by businesses, government, and
  foreigners, but include consumer goods and
  services currently produced in the U.S., used
  goods and imported goods.

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From Price Index to Inflation Rate

• Consumer Price Index is a measure of the price
  level in the economy
• Changes in price index
• Inflation when price level is rising
• Deflation when price level is falling, or
  negative inflation

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Figure 1 The Rate of Inflation Using the
Consumer Price Index, 1950-2001
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Inflation, Nominal and Real Values

• Important point
• When we measure changes in macroeconomy, we
  usually care about purchasing power those dollars
  represent
• Not about the number of dollars we are counting
• Translate nominal values into real values using
  the formula

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Inflation, Nominal and Real Values

• Suppose that from December 2004 to December 2005,
  your nominal wage rises from 15 to 30 per hour
• Are you better off?
• Real wage formula is as follows

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Inflation, Nominal and Real Values

• An example

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Redistributive Effect of Inflation

• Inflation is not the cause behind the erosion of
  purchasing power, but just the mechanism
• Inflation can redistribute purchasing power from
  one group to another

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Redistributive Effect of Inflation

• How does inflation redistribute real income?
• Inflation hurts those who receive a fixed amount
  of payment specified in nominal terms
• Example salary specified in a contract
• Inflation benefits those who make a fixed amount
  of payment specified in nominal terms
• Examples mortgage payment, car loan monthly
  payment

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Expected vs. Unexpected Inflation

• Over any period, percentage change in a real
  value (? Real) is approximately equal to
  percentage change in associated nominal value (?
  Nominal) minus the rate of inflation
• ?Real ?Nominal Rate of Inflation
• If inflation is fully anticipated, and if both
  parties take it into account, then inflation will
  not redistribute purchasing power
• When inflation is not correctly anticipated,
  however, inflation does shift purchasing power
  from one group to another.

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Expected vs. Unexpected Inflation

• An example
• Joe borrows 100 from Mike and
  promises to pay back the money plus interest in a
  year. Mike wants to charge a real return of 3.
  Meanwhile, Mike expects the inflation rate to be
  3 for the next year and Joe expects it to be 5.
  So, Joe happily agrees to pay Mike 6 nominal
  interest rate. If the actual inflation rate is
  4, how will the purchasing power shift between
  Joe and Mike?

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Positive and Negative Unexpected Inflation

• Positive unexpected inflation
• An inflation rate higher than expected harms
  those awaiting payment and benefits the payers
• Negative unexpected inflation
• An inflation rate lower than expected harms the
  payers and benefits those awaiting payment