Inflation

1
Inflation

• Inflation is a type of instability which can
  compromise economic growth and bedevil policy
  makers. It can mask true change in the economy
  and make the value of currency decline to the
  point of worthlessness. It can destroy confidence
  in ones government and in oneself.

2
Inflation

• Definition A rise in the price level (the
  compilation of the prices of all goods and
  services in the economy in the form of a price
  index) over time. Generally inflation is measured
  from month to month and also year over year which
  is the more important measurement. Change in
  price level is usually measured in producer and
  consumer indices.

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How to figure inflation

• Inflation is figured as the rate of increase
  expressed as a percentage in the general price
  level from one year to the next.
• The rule of 70 can be used to approximate how
  long it will take inflation to double the price
  level or halve the value of the currency. For
  example if price level rises at an average of 3
  then in about 23 years price level will double.
  If inflation is 10 then price level will double
  in 7 years. Simply divide the percentage change
  average into 70 to get doubling time. This works
  for any percentage change you want to assess for
  doubling time including money that you may have
  invested in banks.

4
Deflation

• Deflation is a decrease in the general price
  level over time. Deflation is almost always
  accompanied by recession or depression in the
  modern era. It may also be the result of
  increased productivity or the acquisition of new
  resources which both lower the per unit cost of
  production. However, deflation increases the
  value of the currency, lowers real wages, and
  tends to be not liked by governments which prefer
  inflation since deflation lowers revenues.

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Causes of inflation

• Demand Pull inflation
• Is the result of excessive total spending in the
  economy.
• Increases in total spending do not increase the
  price level when spending in in Range 1 and the
  UE rate is high.
• As the economy nears the FE output in Range 2
  some inflation begins to reduce the gain in real
  GDP.

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Causes of Inflation

• If and when an economy enters Range 3 all
  increase is the result of price level change and
  none of the increase is the result of output
  increase. This is because the economy is already
  operating at or above full employment and has no
  way to produce more goods and services. As too
  many people are employed and too many resources
  are used to produce what can be produced,

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Causes of Inflation

• competition for factors of production pushes up
  the costs and results in producers increasing all
  price levels to keep profits. As prices increase
  labor will demand higher wages which in turn sets
  off another round of price increases. The danger
  of demand pull inflation is that is will cause a
  wage/price spiral and become hyperinflation.

8
Cost Push Inflation

• This is also known as supply side inflation.
• Price level rises as per unit production costs
  increase some possible causes of cost push
  inflation could be union strength in negotiating
  wage rises or supply shocks which occur when raw
  material resource prices increase without warning

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Difficulties in interpretation

• It may not be easy to distinguish between the two
  types of inflation especially if you are going to
  design a policy or process to contain or reduce
  it. However, cost push inflation will usually die
  out in the recession which accompanies it as
  demand by producers for the raw materials
  decrease reducing price pressure on producers and
  if total spending doesnt increase.

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difficulties

• So what this means is if government attempts to
  fight the recession caused by supply shocks with
  stimulus spending, this can amplify the cost push
  inflation and deepen the recession.

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Anticipated Inflation

• Anticipated inflation is that which is accounted
  for by economists, lenders, and government. That
  is, it is EXPECTED inflation, and as such is
  usually incorporated into interest rates and
  other areas prior to its advent. Generally,
  lenders do not lose out to anticipated inflation
  nor do revenue seekers in government, nor do
  producers or consumers who are able to prepare.

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Effects of inflation

• However, even with anticipated inflation there
  are consequences.
• Redistributive effects
• Fixed income groups will lose real income as
  their nominal income will not rise with inflation
• Savers will be hurt by UNANTICIPATED inflation
  because interest rates will not reflect any
  inflation premium. Inflation premium is the
  amount interest rates are raised to cover
  anticipated inflation.

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Effects of inflation cont.

• Debtors (borrowers) can be helped by inflation.
  It reduces the value of dollars they are paying
  back without changing the nominal amount they
  owe.
• Creditors will be hurt by inflation if they have
  not anticipated it by adding an inflation premium
  to their lending rates.
• Generally, the effects of inflation fall
  disproportionately on lower income earners.

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NEW CONCEPT !!!!!!!!!

• Interest rate come in two varieties
• Nominal Interest rate small i subscript n
• Real interest rate small i subscript r
• The real interest rate is equal to the nominal
  interest rate minus inflation.
• Since interest rates drive Ig, real interest
  rates are important to how GDP grows and,
  perhaps, in the business cycle.

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Contrariness and inflation

• Deflation will have many of the opposite effects
  of inflation. However, this is not the merry
  picnic you might expect. Generally, deflation is
  accompanied by recession or abnormally slow
  growth. Because price level falls even growth in
  output may bring lower real GDP and lower real
  GDP per capita in certain situations.

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Contrariness cont.

• Inflation is an arbitrary master. It will affect
  people differently depending on their personal
  situation. There is no one quick fix for
  inflation. In the US the most effective brake on
  inflation has been to induce a recession through
  use of high interest rates to kill spending and
  investment in capital goods. While this will kill
  inflation it also kills growth.

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Output and inflation

• If cost push inflation occurs it may cause output
  (production) and employment to decline
• Mild inflation (up to 3) is generally considered
  under control and in fact governments like mild
  inflation. However, it may undermine real income
  growth and real output growth. And it does
  depreciate the value of the currency.

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Dangers of inflation

• Development of hyper inflation must always be
  watched for. This out of control spiral has
  occurred in the past especially in post war
  situations. Weimar Germany is the best known
  example although Hungary after WWI is also
  instructive the price level rose to 828
  octillion (1 followed by 28 zeros) pengos to one
  prewar pengo. More recent examples can be found
  in Zimbabwe and other small nations.

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One final look at instability

• Does the stock market cause or indicate
  instability in the capitalist economy? Yes and
  no. Consumer spending rises when peoples assets
  increase in value and decreases as assets
  decrease in value. This is a small effect
  normally. Also there is some effect on Ig as
  well. If stock share prices move up, more people
  will invest in the company giving it more capital
  for investment purposes. The reverse is true if
  it falls in value. These are tenuous causes to be
  sure.