Chapter IV: Prices and Inflation

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Chapter IV Prices and Inflation

• A. Measuring prices and inflation
• B. The AS-AD Model and inflation
• C. Cost-push and demand-pull inflation
• D. Inflation as a monetary phenomenon
• E. Effects of inflation and inflation hedging
• F. Controlling inflation

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Distinguishing real and nominal values

• Keynes had reasons to treat the aggregate price
  level as given, but in many instances the price
  level will change over time
• In this case we need to know more about the price
  deflator for GDP
• It allows to distinguish between real GDP growth
  and nominal values of GDP
• First we look at how prices are measured

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Measuring pricesTwo approaches

• Prices are often given with reference to a
  standard product for raw materials
• Other prices are given as a compound measure for
  a basket of goods and services
• Example
• When newspapers write about oil prices, they
  usually mean one of two reference crudes Brent
  from the North Sea, or West Texas Intermediate
  (WTI)
• When ministers from the Organization of the
  Petroleum Exporting Countries (OPEC) discuss
  prices, they usually refer to a basket of heavier
  cartel crudes, which trade at a discount to WTI
  and Brent

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Consumer price index (CPI)

• An important indicator is the consumer price
  index (CPI)
• It attempts to measure the evolution, over time,
  of the cost of living of a typical household
• It implies definition of
• A typical household
• A typical basket of goods and services of that
  household

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Constructing the CPI

• What do we need to construct a CPI?
• A base year t0 (in Germany 2000)
• A typical household (in Germany various types)
• A basket with typical of goods and services
  of the household (xi,0 ) for t0 (in Germany
  about 750)
• Prices of the base year pi,0 and current prices
  pi,t for that basket

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Two types of price indices

• If the weights xi,0 of the base period remain
  fixed, it will give us a Laspeyres index
• If the weights are updated every period (flexible
  basket), xi,t, we obtain a Paasche index

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Example A Laspeyres price index
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Problems of the Laspeyres index
The CPI according to Laspeyres overstates the
cost of living

• Reasons The following is not measured
• Shoppers revise shopping plan in response to
  changes in price relativities (substitution bias)
• There are new products that are not incorporated
  in the original basket
• There are improvements in the quality of products
  and services (quality bias)

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Problems of the Paasche index

• The Paasche index
• Is more difficult to administer (the denominator
  has to be re-calculated every year)
• Requires quantity data for each year, which may
  be difficult to obtain
• Could be misleading, because each time different
  quantities are used, and therefore changes may
  not solely be attributable to price changes

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Impact of CPI on public and private agents

• In the U.S., the CPI affects the income of almost
  80 million people as a result of statutory action
• Social Security beneficiaries,
• Military and Federal civil service retirees,
• Food stamp recipients
• Changes in the CPI also affect the cost of
  lunches for children who eat lunch at school
• Some private firms and individuals use the CPI to
  keep rents, royalties, alimony payments and child
  support payments in line with prices

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Chain-linked indices

• To alleviate the burden of the traditional CPI
  on the federal budget, the US Bureau of Labor
  Statistics publishes chain-weighted indexes using
  a rolling base year since 1995
• Other countries followed

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Real GDP

• Real GDP is measured in prices of a base year
• For instanceReal GDP of 2005 (in prices of
  2000)

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Real GDP and the GDP deflator

• The GDP deflator is defined as follows

Nominal GDPReal GDP
GDP deflator
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Reading
Reading 4-1Fighting Americas inflation flab,
The Economist, October 5, 2000(on
methodological tricks with indices) Abel,
Bernanke and Croushore, Chapter 2 (only 2.4 and
2.5)
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CPI and GDP deflatorDifferences

• The CPI is a Laspeyres index, whereas the GDP
  deflator is a Paasche index
• The difference depends on what basket of goods
  we use to calculate the index
• Is it best to use the same one (of the reference
  year)?
• Or should we use the one at time t, which
  changes period by period?
• The answer is not obvious!

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Example Oil shock (1)

• Suppose we choose the Laspeyres index and take
  the time-zero basket fixed
• There is an oil shock at time 0, the oil price
  skyrockets
• households reduce the demand for gasoline and
  cars
• increase the use of substitute means of
  transportation (for instance subways)

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Example Oil shock (2)

• At time t the actual basket of goods includes
  much less gasoline than at time zero, but the
  Laspeyres formula does not take it into account,
  so it will overstate inflation
• The Paasche tends to understate inflation
  instead, because it gives a smaller weight to
  gasoline (the share of gasoline expenditures at
  time t)

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Reading Oil shock and prices
Reading 4-2Pistol pointed at the heart, The
Economist, May 29th, 2008
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Differences between CPIand GDP deflator summary
Price index GDP deflator
Goods and services Only private goods and services are included All private and public goods are included
International trade No distinction between national or international goods and services Only national goods and services are summarized
Basket Fixed composition Flexible composition
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The inflation rate and the growth rate

• The annual inflation rate is calculated as

• The annual growth rate is calculated as

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International GDP deflators1971-2005 North and
South America
Source Worldbank own calculations
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International GDP deflators1971-2005 Europe and
Asia
Source Worldbank own calculations
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World inflation
Consumer price inflation, median for developing-
and GDP weighted mean for high-income
Percentage increase p.a.
Developingeconomies
High revenue economies
Source Worldbank
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Inflation history of the United States
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A useful link

• http//www.bls.gov/data/inflation_calculator.htm

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Inflation in the Euro area, recent trends (HICP)
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World inflation
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Inflation in transition economies
Inflation rates of transition economies even
dwarf those of Latin America in the early 1990s
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The AS-AD modeland inflation

• If the AS curve is steeper, a variation of the AD
  changes GDP at constant prices and triggers an
  increase of the price deflator

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Output and employment

• This seems to suggest that there is a positive
  relationship between the price level and output
  for varying AD functions
• Given the production function Is there a
  tradeoff between unemployment and price
  stability? I.e. If we want more employment, we
  have to accept higher prices?
• This hypothesis is expressed in the so-called
  Phillips curve

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Phillips curve
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Phillips curve

• The discussion about the Phillips curve is very
  much related to Keynesian demand management
• Unfortunately there is no trade off between
  unemployment and inflation
• The Phillips curve simply overlooks long term
  reactions on the supply side
• Lets see what happens if the economy is
  constrained by its potential

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The AS-AD modeland inflation

• In the long run the AS curve is vertical, the
  expansion of output is only temporary
• In the long run we return to potential output at
  point C
• All we have achieved is an increase of the price
  level

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Long run Phillips curve

• In the long run employment is to remain at its
  natural level (natural employment)
• So the Phillips curve tradeoff works only in the
  short term
• (We shall come back to this when we discuss
  demand pull inflation)
• Let us come back to the price increase induced by
  shifting along the AS curve

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Price level increaseand inflation

• Is this price increase called inflation?
• For most people it is, but economists speak of
  inflation only if it is reoccurring and
  persistent
• So the case discussed here is a one-time price
  adjustment only, not necessarily inflation
• How then is inflation generated?

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Why is there inflation?

• Inflation could result from activist economic
  policies
• There are two types of mechanisms
• Cost push
• Demand pull
• Each on its own will provoke price increases, but
  not necessarily inflation
• However both mechanisms in tandem could cause
  inflation indeed

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Oil shock and policy reactions

• Lets assume there is an oil price shock as in
  the example discussed
• It would shift the supply curve to the left
  creating a price increase and reducing production
• Reduced production entails unemployment
• The government reacts with expansionary fiscal
  policies

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Cost-push inflation
Price level
Each time the priceincrease feedsback into
wagesand costs
Inflation is dueto accommodatingfiscal policy
Aggregate output
GDPpotential
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Government demand asa driving force of inflation

• Lets assume that the natural rate of
  employment is reached, but there is residual
  structural unemployment
• The government does not tolerate this and expands
  government outlays to inflate aggregate demand
• It must drive prices up, which then feed back
  into wages and costs shifting the AS curve to the
  left

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Demand-pull inflation
Price level
Fiscal policy drivesprices up, and each time
the price increase feeds back into wagesand
costs
Aggregate output
GDPpot
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The role of monetary policy

• But neither cost push nor demand pull could
  provoke inflation without monetary expansion

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Views on inflation the monetarists
Price level
1
1 initial equilibrium
Aggregate output
GDPnatural
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Inflation and the supply of money
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Reading
Reading 4-3An old enemy rears its head, The
Economist, May 22nd, 2008
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Once morethe Phillips curve

• Activist fiscal or monetary policies trying to
  push employment beyond the natural employment
  rate should show up in the Phillips curve
• Lets have a look at the Phillips curve for
  Germany

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Phillips curve for Germany
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Natural unemploymentand hysteresis

• As the short-term tradeoff between unemployment
  and inflation is exploited, there are
  irreversible structural effects
• People thrown out of job loose their
  qualification and become structurally
  unemployed
• This process is called hysteresis
• It is exacerbated by structural changes in the
  economy (the production function)

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Inflation and hysteresisof unemployment
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The dynamics of the Phillips curve
Turning clock-wise does in fact support the
thesis that expansionary policy is followed by
inflation
?
u
The shift toward the right supports hysteresis
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Reading

• Abel, Bernanke and Croushore, Chapter 12.1 and
  12.2

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Is inflation so bad?
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Creeping progression and inflation tax

• As the income tax is progressive, inflation will
  automatically increase the tax burden relative
  to GDP in real terms (bracket creep)
• There is an inflation tax on money holdings
• The counterpart is seignorage
• It could diminish welfare by reducing cash
  holdings below the optimum for transactions
• The inflation tax hits the poor more than the
  rich, because the latter can hedge assets against
  inflation

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Inflation and distortions of allocation

• Inflation can cause serious distortions on the
  allocation of capital because
• the tax system ignores inflationary gains
  (losses), and it charges certain activities too
  heavily (lightly)
• profits could be inflated by deficient accounting
  which (inter alia)
• fixes depreciation at historical costs
• leads to difficulties in evaluating inventory
  flows
• treats dividends and debt charges differently

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Inflation and distortions of allocation

• If inflation is expected, consumers could reduce
  savings to spend more on consumption, which
  would increase the costs of investment, and
  reduce growth
• Inflation entails uncertainty, which could affect
  consumers and investors behavior negatively
• Accounting techniques could be improved to
  adjust for inflation, but this leads to higher
  information costs

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Inflation and redistribution

• There are distributional arguments against
  inflation. It is alleged
• to let profit income earners benefit more than
  wage earners
• to penalize nominal income earners
• Pensioners?
• Fixed-income earners (from securities etc.)?
• to benefit debtors at the expense of creditors
• to make the the government win at the expense of
  the private sector

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Hedging against inflation

• The distributional effects largely depend on
  whether inflation is expected, or not
• If inflation is expected, it could be built into
  contracts
• One way of incorporating unforeseeable inflation
  is to use indexing
• Indexing is also an incentive for governments to
  control the price level
• It is crucial to distinguish between passive
  contract from self-referencing contracts

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Scala mobile in Italy

• An example for a self-referencing indexing scheme
  is the scala mobile in Italy
• From 1946 until 1992, Italy had linked wage
  increases to the CPI
• This lead to continuous inflationary pressures
  that were hard to resist by monetary policies
• Moreover the Banca dItalia was dependent on the
  government
• In 1992 the scala mobile was repealed
• The central bank became more independent

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Prohibition of indexation in Germany

• In 1948 indexation was prohibited in Germany
• It was only permitted by Bundesbank
  authorization, and permissions were rare
• The introduction of the euro in 1999 changed this
  policy, but the indexation of wages and leasing
  fees is still forbidden
• The central government has heralded an
  inflation-indexed bond with a volume of 10
  billion for the year of 2005
• Nowadays more than 26 countries worldwide offer
  inflation-indexed bonds

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Reading

• Abel, Bernanke and Croushore,
• Chapter 12.3

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Different types of inflation

• There are different types of inflation
  creeping, rapid, and hyperinflation
• The German hyperinflation is a striking example
  of money expansion driving the inflation rate
• This experience qualifies as a controlled
  experiment and support Friedmans thesis that
• inflation is always and everywhere a monetary
  phenomenon

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ExampleGermany after WW I
Hyperinflation in Germany
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The German hyperinflation 1922-23
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Is inflation under control now?

• Today, both the Fed and the European Central Bank
  are independent institutions with conservative
  monetary policies
• The two world currencies, the dollar and the
  euro, show little signs of inflation
• Many countries have anchored their currencies
  in one of the world currencies
• Sometimes anchoring even entails deflation (e.g.
  Argentina)

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Discussion 4Inflationary risks and corporate
management

• Why should firms be concerned about inflation?
• What strategies can be adopted to hedge
  inflationary risks at the firm level?
• Do firms need inflationary risk management where
  currency boards appear to guarantee price
  stability?

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