Inflation Flashcards
Inflation rate
An increase in the general average (percentage) price level in the economy, usually measured over a time period
Measure 1: GDP Deflator
GDP deflator = 100 x Nominal GDP/Real GDP
- Only tracks change in prices for all domestically produced final goods and services in the component of GDP
- Measured as the ratio of Nominal (current prices) GDP to real (base-year prices) GDP
Measure 2: Consumer Price Index
Price of a fixed bundle of consumer goods
- Reflect the spending of a typical household in the economy
- Often considered to measure changes in the ‘cost of living’
CPI vs GDP Deflator
Prices of capital goods:
- Included in GDP deflator (if produced domestically)
- Excluded from CPI
Prices of imported consumer goods:
- Included in CPI
- Excluded from GDP deflator
Effects of Imports on GDP deflator vs CPI
If the average price level of import goods decrease:
- If the import is in CPI, then the CPI must decrease
If not:
- With import goods being cheaper, it gives pressure to domestic market (think of more competition), and eventually it decreases domestic prices
1) CPI should decrease because of lower prices
2) GDP deflator will decrease because of lower prices in the domestic market (in reaction to competition)
The classical view of inflation
- A change in the price level is merely a change in the units of measurement
- Inflation is a problem when wages don’t increase inflation
- Inflation is bad: most wages are fixed in nominal terms, if prices rise, your cost of living increases
- Inflation is good: unindexed inflation means that borrowers benefit as the money they owe is worth less in the future
The costs of inflation: Relative price distortions
- Firms change prices infrequently -> as general price level rises throughout the year, the firm’s relative price will fall
- Different firms change their prices at different times, leading to relative price distortions causing inefficiency in the allocation of resources
- Prices in higher inflation environment divorce from the relative scarcity by larger amounts
- Inflation does damage to prices
Mistakes and misperceptions of relative prices
- Consumers and firms may mistake nominal price changes for relative price changes
- E.g. they may feel that their purchasing power is falling when it is not.
- Two ways this is costly: Misallocation of resources, direct negative psychological effect
- Firm invest less, consumers consumer less
- Price misinformation, don’t represent scarcity
- People stressed about price changes = welfare hit
- A 2% target allows firms and consumers to be calm and to plan
Increased uncertainty
- The higher the inflation rate, the more variable and unpredictable it becomes
- This creates higher uncertainty, making risk averse people worse off
- Complicates financial planning
- Determines purchasing power of paying back loan
- People won’t buy bonds (inflation - lower interest rates and lower yields, will invest in other assets)
- Interest rates and yields are inversely proportional -> if you get paid back after inflation, purchasing power is less from dividends off bonds (as interest rates increase, yields decrease?)
Benefits of moderate inflation
Real wage flexibility
- Nominal wages are rarely reduced -> make recessions worse
- Inflation allows real wages to fall without nominal wage cuts
- Therefore, helps improve functioning of the labour market
Stay away from ELB
- Stay away from deflation
- Interest rate is difference between nominal interest and inflation
- A higher interest rate and inflation mean an AD shock is less likely to take us to ELB
Inflation targets
- In order to anchor expectations some central banks
- BoE: 2%, ECB: <2%
- If inflation gets too high (“baked” in annual price and wage changes), Central bank must engineer a recession with a sharp increase in rates to force price down
Hyperinflation
Common definition: Inflation > 50% per month
- Monetary inflation occurring at a very high rate
- Money rapidly lose value and purchasing power
- People won’t to buy now as things will become more expensive later, rapid spiral
- Not many in grey zone between inflation and hyperinflation
What cause hyperinflation?
- Hyperinflation is caused by excessive currency creation
- When the government prints money, the price level rises
- If it prints rapidly enough, the result is hyperinflation
What causes excessive money printing?
- Large budget deficits
- No room or political fiscal adjustment (want to stay in power)
- No access to capital markets
- Inability to increase taxes
- Cannot borrow -> already borrowed too much
- See Greece and Venezuela crises
Ending Hyperinflation
Political crisis first
Fiscal reform:
- Government less dependent on money printing
Monetary:
- Fixed rate of M growth
- Inflation target
- Fixed exchange rate (peg) -> more reliable cause gov can lie
Print too much money, and currency depreciates -> predict trade wars
Print too little, and it appreciates
