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Chapter IV: Prices and Inflation


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 ... – PowerPoint PPT presentation

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Title: Chapter IV: Prices and Inflation

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

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

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
  • 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

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

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

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

Example A Laspeyres price index
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)

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

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

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

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

Real GDP and the GDP deflator
  • The GDP deflator is defined as follows

Nominal GDPReal GDP
GDP deflator
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
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
  • Or should we use the one at time t, which
    changes period by period?
  • The answer is not obvious!

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
  • households reduce the demand for gasoline and
  • increase the use of substitute means of
    transportation (for instance subways)

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)

Reading Oil shock and prices
Reading 4-2Pistol pointed at the heart, The
Economist, May 29th, 2008
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
The inflation rate and the growth rate
  • The annual inflation rate is calculated as
  • The annual growth rate is calculated as

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

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

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

Phillips curve
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

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

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

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
  • So the case discussed here is a one-time price
    adjustment only, not necessarily inflation
  • How then is inflation generated?

Why is there inflation?
  • Inflation could result from activist economic
  • 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

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

Cost-push inflation
Price level
Each time the priceincrease feedsback into
wagesand costs
Inflation is dueto accommodatingfiscal policy
Aggregate output
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

Demand-pull inflation
Price level
Fiscal policy drivesprices up, and each time
the price increase feeds back into wagesand
Aggregate output
The role of monetary policy
  • But neither cost push nor demand pull could
    provoke inflation without monetary expansion

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

Phillips curve for Germany
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
  • This process is called hysteresis
  • It is exacerbated by structural changes in the
    economy (the production function)

Inflation and hysteresisof unemployment
The dynamics of the Phillips curve
Turning clock-wise does in fact support the
thesis that expansionary policy is followed by
The shift toward the right supports hysteresis
  • Abel, Bernanke and Croushore, Chapter 12.1 and

Is inflation so bad?
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 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
  • treats dividends and debt charges differently

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

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

Hedging against inflation
  • The distributional effects largely depend on
    whether inflation is expected, or not
  • If inflation is expected, it could be built into
  • 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

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
  • In 1992 the scala mobile was repealed
  • The central bank became more independent

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

  • Abel, Bernanke and Croushore,
  • Chapter 12.3

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

ExampleGermany after WW I
Hyperinflation in Germany
The German hyperinflation 1922-23
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.

Discussion 4Inflationary risks and corporate
  • 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

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