Lecture 4 ~ Macroeconomics
Basic Elements of Macroeconomics
Macroeconomic Objectives
• Distinction between microeconomics and
macroeconomics
• The major macroeconomic issues
– economic growth
– unemployment
– inflation
– balance of payments and exchange rates
• balance of payments deficits and surpluses
• exchange rate movements
Economic growth (average % per annum),
Unemployment (average %), Inflation (average % per annum)
France Germany Italy Japan
UK
USA EU(15) OECD Brazil Malaysia Singapore
Growth
1960-9
1970-9
1980-9
1990-9
7.5
3.2
2.2
1.7
4.4
2.6
1.8
2.1
5.3
3.8
2.4
1.4
10.9
4.3
4.0
1.3
2.9
2.0
2.4
2.2
4.3
2.8
2.5
3.3
3.5
3.2
2.2
1.9
4.6
3.6
2.6
2.4
5.4
8.1
3.0
3.2
6.5
7.9
5.8
7.8
8.8
8.3
6.1
8.6
Unemployment
1960-9
1970-9
1980-9
1990-9
1.5
3.7
9.0
11.2
0.9
2.3
5.9
7.5
5.1
6.4
9.5
10.6
1.3
1.7
2.5
3.0
2.2
4.5
10.0
5.8
4.1
6.1
7.2
5.8
2.5
4.0
9.3
9.9
2.5
4.3
7.3
7.2
n/a
n/a
n/a
n/a
n/a
n/a
6.2
3.9
n/a
n/a
3.6
2.6
Inflation
1960-9
1970-9
1980-9
1990-9
4.2
9.4
7.3
1.9
3.2
5.0
2.9
2.5
4.4
13.9
11.2
3.9
4.9
9.0
2.5
1.1
4.1
13.0
7.4
3.5
2.8
6.8
5.5
2.8
3.7
10.3
7.4
3.2
3.1
9.2
8.9
4.9
46.1
38.6
227.8
300.9
-0.3
7.3
2.2
3.8
1.1
5.9
2.5
2.0
Macroeconomics
• MACRO is concerned with economic aggregates
and averages.
• Aggregates:
Gross Domestic Product (GDP) is a standard
measure of aggregate economic activity
The rate of unemployment
• Averages:
The Average level of prices & the rate of
inflation
Gross Domestic Product: GDP
• Gross Domestic Product (GDP) is a standard
measure of aggregate economic activity
GDP measures the total value of the economy’s
output of final goods & services.
GDP also measures the income earned by the
economy’s factors of production – labour, land
& capital.
GDP
• GDP can be measured in NOMINAL or in REAL
terms
Nominal: the € value of the economy’s output
Real: Nominal GDP divided by the average
price of all goods & services.
The economy’s rate of growth is measured by
the annual percentage change in real GDP.
Average Growth Rates (%): 1960-2002
IRL
EU
USA
JPN
1961-70
4.2
4.9
4.2
10.1
1971-80
4.7
3.0
3.2
4.4
1981-90
3.6
2.4
3.2
4.2
1991-00
7.0
2.1
3.4
1.3
1998-02
8.7
2.9
3.7
0.7
Source: European Commission
Growth Rates (%): 1960 – 2002.
12
10
Ireland
8
6
EU
4
2
0
1960
1970
1980
1990
2000
Source: European Commission
Measuring GDP
• GDP can be defined as:
• The market value of all final goods & services
produced in a given time period (one year)
• Market value simply means the money value of
the economy’s output
If we produce 1m computers at a price of
€1,000 each the market value is €1,000m
• To aggregate over different goods we must
measure in money terms – market value
Measuring GDP
• Final Goods: Goods & services which are
purchased & consumed by the final user
• Other goods & services which are used in the
production of final goods are not counted in GDP
– intermediate goods
• Including intermediate goods would imply double
counting & overstate GDP
Measuring GDP
• Consider the following example
• Three stages in producing a litre of milk
Farmer produces raw milk & sells it to a dairy
for processing
Dairy sells it to a retailer who then sells it to the
consumer
In € terms what contribution does the litre of
milk make to GDP?
Measuring GDP
• Suppose the farmer has zero costs and:
Processor pays farmer €0.70
Retailer pays the processor €1.20
Consumer pays the retailer €1.50
• Total value of all transactions is €3.40
• The contribution to GDP is the value of the final
purchase (€1.50) not the total value of all
transactions (€3.40) WHY?
Measuring GDP
• The processor pays the farmer €0.70 per litre
As the farmer has zero costs his income = €0.70
• The processor sells to the retailer at €1.20 per litre
Hence the processor’s net income = €0.50
• The retailer sells to the consumer at €1.50
Hence the retailer’s net income = €0.30
Measuring GDP
• Hence the net income or VALUE ADDED at each
stage is:
Farmer:
€0.70
Processor: €0.50
Retailer:
€0.30
• Total:
€1.50
• Which equals final expenditure by the consumer
Measuring GDP
• The purchase of raw milk by the processor
from the farmer is an intermediate purchase
• It is part of the farmer’s income but not the
processor’s income
• To include it in both would lead to double
counting & overstate GDP
• The same holds for the purchase of
processed milk by the the retailer
Measuring GDP
• GDP is the sum of the net income or value added
at each stage of production
• This sum equals the market value of the final
purchase
• The economy's GDP is measured in two ways
The Expenditure Method
The Income Method
Calculating GDP: Expenditure Method
• GDP = total amount spent on all final goods in a
given year
• Final goods & services are bought by 4 sectors:
Individual Consumers or Households
Firms
Government
The Foreign Sector or Rest of the World
(ROW)
Calculating GDP: Expenditure Method
Expenditure by:
Households: Consumption (C)
Firms: Gross Investment (I)
Government: Purchases of goods & services
(G)
ROW: Expenditure on exports (EX) less
domestic expenditure on imports (IM): net
exports NX = (EX – IM)
• Total expenditure on GDP = C + I + G + NX
Calculating GDP: Expenditure Method
• Consumption (C): Household or personal
expenditure on goods & services
• Investment (I): Expenditure by firms on fixed
capital formation plus changes in inventories
• Government Expenditure (G) includes:
Wages & salaries paid to all government
employees
Expenditures on office supplies, military
equipment, roads etc.
• It does not include transfer payments
Calculating GDP: Expenditure Method
• Net Exports (NX) = Exports - Imports
• Exports : sales of domestically produced goods &
services to foreigners
• Imports: domestic purchases of foreign produced
goods & services
• Denote GDP as Y: Hence Y is the sum of four
different types of expenditure. That is:
• Y = C + I + G + NX
Origins of GDP, 2001
Ireland
UK
US
Sector of the Economy
% of GDP
% of GDP
% of GDP
Agriculture
3.7
1.1
1.4
Mining
0.4
3.3
1.4
Manufacturing
40.8
18.4
15.8
Utilities
0.9
1.6
2.3
Construction
4.3
5.2
4.7
Wholesale & retail trade,
Restaurants & Hotels
7.7
15.9
15.9
Transport, Storage &
Communications
3.8
8.0
6.0
Finance, Insurance, Real Estate
& Business Services
13.0
24.1
19.6
Community, personal & social
services
9.5
11.3
22.1
Other
55.5
11.1
10.8
Total
100.00
100.00
100.00
Nominal & Real GDP
• GDP is measured in money terms (€’s)
• Suppose the economy produces n different final
goods & services (computers, potatoes, phones
etc.)
• Let Qi = the output of any good i (number of
computers etc)
• Let Pi = the price of good i in €’s
• PiQi = nominal or money value Qi
Nominal & Real GDP
• As there are n goods & services, nominal
GDP is:
Y = P1Q1 + P2Q2 + … + PnQn
• Suppose we want to compare GDP in two
years 1 & 2
• Suppose there are two goods A & B
• QAi & QBi = production in each year, i = 1,2
• PAi & PBi = prices in each year, i = 1,2
Nominal & Real GDP
•
•
•
•
Nominal GDP in each year is:
Y1 = PA1QA1 + PB1QB1
Y2 = PA2QA2 + PB2QB2
Y1 & Y2 measure nominal GDP at current year
prices
• Y can change for two reasons
• Production changes and/or prices change
• If we want to compare economic activity in the
two years we need to exclude the effects of price
changes.
Nominal & Real GDP
•
•
•
•
•
QA1 = 10, QB1 = 15, PA1 = €10, PB1 = €5
Y1 = €175
QA2 = 20, QB2 = 30, PA2 = €12, PB2 = €6
Y2 = €420
Production of each good has doubled (100%
increase) but Y has increased by 140%
• The rise in nominal GDP overstates the
increase in economic activity
Nominal & Real GDP
• Real GDP corrects for this by measuring the value
of each year’s production at constant prices
• Suppose we use Year 1 prices: the base year
• Year 1 GDP at year 1 prices is €175
• Year 2 GDP at year 1 prices is:
• PA1QA2 + PB1QB2 = €350
Nominal & Real GDP
• Hence: evaluating each year’s production at
constant (year 1) prices gives:
 Real GDP in year 1 = €175
 Real GDP in year 2 = €350
• Increase = 100% which reflects the increase in
production only
• Nominal GDP evaluates production at current
prices
• Real GDP evaluates production at constant prices
Nominal & Real GDP
•
•
•
•
•
Note: we can also use year 2 as the base year:
Y1 at year 2 prices = €210
Y2 at year 2 prices = €420
Increase = 100%
The following graph shows Irish nominal & real
GDP over 1995-2000: Real GDP is measured at
1995 prices
Irish Nominal & Real (1995 prices) GDP
£billion
Nominal
Real
100
80
60
40
20
0
1995 1996 1997 1998 1999 2000
Source: National Income & Expenditure
GDP & Economic Welfare
• Real GDP is a measure of economic activity
• It is not necessarily a good measure of economic
welfare or economic well-being
• Increases in real GDP imply that the economy is
producing more goods & services & that we can
increase consumption
• However GDP excludes activities which may
affect overall economic welfare
GDP & Economic Welfare
• Pollution: Increases in real GDP may result in
increased pollution which reduces economic
welfare. The cost of pollution is not included in
GDP
• GDP does not reflect the distribution of income
and economic inequalities.
• Non-Market Activities such as home-making &
volunteer services may increase welfare but are
not included in GDP
GDP & GNP
• GNP is Gross National Product:
• GNP = GDP + Net Factor Income from the Rest of
the World (NFI)
• In any given year Irish residents & firms make and
receive payments to & from the ROW (other than
those for exports & imports) – interest, dividends,
profits etc.
GDP & GNP
• Irish households may own foreign assets:
Shares in UK or US firms & receive annual
dividends
Deposits in foreign banks & receive annual
interest payments
• Irish firms may receive profits from investment in
other countries
• These payments are an income flow from the
ROW to Ireland
GDP & GNP
• Foreign households may own Irish assets:
Shares in Irish firms & receive annual
dividends
Deposits in Irish banks & receive annual
interest payments
• US firms operating in Ireland may send the profits
back to their parent firm in America
• These payments are an income flow from Ireland
to the ROW
GDP & GNP
• Net Factor Income (NFI) is:
• NFI = interest, dividends profits etc. received from
the ROW minus similar payments to the ROW
• GNP = GDP + NFI
• In large countries the difference tends to be small.
• For Ireland it is large: Typically NFI < 0 & GDP >
GNP
• In 2000 NFI was approximately -£12.8b or 16% of
GDP
Irish Real GDP & GNP (1995 prices)
£billion
GDP
GNP
100
80
60
40
20
0
1995
1996
1997
1998
1999
2000
Source: National Income & Expenditure
Real GDP and GNP growth rates compared,
1991 – 2002
12%
10%
8%
6%
4%
2%
0%
1991
1996
GDP
2001
GNP
Real GDP and GNP compared
(1995 prices)
105
GDP
95
billion €
85
75
GNP
65
55
45
35
25
1990
1992
1994
1996
1998
2000
2002
10
Growth rates in selected industrial countries
UK
France
Annual growth rate (%)
9
8
Germany
USA
7
6
5
4
3
2
1
0
-1
-2
-3
1970
1975
1980
1985
1990
1995
2000
Irish and US growth rates compared,
1991 – 2002
12%
IRL
10%
8%
6%
USA
4%
2%
0%
-2%
1991
1996
2001
Economic Growth and
the Business Cycle
• Growth in actual and potential output
• Economic growth and the business cycle
– fluctuations in actual growth
The business cycle
National output
Potential output
Actual
output
O
Time
Economic Growth and
the Business Cycle
• Growth in actual and potential output
• Economic growth and the business cycle
– fluctuations in actual growth
– the phases of the business cycle
The business cycle
National output
Potential output
3
2
3
4
2
1
1
O
Time
4
Actual
output
Economic Growth and
the Business Cycle
• Growth in actual and potential output
• Economic growth and the business cycle
– fluctuations in actual growth
– the phases of the business cycle
– trend growth
The business cycle
Potential output
National output
Trend
output
Actual
output
O
Time
Economic Growth and
the Business Cycle
• Economic growth and the business cycle
– fluctuations in actual growth
– the phases of the business cycle
– trend growth
– the business cycle in practice
• the irregularity of the cycle
• the length of the phases
• the magnitude of the phases
Economic Growth and
the Business Cycle
• Causes of actual growth
– aggregate demand
– aggregate demand relative to potential output
• Actual growth in practice
– experience since 1970
Real GDP Ireland 1960-99 (£ Billion, 1998 Prices)
£100
Celtic Tiger
50
61
Recession Mid 80’s
1973-75 Recession
Recession Early 90’s
11
£10
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
Fig. 24.1
Fluctuations in U.S. Real GDP,
1920-1999
Economic Growth and
the Business Cycle
• Causes of potential growth
– increases in the quantity of factors
•
•
•
•
capital
labour
land and raw materials
the problem of diminishing returns
– increases in factor productivity
• Policies to achieve growth
– demand-side and supply-side policies
– market-orientated & interventionist policies
Macroeconomic Policies
• Crucial to distinguish between:
• Growth policies (long-run) and Stabilisation
policies (short-run)
Growth policies attempt to increase the longrun or average growth rate
Stabilisation policies attempt to dampen the
business cycle – keep actual GDP close to the
trend
Macroeconomic Policies
• Growth Policies – support for education, training,
R&D etc.
• Stabilisation Policies: Two types
Fiscal or Budgetary Policy – changes in rates of
taxation, government expenditure plans etc.
Monetary Policy – changes in interest rates &
exchange rates.
Macroeconomic Policies
• We will see that Irish participation in the euro
means:
• A complete sacrifice of monetary independence
 Irish interest rates etc. now determined in
Frankfurt
• Strict limitations on fiscal policy
The Stability Pact
Aggregate Demand and Supply
• The aggregate demand curve
Price level
Aggregate demand and aggregate supply
AD
O
National output
Aggregate Demand and Supply
• The aggregate demand curve
– Why aggregate demand curves slope
downwards
• import effect
Price level
Aggregate demand and aggregate supply
AD
O
National output
Aggregate Demand and Supply
• The aggregate demand curve
– Why aggregate demand curves slope
downwards
• import effect
• interest-rate effect
Price level
Aggregate demand and aggregate supply
AD
O
National output
Aggregate Demand and Supply
• The aggregate demand curve
– Why aggregate demand curves slope
downwards
• import effect
• interest-rate effect
• savings effect
Price level
Aggregate demand and aggregate supply
AD
O
National output
Aggregate Demand and Supply
• The aggregate demand curve
– Why aggregate demand curves slope
downwards
• import effect
• interest-rate effect
• savings effect
• The aggregate supply curve
Aggregate demand and aggregate supply
Price level
AS
AD
O
National output
Aggregate Demand and Supply
• The aggregate demand curve
– Why aggregate demand curves slope downwards
• import effect
• interest-rate effect
• savings effect
• The aggregate supply curve
– Why aggregate supply curves generally slope upwards
Aggregate demand and aggregate supply
Price level
AS
AD
O
National output
Aggregate Demand and Supply
• The aggregate demand curve
– Why aggregate demand curves slope downwards
• import effect
• interest-rate effect
• savings effect
• The aggregate supply curve
– Why aggregate supply curves generally slope upwards
• Equilibrium
Aggregate demand and aggregate supply
Price level
AS
Pe
AD
O
National output
Aggregate demand and aggregate supply
Price level
AS
Pe
P2
b
a
AD
O
National output
Aggregate Demand and Supply
• The aggregate demand curve
– Why aggregate demand curves slope downwards
• import effect
• interest-rate effect
• savings effect
• The aggregate supply curve
– Why AS curves generally slope upwards
• Equilibrium
– Effect of a shift in the AD curve
Unemployment
• Unemployment is the total number of people not
working but seeking employment in the economy
• The rate of unemployment is the percentage of the
labour force who are unemployed
Labour force: Number employed plus the
number unemployed
Unemployment Rates (%): 1960 – 2002.
18
16
Ireland
14
12
10
8
EU
6
4
2
0
1960
1970
1980
1990
2000
Source: European Commission
Unemployment rates in selected industrial countries
UK
France
Unemployment (% of workforce)
14
Germany
USA
12
10
8
6
4
2
0
1970
1975
1980
1985
1990
1995
2000
Unemployment
• Unemployment and the labour market
– the aggregate demand and supply of labour
– equilibrium in the model
Aggregate demand and supply of labour
Average (real) wage rate
ASL
We
ADL
O
Qe
No. of workers
Unemployment
• Unemployment and the labour market
– the aggregate demand and supply of labour
– equilibrium in the model
– disequilibrium unemployment
Disequilibrium unemployment
Average (real) wage rate
ASL
B
A
W2
We
ADL
O
Q
2
Q
1
No. of workers
Unemployment
• Unemployment and the labour market
– the aggregate demand and supply of labour
– equilibrium in the model
– disequilibrium unemployment
– equilibrium unemployment
Equilibrium unemployment
Average (real) wage rate
ASL
e
We
ADL
O
Qe
No. of workers
Equilibrium unemployment
Average (real) wage rate
ASL N
e
We
d
ADL
O
Qe
Q2
No. of workers
Equilibrium and disequilibrium unemployment
Average (real) wage rate
ASL
e
We
ADL
O
Qe
No. of workers
Equilibrium and disequilibrium unemployment
Average (real) wage rate
ASL
Disequilibrium
unemployment
b
a
W2
e
We
ADL
O
No. of workers
Equilibrium and disequilibrium unemployment
Average (real) wage rate
ASL
Disequilibrium
unemployment
b
a
W2
N
c
e
We
Equilibrium
unemployment
ADL
O
No. of workers
Unemployment
• Disequilibrium unemployment
– real-wage (classical) unemployment
– demand-deficient (cyclical) unemployment
– unemployment arising from a growth in the
labour supply
Unemployment
• Equilibrium unemployment
– frictional (search) unemployment
– structural unemployment
• changing pattern of demand
• technological unemployment
• regional unemployment
– seasonal unemployment
The CPI & Inflation
• Inflation is normally measured by the annual
percentage change in the Consumer Price Index
(CPI)
• The CPI is an average price of a standard basket of
goods & services
• It is measured by comparing the cost of a fixed
basket at each year’s prices
The CPI & Inflation
• Example; Consider three goods: A, B & C
• Suppose that in a given year (year 1) the
typical household purchases:
• 1 unit of A at €100 per unit:
€100
• 10 units of B at €8 per unit:
€80
• 20 units of C at €6 per unit:
€120
• Total cost at Year 1 prices =
€300
The CPI & Inflation
• Suppose in a subsequent year (year 2) the prices
are:
• €105 for A, €10 for B & €6.25 for C
• The same quantities will cost:
• A: 1 at €105
€105
• B: 10 at €10
€100
• C: 20 at €6.25
€125
• Total cost at Year 1 prices = €330
The CPI & Inflation
• Cost of the fixed basket (same quantities of each
good)
• At year 1 prices: €300
• At year 2 prices: €330
• Hence relative to year 1, the average price of the
same basket in year 2 is 330/300 = 1.1
• Hence the CPI compares the cost of a fixed basket
of goods & services at the prices in each year
The CPI & Inflation
• Note that the CPI is a price index
• A price index measures the average price of a
fixed basket of goods & services relative to the
prices in the base year.
• In Ireland the CPI is computed in two stages
A price index is computed for each commodity
group – housing, fuel, clothing, food etc.
The CPI is the weighed average of these indices
using base year expenditure weights.
The CPI & Inflation
• Price index for each commodity group is:
• Current year price
 divided by
• Base year price
• Year 1 (base year) prices:
A €100: B €8: C €6
• Year 2 prices:
A €105: B €10: C €6.25
The CPI & Inflation
• Year 1 Indices (base year)
A
100/100 = 1
B
8/8 = 1
C
6/8 = 1
• Year 2 Indices:
A
105/100 = 1.05
B
10/8 = 1.25
C
6.25/6 = 1.04
The CPI & Inflation
• Base year expenditure weights:
• Base year expenditure on each good
Divided by
• Total base year expenditure (€300)
A:
100/300 = 0.33
B:
80/300 =
0.27
C:
125/300 = 0.4
Price Indices
Year 2
A
Base
Year
1
1.05
B
1
C
1
Weights
Price Indices times
Weight
Year 2
0.33
Base
Year
0.33
1.25
0.27
0.27
0.33
1.04
0.40
0.40
0.42
1.00
1.1
CPI = Sum of Indices times the
Weights
0.35
Irish CPI Weights: % (Base Dec. 2001)
•
•
•
•
•
•
Food
Alcohol
Tobacco
Clothing
Fuel & Light
Housing
20.8
11.9
4.4
4.9
3.3
9.7
• Durable Household
Goods
3.6
• Other Goods
5.8
• Transport
15.4
• Services
20.2
• TOTAL: 100%
Inflation Rates (%): 1960 – 2002.
25
Ireland
20
15
10
EU
5
0
1960
1970
1980
1990
2000
Source: European Commission
Inflation rates in selected industrial countries
Inflation (% increase in retail prices)
26
USA
UK
EU 15
24
22
Japan
20
18
16
14
12
10
8
6
4
2
0
-2
1965
1970
1975
1980
1985
1990
1995
2000
Inflation
• Types of inflation
– demand pull
Demand-pull inflation
Price level
AS
P1
AD1
O
Q1
National output
Demand-pull inflation
Price level
AS
P1
AD2
AD1
O
Q1
National output
Demand-pull inflation
Price level
AS
P2
P1
AD2
AD1
O
Q1 Q2
National output
Inflation
• Types of inflation
– demand pull
– cost push
• wage push
• profit push
• import-price push
Cost-push inflation
Price level
AS1
P1
AD
O
Q1
National output
Cost-push inflation
AS1
Price level
AS2
P1
AD
O
Q1
National output
Cost-push inflation
Price level
AS2
AS1
P2
P1
AD
O
Q2
Q1
National output
Inflation
• Types of inflation
– demand pull
– cost push
• wage push
• profit push
• import-price push
– the interaction of demand-pull and cost-push
inflation
The interaction of demand-pull and cost-push inflation
Price level
AS1
P1
AD1
O
National output
The interaction of demand-pull and cost-push inflation
Price level
AS2
AS1
P2
P1
AD2
AD1
O
National output
The interaction of demand-pull and cost-push inflation
AS3AS
Price level
2
AS1
P3
P2
AD3
P1
AD2
AD1
O
National output
Inflation
• Types of inflation
– demand pull
– cost push
• wage push
• profit push
• import-price push
– the interaction of demand-pull and cost-push
inflation
– structural (demand shift)
Inflation
• Types of inflation
– demand pull
– cost push
• wage push
• profit push
• import-price push
– the interaction of demand-pull and cost-push
inflation
– structural (demand shift)
– expectations and inflation
Inflation
• Policies to tackle inflation
– demand-side policies
– supply-side policies
Nominal & Real Quantities
• A nominal quantity is measured in current euro
terms
• A real quantity is measured in physical terms –
quantities of goods & services
• Two examples:
Real wages & incomes
Real interest rates
Nominal & Real Quantities
• Suppose a household earns €30,000 in 2001
and €31,500 in 2002 (a 5% increase)
• Is the household better-off? Does the 5%
increase in nominal income permit it to buy
more goods & services?
• The answer depends on the CPI
• In any year the household’s real income is:
Its nominal income/CPI
Real & Nominal Interest Rates
• Suppose you save €100 at a bank with an annual
deposit interest rate of 5%.
• After 1 year you will have €105:
€100 capital plus €5 interest.
• The €5 the nominal interest on your savings
• Question: are you better or worse off by saving
€100 for 1 year?
• OR: Does €105 buy more or less than €100 would
one year ago?
Real & Nominal Interest Rates
• Suppose that over the year the CPI increases by
5%
• This means that the real purchasing power of €105
at the end of the year is the same as the real
purchasing power of €100 at the start of the year
• OR: the real return on your saving is zero.
Real & Nominal Interest Rates
• To be more formal let:
• i = the nominal interest rate (5% in the previous
example)
• π = rate of inflation (% change in CPI)
• The the real rate of interest (r) is:
r=i–π
Real & Nominal Interest Rates
•
•
•
•
Let i = 5% & π = 4%
The the real rate of interest (r) is:
r = i – π = 5 – 4 = 1%
Hence if you save €100 at 5% your real return is
1%
• That is: €105 buys 1% more than €100 did a year
ago.
Real & Nominal Interest Rates
•
•
•
•
Let i = 5% & π = 6%
The the real rate of interest (r) is:
r = i – π = 5 – 6 = -1%
Hence if you save €100 at 5% your real return is 1%
• That is: €105 buys 1% less than €100 did a year
ago.
Actual & Expected Inflation
• Many contracts are agreed in nominal terms
You deposit €100 in a bank at a nominal fixed
interest of 5%
Unions agree to a nominal wage increase of 5%
etc.
• When the contract is agreed the expected real
return is:
The nominal or money increase minus the
expected inflation rate over the contract period
Actual & Expected Inflation
• For example: If you expect inflation to be 3% then
saving at 5% nominal interest means that you
expect a real return of 2%.
• However the expected real outcome will only be
realised if the actual inflation rate equals the
expected inflation rate
• Two examples:
Savers & Borrowers
Workers & Employers
Savers & Borrowers
• Normally the nominal interest rate for borrowing
is greater than the nominal rate for saving
• Let saving rate = 5%
• And borrowing rate = 7%
• Suppose both savers & borrowers expect inflation
to be 4% over the coming year.
• Expected real return to saving = 1% per year
• Expected real cost of borrowing = 3% per year
Real & Nominal Interest Rates
• Suppose the expected or forecasted inflation rate
turns out to be incorrect & actual inflation is 6%
rather than 4%
• That is: inflation is 2% higher than expected
• Actual real return to saving = 5 – 6 = -1%
• Actual real cost of borrowing = 7 – 6 = +1%
• Hence, an unanticipated rise in inflation makes
savers (lenders) worse-off and borrowers betteroff.
Real & Nominal Interest Rates
• Conversely actual inflation is 3% rather
than 4%
• That is: inflation is 1% lower than expected
• Actual real return to saving = 5 – 3 = 2%
• Actual real cost of borrowing = 7 – 3 = 4%
• Hence, an unanticipated fall in inflation
makes savers (lenders) better-off and
borrowers worse-off.
Real & Nominal Interest Rates
•
•
•
•
The the real rate of interest (r) is:
r = i – π OR the nominal rate is:
i=r+π
Hence, given r, nominal interest rates (i) will be
positively correlated with inflation
• The Fisher Effect: Nominal interest rates tend to
be high (low) when inflation is high (low)
Workers & Employers
• Suppose workers (unions) & employers expect
inflation to be 5% and agree a nominal wage
increase of 5%. Hence:
• Workers expect their real standard of living to be
maintained
• Employers expect the real cost of hiring labour to
be constant
Workers & Employers
• Suppose actual inflation turns out to be 6% over
the contract period.
• That is: unanticipated inflation = +1%
• Result: real wages fall by 1%
• Workers are worse-off because real living
standards have declined
• Employers are better-off because the real cost of
hiring labour has fallen
Workers & Employers
• Suppose actual inflation turns out to be 4% over
the contract period.
• That is: unanticipated inflation = -1%
• Result: real wages increase by 1%
• Workers are better-off because real living
standards have increased
• Employers are worse-off because the real cost of
hiring labour has increased
The Costs of Inflation
• These examples suggest that so long as inflation is
correctly forecast it is not a problem.
• Let π = actual inflation, πe = expected inflation
• Suppose: π = πe: Inflationary expectations are
always correct
• So long as nominal interest rates, wages etc.
change with expected inflation
• Real interest rates & real wages will be constant
The Costs of Inflation
•
•
•
•
•
•
•
Suppose savers will accept a real return of 3%
If π = πe = 2%
A nominal interest rate i = 5%
Gives a real rate: r = i – π = 3%
If π = πe = 10%
A nominal interest rate i = 13%
Gives a real rate: r = i – π = 3%
The Costs of Inflation
• Likewise, if money wages always rise in line with
inflation then real wages will be constant at all
inflation rates
• If the % change in money wages = πe and π = πe
• Then the real wage will be the same irrespective
of the rate of inflation
• Why then is high inflation considered a problem?
The Costs of Inflation
• High inflation can impose costs especially if it is
unexpected.
• We have seen that when contracts are fixed in
money terms an unanticipated rise in inflation
leads to a redistribution of income:
From savers to borrowers
From workers to employers
The Costs of Inflation
• Irish wage bargaining process – Social Partnership
• Fixes nominal wage increases for a 2/3 year period
• If inflation is higher than expected real wages &
incomes will be lower than expected
• This happened in 2000-01 & the current
agreement (PPF) had to be renegotiated.
The Costs of Inflation
• Inflation can also distort the tax system.
• Suppose: First €10,000 of income is tax exempt &
all additional income is taxed at 20%
• A household earning €20,000 would pay
Zero on the first €10,000
20% or €2,000 on the next €10,000
Total tax = €2,000 or 10% of total income
The Costs of Inflation
• Suppose: Over time income doubles to €40,000
but real incomes remain the same (money income
rises with inflation)
• A household earning €40,000 would pay
Zero on the first €10,000
20% or €6,000 on the next €30,000
Total tax = €6,000 or 15% of total income
The Costs of Inflation
• Hence unexpected increases in inflation can lead
to a redistribution of income & wealth:
Between savers & borrowers
Between workers & employers
Between taxpayers & government
The Costs of Inflation
• To avoid these problems interest rates, wages,
pensions and tax bands are sometimes indexed to
the rate of inflation
• In the previous example the tax exempt band
would be raised to €20,000:
• A household earning €40,000 would pay
Zero on the first €20,000
20% or €4,000 on the next €30,000
Total tax = €4,000 or 10% of total income
The Costs of Inflation
• Inflation has other costs:
• “Shoe-Leather” Costs:
• Inflation erodes the real value or purchasing
power of cash holdings
• The higher the inflation rate, the greater the
amount of cash required to finance a given volume
of transactions – see example 19.8
The Costs of Inflation
•
•
•
•
•
Distorting the Price System:
Let P = CPI, Px = price of good X
Px/P = the relative price of X
Suppose P rises in line with wages, costs etc.
An increase in Px/P is a signal that it is profitable
to increase the production of X
• In an efficient economy resources will be allocated
towards goods whose relative prices are rising &
away from those whose relative prices are falling
The Costs of Inflation
• When inflation is high & variable there is “noise”
in the price system
• More difficult to interpret relative price changes
• Leading to distortions in resource allocation
Is The CPI a Good Measure of Inflation?
• Inflation is normally measured by the % change in
the CPI.
• The CPI suffers from the problems of Substitution
Bias and Quality Adjustment Bias
• Boskin Commission (US, 1996) estimates that
these effects can overstate inflation by 1-2% per
year.
Is The CPI a Good Measure of Inflation?
• Substitution Bias
• The CPI is a weighted average of the prices of
goods & services in the “typical” consumption
basket
• This basket may change over time because:
• Relative prices change – less expensive goods are
substituted for more expensive goods
• Tastes change or new goods become available –
how much olive oil was bought in Ireland 30 years
ago?
Is The CPI a Good Measure of Inflation?
• Quality Adjustment Bias:
• The CPI does not adjust for changes in quality
• Suppose that the price of this year’s computer is
10% higher than last year’s.
• This years’s model may have more memory, faster
processing speed etc.
• The price per unit of computing power may have
increased by less than 10% over may have fallen