Lets take a look at inflation
What is inflation? Is defined as a consistent increase in the general (average)
price level. That means the entire basket of goods represented by the CPI or the
GDP deflator will be persistently affected.
Inflation shows the change in the price level between two time periods: this is
the rate of inflation.
Creeping inflation: would be moderate and involve a change in prices of a few
percent per year. Most nations of the world show this.
Normal between 1 and 6 %
Hyper inflation: is a situation where inflation hits triple digits
Brazil, 2500% during the 90’s Russia 150% 90’s Zimbabwe nov. 2008 was
89,700,000,000,000,000,000,000%
Core inflation is when economists exclude volatile goods such as oil and certain
agricultural goods.
What is the problem with inflation? It decreases the ability of money to function.
Almost every society uses some form of a money unit this is a medium of
exchange.
It also stores a value
It allows firms or consumers to defer payment
It also acts as a unit of account. Meaning it can put a value that is across the
board on all goods in a society.
What are the costs of inflation?
Redistribution effects of inflation.
The govt. taxes people and attempts to balance out income rich lose and poor
gain to make all equal.
Those on a fixed income become kind of unhappy.
Ex. My wifes grandparents who had a pension from the state of 100 rubles. Ship
captain.
Remember that the average salary in 1992 was aprox. 300 and state exchange
was 1dollar to 1 ruble.
A new car lada or zhiguli cost about 2000 rubles.
My father in law was military officer so he had a good salary aprox 200 rubles
He had a savings of aprox 20,000 rubles a lot of money in pre 92 terms but by
1995
This is when major inflationary pressure hit the state by the beginning of 1995
the ruble to the dollar was at 5,000 to 1, so he ended up with no money.
Two groups which stand to loose real income due to inflation are lenders and
savers, Inflation will eat away at an interest rate a bank creates for a loan,
therefore banks are far less likely to make loans, for the saver. As you can by the
last example, you can lose it all in a very short time.
Negative effects on growth: A lack of investment occurs which leads to firms
look at spending and loans rather than investing.
Behavioral distortions in the economy, ie it causes firms to become less secure
and unpredictable.
It can also lead to a breakdown of the monetary economy. This is only in
hyperinflationary situations. Many resort to getting rid of the money quickly or
barter.
Finally Exchange Rates; inflation is strongly linked to the external value of the
currency.
What are causes of inflation
Cost Push inflation: Is when you have an increase of factor costs on a macro
level.
It is also frequently associated with one off’s or increases in price level, known as
supply side shocks.
There are a number of causes of cost push inflation such as ages rising faster
than productivity gains in the economy, a fall in the exchange rate driving up the
price of imported raw materials and components, or an increase in factor prices
such as oil or labor.
Demand Pull inflation: AD might rise for a number of reasons such as
stimulatory monetary /fiscal policy, greater consumption or consumer
confidence, or expansion by firms.
Excessive Monetary growth: basically if you put more money into the
economy you will increase the value of goods. Causing inflation. But if the
economy can continue to produce more goods through growth, then the money
will be divided among the population better and diffuse the inflationary
pressure.
This is known as Monetary Transmission mechanism ( a monetarist view)
So remember that monetarist view inflation as a demand pull causation. They
also view money as relatively inelastic, so an increase in the supply of money will
have a large impact on firms investments and households consumption.
Neo Classical view of money driven inflation: LR effects
it is important to understand that monetarist view that any increase in money
that is not matched with an increase in real potential output LRAS as being soley
inflationary in the lr. As the increase in the AD has pushed output beyond LRAS,
the increase in real GDP will not last, since wages will rise to match labor
demand, basically the same as the monetarist. Milton Friedman being one of the
most famous monetarists.
How to Measure Inflation
Use of the CPI
Problems with the methods of measuring inflation.
the biggest problem lies with averages, with that each household will not be
equally affected by inflation.
Also Quality and novelty bias; products improve over time some them a lot. Look
at computers. The CPI does not take this into account.
Substitution bias; The CPI does not adequately take into account that consumers
will substitute expensive goods for lower priced goods.
Weight and content bias; another way in which the CPI overestimates inflation
due to time lags arises when a good becomes obsolete. The CPI needs to keep up
with current household needs.
A neoclassical or monetarist view says that no they will not suffer from this view
and will therefore adapt to changing inflation rates by altering their inflationary
expectations.
Meaning you will expect higher wages on the expectations of higher inflationary
pressure.
Deflation and its consequences
What is deflation: is a decrease in the average price level or an increase in the
value of money. And can be a major threat to an economy.
There are two basic causes of deflation; one is extremely bad and the other is
good. Deflation due to a fall in Ad (known as demand deficient deflation) is a
threat to an economy. Which can lead to a worsening recession, in which firms
faced with continuously falling prices lay off increasing numbers of workers,
lowering disposable incomes and further worsening the deflationary pressure in
the economy.
If deflation is caused by an increase in productivity of the nations resources or
lower costs of production to firms, it is considered desirable. (supply side
deflation)
Causes of Supply side Deflation
Lower oil prices
More productive labor force
Appreciation of a nations currency, where much of the raw materials of
production are imported.
Lower min. wage
Better infrastructure
A demand deficient recession leads to rising unemployment and puts
downwards pressure on the price level. Following a decrease in expenditures,
prices tend to be inflexible in the short run and AD moves along the horizontal
portion of the AS curve. The longer the recession the greater the downwards
pressure on prices.
The costs of Deflation are
Rising unemployment
Falling investment
Falling consumption and increased savings
Increased debt burden on households
Falling net exports.
Phillips Curve
This will explain money illusion. Ie assume that with the rightward shift workers
have agreed to a 3% increase in yearly wage yet inflation is at 3.5% that means
workers may be gaining something but are taking a wage loss of 0.5% this is
called money illusion. IT will ultimately adjust demand and spending to real
wages. (slowing down AD) thus deflationary pressure will lower inflation and
increase unemployment.
Do laborers suffer from money illusion?
Lets looks at the short run phillip curve, why does it work in the SR and not the
Lr as seen by the 70s and stagflation.
Use cost push diagram and spiral to explain or understand
Short run Phillips curve – criticism of neoclassical school
Show diagram of expanded AD and SR Phillips curve