Chapter IV: Prices and Inflation

1. 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

2. 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

3. Measuring prices:Two 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

4. 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

5. 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,0and current prices pi,t for that basket

6. 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”

7. Problems of the Laspeyres index • 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) The CPI according to Laspeyres overstates the cost of living

8. 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

9. 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

10. “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

11. Real GDP Real GDP is measured in prices of a base year For instance:Real GDP of 2005(in prices of 2000):

12. Real GDP and the GDP deflator The GDP deflator is defined as follows: Nominal GDPReal GDP GDP deflator =

13. Reading Reading 4-1“Fighting America’s inflation flab”, The Economist, October 5, 2000(on methodological tricks with indices) Abel, Bernanke and Croushore, Chapter 2 (only 2.4 and 2.5)

14. CPI and GDP deflator:Differences • 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!

15. 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)

16. 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)

17. Reading: Oil shock and prices Reading 4-2“Pistol pointed at the heart”, The Economist, May 29th, 2008

18. Differences between CPIand GDP deflator: summary

19. The inflation rate and the growth rate • The annual inflation rate is calculated as • The annual growth rate is calculated as

20. International GDP deflators1971-2005: North and South America Source: Worldbank; own calculations

21. International GDP deflators1971-2005: Europe and Asia Source: Worldbank; own calculations

22. 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

23. Inflation history of the United States

24. A useful link • http://www.bls.gov/data/inflation_calculator.htm

25. Inflation in the Euro area, recent trends (HICP)

26. World inflation

27. Inflation in transition economies Inflation rates of transition economies even dwarf those of Latin America in the early 1990s

28. 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

29. 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”

30. 8 7 6 5 4 3 2 1 Inflation Source: Economic Report to the President, 1985 Phillips curve 2 3 4 5 6 7 Unemployment Phillips curve

31. 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 • Let’s see what happens if the economy is constrained by its potential

32. C B A 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

33. 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

34. 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?

35. 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

36. Oil shock and policy reactions • Let’s 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

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

38. Government demand asa driving force of inflation • Let’s 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

39.    GDPtarget Demand-pull inflation Price level Fiscal policy drivesprices up, and each time the price increase feeds back into wagesand costs Aggregate output GDPpot

40. Milton Friedman 1912-2006, Nobel prize in 1976 “Inflation is always and everywhere a monetary phenomenon” The role of monetary policy But neither cost push nor demand pull could provoke inflation without monetary expansion

41. 3: restoration of “natural output” level 2’: expansion of money supply and of AD 4 2: restoration of “natural output” level 3’ 3 2’ 2 1’ 1’: expansion of money supply and of AD Views on inflation: the monetarists Price level 1 1: initial equilibrium Aggregate output GDPnatural

42. Increase in Inflation and money supply in the USA (10 years annual average) 1910 1970 1940 1980 1960 1950 Growth rate of the Inflation 1900 1890 1930 1880 1870 1920 Growth rate of the money supply in percent Inflation and the supply of money

43. Reading Reading 4-3“An old enemy rears its head”, The Economist, May 22nd, 2008

44. Once more:the Phillips curve • Activist fiscal or monetary policies trying to push employment beyond the “natural employment rate” should show up in the Phillips curve • Let’s have a look at the Phillips curve for Germany

45. Years 1961 to 1973 Years 1961 to 1996 Inflation rate in % Inflation rate in % Unemployment rate in % Unemployment rate in % Phillips curve for Germany

46. “Natural unemployment”and 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)

47. Phillips curve for Germany 1961 to 1996 Inflation rate in % un1 un2 un3 Unemployment rate in % Inflation and hysteresisof unemployment

48. 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

49. Reading Abel, Bernanke and Croushore, Chapter 12.1 and 12.2

50. Is inflation so bad?