Low Inflation - Questions for Further Study

QUESTIONS FOR FURTHER STUDY

1. Chile experienced hyperinflation in 2005. What was the inflation rate? What caused Chile’s hyperinflation?

2. Go to the web site for the Bureau of Labor Statistics (www.bls.gov) to find historical U.S. inflation data. Is there a correlation between high inflation rates of inflation and U.S. involvement is wars? What explanation does economic theory provided for this correlation?

3. Stagflation is the economic condition of having relatively high unemployment and inflation at the same time.
(a) Since cyclical unemployment is caused by insufficient aggregate demand and demand-pull inflation is caused by excessive aggregate demand, how is it possible to have stagflation?
(b) What remedies might you suggest for stagflation?
(c) Which is the greater concern: high unemployment or high inflation?
(d) When has the U.S. economy experienced stagflation? What were its causes? How was it remedied?

Important Definitions Related to the Macroeconomic Policy Goal of Low Inflation

· Inflation is a general increase in the level of most prices in an economy.

· The price level represents the prices of most products in an economy. It is approximated by a price index, such as the Consumer Price Index (CPI), Producer Price Index (PPI), or the GDP deflator.

· The inflation rate is a measurement of how quickly prices are rising in an economy. It is typically reported as the annual percentage increase in the price level.

· Deflation is a general decrease in the price level.

· Disinflation occurs when the inflation rate decreases, but remains positive.

· Hyperinflation is extreme inflation in which the inflation rate exceeds 50% per month.

· Nominal data have not been adjusted for inflation.

· Real data have been adjusted for inflation. They are reported using prices from a common base year.

· The shoe leather costs of inflation are the wasted time and inconveniences caused when inflation encourages people to reduce their holdings of currency.

· The menu costs of inflation are the costs associated with changing the prices of the products sold by a business.

· Purchasing power is the value of the products a person is able to buy with a given amount of money.

· Indexation refers to using a law or contract to automatically correct a dollar amount for the effects of inflation.

· Cost-of-living adjustments (COLAs) automatically increase Social Security benefits to compensate for the loss in purchasing power caused by inflation as measured by the Consumer Price Index (CPI).

· Cost-push inflation is an increase in the price level caused by higher costs of production.

· Demand-pull inflation is an increase in the price level caused by excess demand for newly produced goods and services. Society’s demand for new products exceeds its ability to produce them.

· "Too much money chasing too few goods" is an expression that describes demand-pull inflation, which is an increase in the price level caused by excess demand for newly produced goods and services. Society’s demand for new products exceeds its ability to produce them.

· The quantity theory of money suggests there is a relationship between the supply of money and the inflation rate. If the money supply increases faster than an economy’s output, a likely outcome is inflation.

· A price index is an estimate of the price level that is used to measure inflation. Three commonly used price indices in the United States are the Consumer Price Index (CPI), the Producer Price Index (PPI), and the GDP deflator.

· A basket of goods is a collection of products used to calculate a price index.

· The base year is the year that is used as the comparison year when calculating an index.

· The Consumer Price Index (CPI) is a measure of the price level based on a fixed basket of the goods and services purchased by a typical urban family. It is used to calculate the inflation rate.

· The Producer Price Index (PPI) is a family of indices that measures the price level based on a fixed basket of all goods and services produced and sold by American businesses. It includes consumer products and goods and services used as inputs in the production of other products.

· The GDP deflator is a measure of the price level based on all goods and services produced in a country in a particular year. Unlike the CPI and PPI, the GDP deflator is not based on a fixed basket of goods.

The Most Important Concepts about the Macroeconomic Policy Goal of Low Inflation

· Inflation imposes costs on society that generally result in reduced economic growth and lower present and future standards of living.

· Keeping inflation low is the primary macroeconomic policy goal in the most developed economies of the world.

· Inflation can be very hard to eliminate because expectations of future price increases contribute to continued inflation.

· Inflation is most commonly measured in the U.S. using the consumer price index (CPI). The measurement of inflation using the consumer price index (CPI) exaggerates the actual level of price increases in an economy. Consequently, even when the prices of consumer products are relatively stable, the CPI suggests there is 1-2% inflation in the economy. Thus, the macroeconomic policy goal is low inflation, rather than no inflation.

Strategies for Controlling Inflation

Strategies for Controlling Inflation

1. Break the cycle of expectations. This helps to control cost-push inflation.
2. Reduce the costs of production. This helps reduce cost-push inflation.
3. Reduce aggregate demand. This helps to control demand-pull inflation.

AD = C + I + G + X – M
where:
AD = aggregate demand
C = consumption
I = investment
G = government purchases
X – M = exports – imports = net exports = NE


Objective to help achieve low inflation
Fiscal policy
to achieve this objective
Monetary policy
to achieve this objective
Break the cycle of inflationary expectations.
Anything that convinces the public that the government is committed to reducing inflation.
Anything that convinces the public that the Federal Reserve System is committed to reducing inflation.
Decrease the costs of production.
Anything that reduces costs of production. Increasing the world supply of oil, for example, would reduce production costs for many industries.

Reduce aggregate demand.
Decrease government purchases or increase taxes. Since government purchases are a component of aggregate demand (and GDP), reduced government spending will reduce aggregate demand directly. Higher taxes leave workers and businesses with less disposable income. This leads to a reduction in consumption and investment spending, which are two of the components of aggregate demand.
Decrease the money supply to increase interest rates. Higher interest rates discourage borrowing. This causes a decrease in consumption and investment spending, which are two of the components of aggregate demand
Table 3. Using fiscal and monetary policies to achieve low inflation.

The Importance of Low Inflation when price changes are unexpected and unpredictable.

Type 3: Price changes that are unexpected and unpredicted

Unexpected inflation redistributes income from lenders to borrowers.

There is an additional cost of inflation if the price changes are unexpected. Unexpected inflation redistributes income from lenders to borrowers. Unexpected deflation, by contrast, redistributes income from borrowers to lenders. Loans charge an interest rate that is variable or fixed. Variable rate loans allow the lender to periodically adjust the nominal interest rate to correct for changes in the inflation rate. Fixed rate loans, however, commit the lender to pay the stated nominal rate of interest for the life of the loan. If lenders expect inflation to occur, they include it in the nominal interest rates charged to borrowers. Unexpected inflation reduces the real rate of return, however. In October 2003, a typical interest rate on a 30-year fixed-rate mortgage loan was around 6% per year. The inflation rate during that month was estimated to be about 2% per year. Thus, the real interest rate was about 4% per year. (real interest rate = nominal interest rate – inflation rate) If the inflation rate increases unexpectedly to 5% per year, then the real rate of interest drops to only 1% per year. The borrower is paying a smaller real interest rate than the lender had expected. Thus, borrowers tend to benefit from unexpected inflation, while lenders lose from it. Borrowers pay back the loan with dollars that have less purchasing power than the lender had expected.

When lenders are burned by unexpected inflation, they may attempt to create a larger cushion between the nominal and real interest rates. This is sometimes referred to as a risk premium. Thus inflation can cause real interest rates to rise. This discourages businesses and households from borrowing money for investment projects. Reduced investment leads to lower productivity and reduced economic growth.

Inflation creates uncertainty that discourages long-term investment

The largest cost of inflation may be the effect it has on investment in the economy. Inflation creates an environment of uncertainty, especially when the inflation rate fluctuates. Historically, high inflation rates are rarely constant and predictable. This may make businesses reluctant to proceed with some investment projects (e.g., new factories).

If businesses expect prices to remain steady over the upcoming decade or two, they will be much more inclined to engage in a long-term investment project. Suppose analysts tell the Trek bicycle executives that the company could earn an additional $1 million in each of the next 10 years if they build a new bicycle manufacturing plant in Jacksonville, Florida. If inflation causes erratic changes in the price level, however, Trek executives may have difficulty determining if $1 million per year will be a good rate of return 10 years from now. This uncertainty may make them less inclined to build the new factory.

Since investment (in physical capital, human capital, and technology) is the key to increased productivity and economic growth, inflation can reduce the future standard of living if it causes a reduction in investment.

To illustrate how inflation creates uncertainty, consider two scenarios. In one scenario, imagine that inflation was low and persistent throughout the twentieth century. This would lead most people to predict that inflation will stay low in the coming decades. In the second scenario, imagine that the price level fluctuated wildly throughout the twentieth century. This makes it difficult to reach a consensus on the expected price level in the future. The price level could rise quickly, rise slowly, stay relatively constant, or even fall.




Price
? Level
Unpredictable inflation



Persistent low inflation
?
?
?













Year

Figure 2. Hypothetical inflation rates.
Persistent low inflation leads to more confidence about future price levels than unpredictable inflation.



Inflation is bad because it imposes costs on society that could be avoided in the absence of inflation. These costs generally result in reduced economic growth and lower present and future standards of living. These costs can be minimized if the economy maintains a low inflation rate.

In order to keep inflation low, it helps to understand the types of inflation and their causes. The appropriate policy prescription depends upon the source of the inflation.

The Importance of Low Inflation

The Importance of Low Inflation

Inflation is bad because it imposes costs on society that could be avoided in the absence of inflation. These costs generally result in reduced economic growth and lower present and future standards of living. These costs can be minimized if the economy maintains a low inflation rate.

To understand the importance of low inflation, it helps to consider three types of changes in the price level: (1) expected, predictable, uniform price changes; (2) expected and predictable price changes that are not uniform; and (3) price changes that are unexpected and unpredicted.

Low Inflation - Learning Objectives

After studying the portion of this blog devoted to the macroeconomic policy goal of low inflation, you should be able to:

· define inflation and the inflation rate.
· define and explain the difference between deflation and disinflation.
· define hyperinflation and provide examples of its occurrence in the 20th century.
· explain the relationship between nominal variables, real variables, and the inflation rate.
· use nominal and real interest rate data to calculate inflation rates.
· use inflation and nominal interest rate data to calculate real interest rates.
· use inflation and real interest rate data to calculate nominal interest rates.
· explain why low inflation is an important macroeconomic goal.
· explain the effects of expected, predictable, uniform price changes.
· define and explain the significance of the shoe leather and menu costs of inflation.
· explain the effects of expected and predictable price changes that are not uniform.
· explain the effects of price changes that are unexpected and unpredictable.
· define purchasing power and indexation, and explain their relationships to inflation.
· define and explain the causes of cost-push and demand-pull inflation.
· list and explain the strategies for controlling inflation.
· explain why the goal is low inflation instead of no inflation.
· explain why the consumer price index (CPI) overestimates actual inflation.
· explain the effect of inflation on borrowers and lenders.
· explain the effect of inflation on people with indexed and non-indexed incomes.
· explain the effect of inflation on investment decisions by businesses.
· explain why inflation leads consumers to make inefficient decisions