Understanding Inflation: Definitions, Causes, and Effects - Prof. R. Herzog, Study notes of Economics

Download Understanding Inflation: Definitions, Causes, and Effects - Prof. R. Herzog and more Study notes Economics in PDF only on Docsity! 1 Principles of Macroeconomics Economics 202 Ryan Herzog Inflation
Definitions
Inflation: Increase in the overall price level
Some prices may decrease, but relatively more prices have increased
Deflation: Decrease in the overall price level
Some prices may increase, but relatively more prices have declined
Disinflation: A reduction in the inflation rate
Prices are still increasing but at a lower rate Inflation 2 Inflation
Recessions
Inflation tends to decrease during recessions
Early 1990’s and 2000’s inflation decreased
Expansions
Inflation tends to increase during expansions Inflation and Recession 3.2 6.2 10.3 13.5 5.8 9.1 11.0 INFLATION RATE RECESSION BEGINS Source: See Table 19.8. 1983 1982 1981 1980 1976 1975 1974 Inflation Rates, 1974–1976 and 1980–1983 Inflation and Expansion Source: See Table 19.8. 4.81989 4.11988 3.61987 1.91986 3.61985 4.31984 13.51980 11.31979 7.61978 6.51977 5.81976 11.01974 6.21973 3.21972 INFLATION RATE Inflation During Three Expansions 5 Producer Price Index
The PPI is a measure of the cost of a basket of goods and services bought by firms
This is a strong indicator for increases in the CPI
When firms experience higher input prices this period, the follow periods they will raise output prices Inflation
Current values can be found at
www.bls.gov
Can find different measures for CPI
Also shows average prices of goods Costs of Inflation
Inflation changes the distribution of income
During periods of inflation those on fixed incomes are worse off
Social Security payments are indexed to inflation
Welfare payments are not
Indexation: wages/prices are tied to inflation rate
Increased risk and slower growth
Unanticipated inflation increases the risks associated with investment 6 Costs of Inflation
Shoeleather costs
Inflation erodes the value of money, thus you hold less money
This increases the number of trips to the bank
The resources wasted when inflation encourages people to reduce their money holdings Cost of Inflation
Menu Costs
The cost of changing prices
During periods of inflation firms must change prices more frequently
Relative Prices and Misallocation of Resources
Inflation distorts relative prices of goods
This distorts consumers decisions
Confusion and Inconvenience
Money is a yardstick used to measure value, when inflation increase the yardstick becomes distorted Costs of Inflation
Inflation Induced Tax Distortions
Lawmakers do not account for inflation in their policies
Alternative Minimum Taxes  Designed to force those with high incomes and high deductions to pay a given tax  In 1970 1,900 families paid the AMT now more than 4 million  Most families with children in school will fall into this category  Income greater than $75,000 with some deductions 7 Inflation and Interest Rates
Inflation distorts interest rates
Future interest rates are set based on future expectations
Recall nominal versus real
Real Interest Rates = Nominal Interest Rate – Expected Inflation
Nominal Interest Rate advertised rates Inflation and Interest Rates
When inflation is higher than expected borrowers gain
Wages increases and thus their loans decrease in value
When inflation is lower than expected lenders gain
Wages have not increased as expected, the real interest rate has increased Correcting for Inflation
We can also use CPI to calculate relative prices
I remember when a soda cost a quarter
Example: Your father graduated from school and took his first job in 1972, which paid a salary of $7,000. What is this salary worth in 2005 dollars? Price level in Year 2 Value in Year 2 dollars = Value in Year 1 dollars Price level in Year 1 ×      10 The Sources of Economic Growth
Economic Growth: Any increase in real GDP
Aggregate Production Function
Shows the mathematical relationship between a countries aggregate output and inputs (labor and capital) An Increase in Real GDP
An increase in labor supply
An increase in physical capital
An increase in human capital
An increase in productivity Sources of Growth
Labor Supply
More workers generally increases output
When diminishing returns sets in adding workers will reduce output per worker
Can also occur if a nations capital stock grows slower than it’s labor force
New workers entering the labor force
As long as the economy and the capital stock are expanding rapidly enough, new entrants into the labor force do not displace other workers 11 Sources of Growth
Increases in physical capital
Enhances productivity of workers
Increases in human capital
People in good health are more productive
Education makes individual more productive Sources of Growth
Increases in productivity
Technological change
Advances in knowledge
Economics of scale
More plants can lead to lower transportation costs
Regulation generally hurts productivity Public Policies
Improve quality of education
Hope and Lifetime earning scholarships
Increase savings rate
Capital results from investment, investment is the result of excess saving
Shift from income taxation to consumption taxation
Stimulate investment
Investment tax credits 12 Public Policies
Increase Research and Development
Increased knowledge accounts for 31% of the growth in the US
Reduce Regulations
Controversial
Industrial Policy
Target industries with special subsidies and rapid investment