Chapter 16 a.

Measure of the changes in

Inflation and Money prices of consumer goods
and services
Understanding Inflation b. Applied to the “Average”
 Inflation is a process consumption of households
 Prices rise higher and higher in the economy
 Continuity is part of its essence c. List of items consumed or
 An Old Problem “market basket” presently
o Inflation has been there ever since late third contains more than 400
century/ancient times items
o Emperor Diocletian d. Most popular
 Christian persecutor; e. Most used basis for
 Tried to control inflation by issuing computing inflation rate
new currency to replace old inflated f. Reflects what happens to
coins in circulation; affect to the living
 Decreed death for hoarders and standards of consumers
violators of price and wage 2. GNP Implicit Price Index (Deflator)
controls, but to no avail a. Widest coverage
o Middle Ages (12th-13th and 16th-17th) – b. Average price index
prices rose fourfold in Europe applied to deflate current
 What is large? GNP to constant GNP
o Price increases must be large as to upset the c. Measure which shows the
functioning of markets general price level of the
o There is no generally a cut off point as to final output of goods and
when the inflation rate would be services produced by
dangerously high Philippine nationals for a
o Runaway inflation – what people dread given period
o German inflation – most famous; led to the d. Price index – actually
rise of Hitler; weighted average of the
o “Mickey Mouse” money – having to but price index used to deflate
items with a bayong-full of bills; puppet the different components
government in Japanese occupation 1941- of GNP (C, I, X, G, M)
1945 3. Producers Price Index (PPI)
o Hyperinflation – inflation rate of more than a. Measures the price changes
100% as usable benchmark for finished goods,
intermediate and raw
Measuring Price Changes materials
 Essentially one of taking averages of price changes of b. US & other developed
those items countries  PPI an
 Price index advanced indicator of
o Average of prices of commodities in relation inflation (since changes in
to their prices in a specified base year factory prices will reach
expressed in 100s retail consumer prices)
o Commodities  representative of the items c. Philippines 1992
one is interested in
o Consumer Price Index (CPI) Effect of Inflation
 Separate indices are calculated for  Inflation would have a varying impact on different
food, clothing, housing, & repairs, income groups
fuel-light-water, services, and  Inflation losers
miscellaneous o Retirees
o Sub-indices  Group that would suffer the most
 Weighed to obtain a single CPI  Net loss to the pensioner
value o Usual fixed-salaried employees
o 3 elements in construction of an average  Government employees, industrial
price index: workers, clerks, etc.
1. Items in the market basket  Wages or salaries are not very
2. Weight of each item flexible
3. Base year used as the point of  Needs empirical verification
comparison o Creditors or savers
 Inflation Yardstick  They receive a less-valued fixed
o 3 prices indices used as measures of amount of interest and principal
inflation  As long as the inflation rate exceeds
1. Consumer Price Index (CPI) interest rates, savers lose.
  Savings & long-term lending – key  Tend to be self-fulfilling
ingredients for economic growth;  Usual reaction of govts. In the
discouraged shifting of aggregate supply curve
 Inflation gainers further to the left is to bring back
o Speculators employment
 Lucky or “skilled” individuals who  If spenders then expect the price
are able to buy and sell the goods rise to be temporary, they may just
that enjoy the sharpest prices price wait it eventual reduction
increases  Then if they expect it to be
o People with flexible income that is able to permanent then they would do
increase faster than the inflation rate something to protect themselves
 Usually those in a monopolistic o Demand-Pull Inflation
situation or market power that  When buyers of final goods and
enables them to “get away” with services desire to purchase these
increasing their prices faster than outputs greater than what the
the average domestic economy can produce
 Entrepreneurs, property owners,  State of excess aggregate demand
managers, etc. o Cost-Push Inflation
o Debtors  Source of inflation is the significant,
 They get to pay off their loans and continued increase in some costs of
interest in less-valued money production
 Longer the term of the loan, the  Some factors of production may be
bigger their gain able to increase prices unilaterally
 A.W. Phillips – working with London school of due to monopolistic powers
Economics; 1958 New Zealander economist;  Of firms (profits)
published a study of annual changes in British wage  Suppliers (raw materials)
rates over a period of almost 100 years  Union power (wages)
 Phillips Curve o Made for unilateral
o Fairly stable negative relationship between increases in
the unemployment rate and the inflation wages; even if
rate there’s no excess
o Trade-off between unemployment and demand
inflation is shown in this curve  Autonomous increase – starter of
 The higher the inflation, the less the inflation also
unemployment (more employment)  Unabated price increases of
at least in the short-run imported raw materials
 With this trade-off, policymakers  Rise in the price of factor of
have to make painful choices to production involved is greater than
balance the 2 its productivity increase
o Mirror image of the aggregate supply curve
of the economy Money and Inflation
 Milton Friedman – argued that the trade-off  If money supply were not increased further when
exhibited by Phillips curve may be only true in the inflation begins, price increases will not be sustained
short-run; proposed a vertical Phillips curve in the  Milton Friedman – “inflation is always and
long-run everywhere a monetary phenomenon”
o AS curve is vertical in the long run  Quantity Theory of Money
 Effect on Growth – discussed in later part o Medium of exchange function
 Money as payment for goods and
Types of Inflation services
 “Demand-pull” or “cost-push” but first…  One of the most important
 Dynamics and Expectations functions of money
o A single price rise would not constitute o Money supply – stock concept (i.e. so much
inflation since it entails a continuous of it exists at any one time)
increase in prices o Income – flow concept (i.e. measured for a
o Why prices need not rise continuously: given duration of time)
 Pigou effect
 Shifts the consumption MV = PQ
function downward since
real wealth is reduced by M = money supply
higher prices V = income velocity of money; average
 Expectation number of times per period the stock of
 Main factor that would money was used to pay incomes (or buy
turn an initial price final outputs)
increase into inflation P = price level
 Q = output (real GDP/GNP) o Long-run: initial increase in prices would be
offset by more productive capacity
 Implications on price changes  THEIR REASONING WAS LOGICAL, BUT EVIDENCE
o Velocity DOES NOT SUPPORT IT
 Assumed to be constant in the short o IMF’s study is the opposite
run due to institutional rigidities  IMF study – “once the rate of
 Economy is at full employment inflation exceeds 10 per annum, the
which they sought to prove as the negative aspects of the effects of
normal state of the economy inflation on growth tend to come to
o When money supply doubles, the price level the fore.”
will double; if it is halved, prices will also o Robert Barro – found a similar negative
drop by half impact of inflation on growth, more
o If economy is temporarily not at full especially at medium to high rates
employment, an increase in money supply  Savings are actually discouraged;
would be accompanied by an increase in its value is eroded by inflation
output until full employment is reached  Investment patterns are distorted
o Beyond that, prices will be affected already. by investors seeking assets whose
o Rate of increase in prices is equivalent to prices keep up with inflation
the difference between the increase in  It has been observed that tax base
money supply and output is eroded in an inflationary
 Why should QTM work? situation; a shift from highly taxed
o Since firms and households do not need to activities to less taxed ones
hold this additional money to carry out their  Oliveira-Tanzi Effect – points to
transactions, they spend it. significant lags in tax collection vis-
o But since the economy is already at full à-vis inflation; which makes budget
employment, this additional demand bids deficit worse, stoking inflation
up prices further
o As prices go up, more money will be  Bad news for developing
required by firms and households for the countries which need taxes
same transactions as before (in a form of savings) to
 Policy Applications develop infrastructures as
o The qtm usefulness for policy purposes is a basis of sustained growth
better seen by taking growth rates instead  Developing country –
of absolute levels used in equation (1) and “open economy”: higher
so: inflation results to higher
demand for imported
M+v=p+q goods, since they become
Where all the terms are now in growth rates relatively cheaper to
domestic goods
o If we assume that velocity is constant at 0 o More pressure is
then you are left with only money growth in exerted on the
the left side of the equation limited foreign
 An assessment exchange reserves
o SIMF or International Monetary of a country
 There’s a substantial evidence of o Foreign exchange
connection between changes in constraints begin
quantity of money and changes in to curtail further
the price level growth
o Economy is never in the long-run o Michael Sarel – found the structural break
equilibrium at 8%
 There are disturbances that upset o The latter study of the IMF also showed that
equilibrium and cause prices and low positive inflation, less than 3%, was
output to diverge from their consistent with higher economic growth
expected long-run values  Low inflation is conductive to
 Keynes – “in the long-run we’re all economic growth and high inflation
dead” rates have a negative effect on
growth
Effects on Long-Term Growth Controlling Inflation
 Past: many thought that inflation could raise the  Demand-Pull Inflation
saving rate, enabling more investment spending, and  Shifts in the AD curve are caused by increased
faster growth spending injected into the circular flow
o Inflation encourages investors; income o Investments (I), Government (G), and
distribution usually favors higher income Exports (X)
groups which have higher saving rates
  All three imply putting o Oil crisis of the 1970s (US and other
more income in the developed countries
economy  Applied tighter monetary
 However, these are not policy but only caused more
equivalent with inflation
respect to their o Arising from the agriculture can be
inflation-generating solved by raising productivity
potentials o Much of our cost-push inflation has
 Excess AD from investment been due to:
spending would occur in a  An increase of $-prices of
boom situation especially when imports
interest rates are low  A peso devaluation or
 Enables banks to depreciation
create money as a  Deflation
consequence of central o Refers to a continuing fall in prices
bank policies  People will tend to not spend ,
 Large investments could cause as they expect prices to go
an initial price increase lower
 Offset in the medium- o It appears to be too far remote for a
term by the developing country like ours
productivity increases
by these investments
 AS function tend to
shift to the right to
eventually offset, or at
least partially, the
rightward shift in the
AD curve
 Foreign demand brings money
to the economy, putting
pressure on domestic prices
when domestic output is
already at its peak
 Exports also mean that
foreign exchange is
made available for
importing
supplementary
consumer goods, raw
materials as inputs to
local industry, and
capital goods to
enhance future
production
 HIGH EXPORT
GROWTH IN NOT
REALLY
INFLATIONARY
 Government spending – where
the remaining demand factor
would come from
 The usual culprit
behind inflation in
developing countries
o Politically,
ruling
governments
have great
temptation to
spend more
than its tax
revenues
 Cost-Push Inflation
o Requires supply-side solution