Inflation Rate

Lecture 10: Measuring the cost

Of living

Intro to macroeconomics
 Outline

1. Measuring the Cost of Living

2. Inflation rate

o Definitions

o Effects of Inflation

o Causes of Inflation

o Inflation and Unemployment

o Cures of Inflation

Intro to macroeconomics
 Measuring the cost of living
o People use their incomes to buy goods and services they
need to live and enjoy life
o The price of goods and services determines the quantity of
commodities bought.
o Overtime, prices change and thus it becomes difficult to
make comparisons about how wages and prices compare.
o The cost of living- refer to how much money people need
to maintain standards of living in terms of the goods and
services they can afford.
o Prices taken at a specific time give us the price level.
o Price level – snapshot of the prices of goods and services
in a particular economy at a particular period of time.

o The consumer price index (CPI) is a measure of the overall cost of the goods
and services bought by a typical consumer

Intro to macroeconomics
 Measuring the cost of living

• Consumer price index (CPI) – is a measure of the overall cost

of the goods and services bought by a typical consumer
• Zamstats – collects the prices of selected goods and
computes the CPI
• Steps to computing the Cpi
a) Fix the Basket. The first step in computing the consumer price
index is to determine which prices are important to the typical
consumer
o Assume a typical HH buys hot dogs and hamburgers
• Assuming HHs buy more hot dogs than hamburgers, then the
price of hot dogs is more important than the price of hamburgers
and, therefore, should be given greater weight in measuring the
cost of living.
b) Find the Prices. The second step in computing the consumer price
index is to find the prices of each of the goods and services in the
basket for each point in time.

Intro to macroeconomics
 Measuring the cost of living

Intro to macroeconomics
 Problem in Measuring the cost of
living
o The objectives of CPI is to measure changes in the cost of living.
o CPI tries to gauge how much incomes must rise in order to maintain
a constant standard of living.
o The CPI index has at least three problems:

1. Substitution bias – when prices change from one year to the next,
they do not all change proportionately;
o Some prices rise by more than others.
o Consumers respond to these differing price changes by buying less of the
goods whose prices have risen by large amounts and by buying more of
the goods whose prices have risen less or perhaps have even fallen.
o That is, consumers substitute toward goods that have become relatively
less expensive
o Yet the consumer price index is computed assuming a fixed basket of
goods.
o By not taking into account the possibility of consumer substitution, the
index overstates the increase in the cost of living from one year to the
next.
Intro to macroeconomics
 Measuring the cost of living

2. Introduction of new goods. When a new good is introduced,

consumers have more variety from which to choose.
o Greater variety, in turn, makes each kwacha more valuable, so
consumers need fewer kwacha to maintain any given standard of
living.
o Yet because the consumer price index is based on a fixed basket of
goods and services, it does not reflect this change in the purchasing
power of the kwacha.
3. Unmeasured quality change – it does not take into account the
changes in the quality. If the quality of a good deteriorates from
one year to the next, the effective value of the Kwacha falls, even if
the price of the good stays the same.
o Similarly, if the quality rises from one year to the next, the value
of a kwacha rises & statisticians try to take the quality change in
the price
o By doing so, the CPI tries to compute the price of a basket of
goods of constant quality.

Intro to macroeconomics
 Inflation

▪ Inflation is a phenomenon which affects everybody in one way or

another.
▪ Low levels or mild inflation in single digits (no more than 5% may be
good for the economy.
▪ How ever, inflation can have adverse effects on the economy
▪ It can lead or give rise to hyperinflation -
that is, very rapidly accelerating inflation
that leads to the breakdown of the
monetary system. Example –Zimbabwe 2008

▪ What is inflation?

▪ Inflation is the persistent rise in the general price level. It only

occurs when the prices of most goods and services are rising
together, thus creating an increase in the average price of the goods
and services we buy.
▪ Inflation reduces the purchasing power of HHs – i.e., hurts the real
buying power of money.
Intro to macroeconomics
 Inflation

• Zambia experienced high and persistent rising

prices all through the 1990s to mid-2000s.

• Inflation dropped to single digit round 2007

• However –rebounded in a fluctuating manner

Intro to macroeconomics
 Inflation

• Related concepts
o Recall: The persistence fall in the general or overall prices in the
economy is called deflation

o As noted previously, measuring deflation and inflation is done by

calculating the percentage change in the CPI ratio of the cost of
the basket to the cost of that basket in the base year.

o Headline inflation - is the measure of all goods that the average

consumer buys . It measures the changes in prices for the entire
market basket of an average consumer

o Core inflation –is the measure of inflation that excludes goods

with historical volatile price changes – e.g., energy.
 Costs/Effects of inflation

• Inflation can be anticipated or unanticipated.

• If fully anticipated, then all groups of individuals in the economy
expect it and are thus able to gain full compensation for it.
• However, inflation may not be anticipated if:
1. There is a general failure on the part of the economy as whole to predict
the inflation correctly so that the actual inflation exceeds the expected
inflation.
2. Some groups or individuals in the economy fail to predict the inflation
rate correctly, hence they seek lower money wage increments than
actually necessary to maintain the real wages.
3. Certain groups or individuals are unable to gain full compensation for it
even though they anticipate it correctly.

• Costs of anticipated inflation

• There are several costs associated with anticipated inflation such as
the shoe-leather costs – i.e., the costs and inconveniences of
reducing money balances to avoid the inflation tax.

Intro to macroeconomics
 Costs/Effects of inflation

1. Shoe leather cost

▪ Generally higher inflation rate leads to a higher nominal interest rate, which
in turn leads to lower real money balances.
▪ If people are to hold lower money balances on average, they must make
more frequent trips to the bank to withdraw money.
▪ The inconvenience of reducing money holding is metaphorically called the
shoe leather cost of inflation, because walking to the bank more often causes
one’s shoes to wear out more quickly.
▪ Recall even online transactions have costs of transactions –through
charges
2. Menu costs
• Second cost of inflation arises because high inflation induces firms to change
their posted prices more often.
• Changing prices is sometimes costly:
o cost of printing new menus
o cost of printing & mailing new catalogs
o New Tv adverts etc

Thus, the higher the inflation, the more frequently firms must change their prices and incur
these menu costs
Intro to macroeconomics
 Costs/Effects of inflation

3. Relative price distortions

• A third cost of inflation arises because firms facing menu costs change prices
infrequently;
o therefore, the higher the rate of inflation, the greater the variability in
relative prices
o For example, suppose a firm issues a new catalog every January.
o If there is no inflation, then the firm’s prices relative to the overall price
level are constant over the year
o Yet if inflation is 1 percent per month, then from the beginning to the end
of the year the firm’s relative prices fall by 12 percent
o Sales from this catalog will tend to be low early in the year (when its
prices are relatively high) and high later in the year (when its prices are
relatively low)
o causing microeconomic inefficiencies in the allocation of
resources.

Intro to macroeconomics
 Costs/Effects of inflation

4. Unfair tax treatment

• Many provisions of the tax code do not take into account the effects of
inflation.
• Inflation can alter individuals’ tax liability, often in ways that lawmakers
did not intend
• Ex. Suppose you buy some stock today and sell it a year from now at the
same real price. It would seem reasonable for the government not to
levy a tax, because you have earned no real income from this
investment.
• Indeed, if there is no inflation, a zero tax liability would be the outcome
• But
▪ suppose the rate of inflation is 12 percent and you initially paid K100 per
share for the stock; for the real price to be the same a year later, you
must sell the stock for K112 per share.
▪ In this case the tax code, which ignores the effects of inflation, says that
you have earned K12 per share in income, the government taxes you on
this capital gain.
▪ The problem is that the tax code measures income as the nominal rather
than the real capital gain

Intro to macroeconomics
 Costs/Effects of inflation
• The Costs of Unexpected Inflation
o Unexpected inflation has an effect that is more pernicious than any of the
costs of steady, anticipated inflation: it arbitrarily redistributes wealth
among individuals.
o Many long-term contracts not indexed on inflation. If inflation turns out
different from expected, then some gain at others’ expense.
1. Unanticipated inflation hurts fixed-income earners and weakly unionized
workers
o People with fixed income find out that the real value of their incomes become
eroded by inflation.
o Weakly unionized workers who fail to bargain for full compensation for price rises
will lose out at the expense of strongly unionized workers.
2. From lenders to borrowers – lenders lose while borrowers gain because when
debt is repaid, the real value will be less than that prevailing when loans
were made.
3. Even when interest is paid, if it is less than inflation rate, there is a loss of
value.
4. From tax-payers to government - as income rise, earners with same real
income move into higher tax bands and pay a bigger proportion of income in
tax. This is called the fiscal drag and occur in countries with a progressive tax
system. Since government redistributes income to consumers, the final effect
will be uncertain
Intro to macroeconomics
 Costs/Effects of inflation

5. From public sector to private sector – if government tries to control

inflation using income and price policies, it may set an example by
resisting the wage claims by public sector workers.
o If the private sector is more willing to concede wage increases, there will
be redistribution from the public sector employees to the private sector
employees. This depends on strength of unions and ability of the private
sector to provide wage increases.

6. From profit earners to wage earners –if wage demands are met by
squeezing profits margins, then the share of profits of the private
sector can provide for wage increases.

Intro to macroeconomics
 Theories of the Causes of Inflation
• There are various schools of thought about the causes of inflation.
The major ones are the classical school of thought and the
Keynesian school of thought.

1) Demand Pull Inflation (Classical School of thought)

• This is based on the classical school of thought. They argue that
inflation is always and everywhere a monetary phenomenon
• Demand-pull inflation is often summed up as “too many dollars
chasing too few goods Or too much money chasing too few goods “
• They argue that the problem is that we can’t produce any more
goods because our economy is already operating at full capacity
• What happens next if demand keeps rising? What if people have
money in their pockets and the desire to spend it?
• The aggregate demand will exceed aggregate output at (or close to )
full employment
• Excess demand initiates inflationary pressure.
• The excess demand can arise from the monetary (increase in money
supply )or real sector (increase in G, I, C & NX)
Intro to macroeconomics
 Theories of the Causes of Inflation
o Assume economy is operating at full
LRAS SRAS2
employment Y f
o In short –run AD1 and AS1 are in Prices
equilibrium at E1 which matches the SRAS1
E3
long-run equilibrium P3
o Assume the central bank increased
P2 E2
money supply
P1 AD2
o The interest rate reduces, and E1
investment rises which results in
AD1
increased output
o AD increases due to increased
0 Yf Y1
money supply and shifts from AD 1 to Output
AD2
Inflationary gap
o At the new equilibrium E2, the
economy is not in equilibrium and the
▪ Equilibrium is established at E3 where
output is beyond the full employment
level. the short-run AS and AD curves meet
▪ the result of an increase in money
o Because demand exceed supply, the
supply is an increase in prices
price will begin to rise towards E3 and
firms will reduce production (why)
o AS shifts to AS2
Intro to macroeconomics
 Theories of the Causes of Inflation

o The increase in money LRAS SRAS2

supply did not result in Price
increased output SRAS1
E3
o Rather, it resulted in the P3

increase in nominal money P2 E2

supply and prices. P1

E1
AD2

o This is called the neutrality AD1

of money
0 Yf Y1
o That is – the idea that in the Output

long-run, changes in the Inflationary gap

money supply affect nominal

▪ The increase in money supply has
variables such as prices and
resulted in increased prices.
wages but do not affect the ▪ Hence- inflation is always and
real outcomes in the everywhere a monetary phenomenon
economy

Intro to macroeconomics
 Cost Push Inflation
2. Cost push inflation arise due to
rising wages, with production costs LRAS SRAS2
passed on to the consumer in the Price
form of higher prices
SRAS1
❑ As prices rise, real wages fall and P3
E3
workers demand higher wages and
E2
this increases the cost, which in P2
turn is passed onto the prices AD2
P1
❑ The continuous rise in the price and
demand for wages results in the AD1
inflationary spiral
❑ The increase in wages increases the 0 Yf
cost of production and AS shifts to
the left from SRA1 to SRAS2, with Keynes argued that with unemployed
new equilibrium at E2 resources, money wages would be more
or less constant.
❑ Government may counter the
decline in output by stimulating At low levels of unemployment, money
aggregate demand which shifts to wages will begin to rise as the bottleneck
the right occurs in the labour market
❑ The economy finally settles at E3 As full employment is reached, money
with the same level of output but wages rise faster.
higher prices
Intro to macroeconomics
 Other causes of inflation

• Imported inflation – this • Multi-causal

occurs when price of imported
final or intermediate goods rise o Excessive Government
o The local price for the imported spending
goods also go up to cover the
costs. There are two reasons o Excessive wage demands by
imported prices rise:
unions
o Rising world prices – if world
prices are rising , all economies
may not be spared by the
inflationary pressure
o Currency depreciation – in a
country with a flexible
exchange rate like Zambia, the
depreciation of the currency will
through the pass-through effect
raise domestic price of
imported goods

Intro to macroeconomics
 Measures to address inflation
1. Fiscal and Monetary policies – • Government can encourage firms
commonly used to control inflation to avoid unjustified price rises
by affecting AD in the economy and to unions to avoid unjustified
o Reduce inflation – cut G or I, wage claims
increase taxes or some combination • Bringing firms and unions
of these to reduce AD deflationary together to obtain some voluntary
fiscal policy) agreement from both parties to
o A cut in Money supply or reduction in keep prices and incomes down –
its rate of growth (deflationary this may require a norm for wage
monetary policy) will have the same increases
effect • Impose legislation regulate or
o Keynesians – place emphasis on even freeze wage and price
fiscal policy as a means of freeze
controlling AD while monetarists 1. Indexation – is not a cure for
place a premium on monetary policy inflation but rather a means of
or money supply living with it. Adjust wages with
2. Princes and Incomes policy – This is increase in inflation
recommended by those who support o It can itself be inflationary
the view that inflation is caused by
o Does nothing to reduce other
unions demanding higher wages. It
costs of inflation
can take a number of approaches

Intro to macroeconomics
 Inflation and Unemployment

o In 1958, an economist named SRAS2

A.W. Phillips plotted the change

in prices against unemployment E2
over a 95-year period P2

o He observed the following: P1 E1

AD2
o As inflation ran high,
unemployment was low
o When inflation was low, AD1
unemployment was high
o The line showing this relationship 0 Y1 Y2
is now called the Philips curve
o Phillips Curve – is a model that ▪ In the short-run, the economy is
shows the connection between initially at E1 with lower prices
unemployment and inflation in and output than at E2
the short-run
o The relationship can be
investigated using the aggregate
demand and supply model
Intro to macroeconomics
 Inflation and Unemployment

o With more economic activity, the Price level

SRAS2
aggregate demand curve moves
to AD2 and establishes a new
equilibrium at E2 E2
P2
o With higher output Y2, firms
must employ more people P1 E1
AD2
o At E2 the prices are also higher.
o This relationship is plotted in the
AD1
figure below
o An increase in AD above Y1
0 Y2
expectations will cause the output
economy to be at a point higher Inflation
and to the left of the Philips curve
P1
•

P1

0
unemployment
P
Intro to macroeconomics