Inflation modules 14 and 15


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Inflation modules 14 and 15

  1. 1. * MODULES 14 AND 15
  2. 2. * The prices have been rising over the years, so are people now poorer?* Real wage: The wage rate divided by the price level.* Real income: The income divided by the price level.* The gradual rise in prices has not made people poorer, because wages and income have risen together with the prices.* The level of prices is different from the inflation rate. *
  3. 3. * *
  4. 4. * In the past, deflation has been as much a problem as inflation. For example, the 1930s depression was a period of declining prices and wages.* All industrial nations have experienced inflation.* Some nations may experience astronomical rates of inflation.* ( Ex: Angola in 1996: 4,415% and Zimbabwe in 2008: 1,694,000%) *
  5. 5. * Highrates of inflation impose significant economic costs. They are:1. Shoe-leather costs: The increased costs of transactions caused by inflation.2. Menu costs: The costs of changing listed prices.3. Unit-of-account costs: The costs that arise from the way inflation makes money a less reliable unit of measurement. *
  6. 6. * Inflation may redistribute income:1. Fixed income groups will be hurt because their real income suffers. Their nominal income does not rise with prices.2. Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation. Their savings will lose purchasing power. *
  7. 7. 3. Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation. Interest payments may be less than the inflation rate, so borrowers receive “dear” money and are paying back “cheap” dollars that have less purchasing power for the lender. *
  8. 8. 4. If inflation is anticipated, the effects of inflation may be less severe, since wage and pension contracts may have inflation clauses (COLAs) built in, and interest rates will be high enough to cover the cost of inflation to savers and lenders.a) “Inflation premium” is the amount that interest rate is raised to cover the effects of anticipated inflation.b) “Real interest rate” is defined as the nominal rate adjusted for inflation. It is found by subtracting: real interest rate = nominal interest rate - inflation *
  9. 9. 1. Unexpected deflation, which is a decline in price level, will have the opposite effect of anticipated inflation.2. Many families are simultaneously helped and hurt by inflation because they are both borrowers and earners and savers.3. Effects of inflation are arbitrary, regardless of society’s goals. *
  10. 10. * Disinflation: The process of bringing the inflation rate down.* Policy makers respond to inflation quickly as a form of preventive medicine for the economy, because disinflation is very difficult and costly once a higher rate of inflation has occurred.* The only way they believe that inflation can be reduced is through policies to depress the economy, which then increase unemployment. *
  11. 11. * The causes and theories of inflation point to two types of inflation:1. Demand-pull inflation: When spending increases faster than production.2. Cost-push (or supply-side) inflation: Prices rise because of rise in per-unit production costs (Unit cost = total input cost/ units of output)a) Wage-push can occur as a result of union strength.b) Supply shocks may occur with unexpected increases in the price of raw materials.3. Complexities: It is difficult to distinguish betweendemand-pull and cost-push causes ofinflation, although cost-push will die out in arecession if spending does not also rise. *
  12. 12. * The “rule of 70” permits quick calculations of the time it takes for something to double. In this case, we can apply it to find the time it takes the price level to double:* Divide 70 by the percentage rate of inflation and the result will be the approximate number of years for the price level to double.* Ex:If the inflation rate is 5%, then it will take about 14 years for the prices to double. *