1UNIT TWO: MODULE TWO, TOPIC ONE:INFLATION1. Inflation: general price level.2. Real and money wages:(a) real and nominal GDP;(b) Real and nominal interest rate.3. The GDP deflator; the retail price index; theproducer price index. Calculations andlimitations of the indices.4. Demand shocks, supply shocks, increase inthe money supply growth rate.5. The costs and benefits of inflation: theimpact of redistribution of wealth; impact ofbusiness activity and growth, impact on thebalance of payments.6. Income policy, monetary policy, fiscalpolicy and supply side measures.7. Trade-off between inflation and the rate ofunemployment: Phillips curve – stagflation.
21)Definition of inflation:Inflation is the general upward price movement of goods andservices in an economy. Over time, as the cost of goods andservices increase, the value of a dollar is going to fall because aperson won’t be able to purchase as much with that dollar as he/shepreviously could.General inflation is a fall in the market value or purchasing powerof money within an economy, as opposed to currency devaluationwhich is the fall of the market value of a currency betweeneconomies. General inflation is referred to as a rise in the generallevel of prices.There are several degrees of inflation to which it is categorized:DEGREE OF INFLATION DESCRIPTION1) Creeping inflation Going up slowly (<5%)2) Trotting inflation Changes by approximately 10%.When this occurs, there is needfor concern. Government putspolicies in place to controlinflation.3) Galloping inflation This is where inflation jumps inthe 20% to 40% range.4) Runaway inflation Almost hyper inflation.
35) Hyper inflation Inflation exceeds 1000%. Moneyloses its value so rapidly; nobodywants to use it as a means ofexchange. E.g. Zimbabwe in the2000’s.2)Real and money wages: a) real and nominal GDPNominal GDP is calculating the GDP using current prices. Thismeans that each year’s GDP is calculated using that year’s prices.E.g. 2008’s GDP is calculated with 2008’s prices. On the other hand,real GDP is calculated using constant prices. For example, a baseyear is chosen, 2008. From that year onward, each year’s GDP iscalculated using 2008’s prices. This method shows the true pictureof what is actually going on in the economy.NOMINALGDPYEAR QUANTITY PRICE GDP2008 10 £2 £202009 10 £4 £40Based on the graph above, there was a nominal change inGDP. In 2008, GDP was £20 and in 2009, prices rose but quantityproduced remained the same. This resulted in a substantial increasein nominal GDP. However, if real GDP used and the constant priceused was £2 and as shown below, the GDP didn’t actually increase.REAL GDP YEAR QUANTITY PRICE GDP2008 10 £2 £202009 10 £2 £20
4b) Real and Nominal interest rates:What Is a Nominal Interest Rate?The nominal interest rate is the actual percentage used tocalculate the interest that a financial product such as a savingsaccount or certificate of deposit will yield. For example, if a savingsaccount has an interest rate of 5 percent, then the money in thatsavings account will grow by 5 percent per year.What Is the Real Interest Rate?The real interest rate is the nominal interest rate minusinflation; if the nominal interest rate is 5 percent per year andinflation is 3 percent per year, then the real interest rate will be 2percent per year. This real interest rate is the actual increase inbuying power an investor gets after both the nominal interest rateand inflation are taken into account.______________________________________________________3) The GDP deflator; the retail price index; the producerprice index. Calculations and limitations of the indices.I) THE GDP DEFLATORThis measure the level of newly domestically produced goodsand services in an economy compared to previous prices. It iscalculated using the following formula:X 100 = GDP deflator.Think of the price deflator as the ratio of the current year priceof a good to its price in some base year. The price in the base year
5is normalised to 100. A price deflator of 200 means that thecurrent-year price of the good is twice its base year price [priceinflation]. A price deflator of 50 means that the current year priceis half the base year price [price deflation].II)Retail Price Index (RPI):The Retail Price Index1(RPI), commonly referred as theConsumer Price Index (CPI), is an economic formula that measuresthe increase or decrease in the price of goods. The retail price index(RPI) is an inflation measurement used to determine the priceincrease in a market basket of goods. The common name for thisformula is the Consumer Price Index (CPI) and is issued on amonthly basis.The procedure for calculating the RPI is given in the following steps: A base year is recorded and the prices of the basket items arerecorded. Following this first step, a weighting is then assigned to eachitem in the basket which reflects its importance to the averagehousehold. A price relative for each item is then determined. This isgoverned by the formula:Price relative: X 100 The RPI is then found by the formula:RPI:
6EXAMPLE OF THE RETAIL PRICE INDEX: Basket of goods and services: Food, transport, clothing,housing. Base year prices (2009): Food - $20 Transport - $25 Clothing - $15 Housing - $30 Prices in 2010 changed to: Food -$25 Transport -$30 Clothing -$20 Housing -$40The RPI can now be calculated by using the given data:BASKET ITEMS WEIGHTING PRICERELATIVEWEIGHTINGS XPRICE RELATIVEFOOD .45 $25/$20 X 100= 125 56.25TRANSPORT .20 $30/$25 X 100= 120 24.00CLOTHING .05 $20/$15 X 100= 133 6.65HOUSING .30 $40/$30 X 100= 133 39.90TOTAL 1.0 126.8RPI = 126.8
7Limitations of the Retail Price Index:The retail price index is a thorough indicator of consumer priceinflation but there are some weaknesses in its usefulness for somegroups of people. It does not take into account the changes in taxes, healthcare, consumer safety, crime levels, water quality, air quality,and educational quality. It also sticks to the experiences of people living in the urbanarea. Psychological behavioural patterns of the buyer are notconsidered. The RPI is not fully representative: Since the RPI representsthe expenditure of the ‘average’ household; it may beinaccurate for the ‘non-typical’ household. Single people havedifferent spending patterns from households that includechildren, young from old, male from female, rich from poorand minority groups. We all have our own ‘weighting’ for goodsand services that does not coincide with that assigned for theretail price index. Housing costs: Housing costs vary greatly from person toperson, from the young house buyer, mortgaged to the hilt, tothe older householder who may have paid off his or hermortgage. The determination of which items should be included in orexcluded from the basket of goods.
8 The determination of the weighting to be applied to each itemin the basket.iii) Producer Price Index:The Producer Price Index (PPI) is a weighted index of pricesmeasured at the wholesale, or producer level. ThePPI shows trendswithin the wholesale markets (the PPI was once called theWholesale Price Index), manufacturing industries and commoditiesmarkets. All of the physical goods-producing industries that makeup the U.S. economy are included, but imports are not.The PPI release has three headline index figures, one each forcrude, intermediate and finished goods on the national level:1. PPI Commodity Index (crude): This shows the average pricechange from the previous month for commodities such asenergy, coal, crude oil and the steel scrap.2. PPI Stage of Processing (SOP) Index (intermediate): Goodshere have been manufactured at some level but will be sold tofurther manufacturers to create the finished good. Someexamples of SOP products are lumber, steel, cotton and dieselfuel.3. PPI Industry Index (finished): Final stage manufacturing, andthe source of the core PPI.4) Causes of inflation:a) Keynesian View - demand pull inflation (demand shock):
9Keynesians believe the level of real GDP depends on AD. If theeconomy is at full employment then an increase in AD leads to an increase inthe price level (as shown below).AD can increase due to an increase in any of its components C+I+G+(X-M).The link between output and inflation suggests that there will be a similar linkbetween inflation and unemployment.According to J.M Keynes, inflation can be caused by increase indemand and/or increase in cost. Demand-pull inflation is a situationwhere aggregate demand persistently exceeds aggregate supplywhen the economy is near or at full employment. Aggregatedemand could rise because of several reasons: A cut in personal income tax would increase disposable incomeand contribute to a rise in consumer expenditure. A reduction in the interest rate might encourage an increase ininvestment as well as lead to greater consumer spending onconsumer durables. A rise in foreigners income may lead to an increase in exportsof a country.Demand-pull inflation is caused by excess demand, which canoriginate from high exports, strong investment, rise in moneysupply or government financing its spending by borrowing. If firmsare doing well, they will increase their demand for factors ofproduction. If the factor market is already facing full employment,
10input prices will rise. Firms may have to bid up wages to temptworkers away from their existing jobs.It is most likely that during full employment conditions, the risein wages will exceed any increase in productivity leading to highercosts. Firms will pass the higher costs to consumers in the form ofhigher prices. Workers will demand for higher wages and this willadd fuel to aggregate demand, which increases once again. Theprocess continues as prices in the product market and factor marketare being pulled upwards.b) Cost Push Inflation (supply shock):Cost push inflation occurs when firms increase prices tomaintain or protect profit margins after experiencing a rise in theircosts of production.There will be a shift to the left in the aggregatesupply (as shown below). This can be shown by an inward shift ofthe short run aggregate supply curve which leads to a contraction inaggregate demand and a fall in real output, but an increase in thegeneral price level.
11The main causes of cost push inflation are: Rising imported raw materials costs perhaps caused byinflation in other countries or by a fall in the value of the TTDin the foreign exchange markets. Rising labour costs - rising labour costs are caused by wageincreases, which are greater than productivity increases this, isespecially important in industries, which are labour-intensive. Higher indirect taxes imposed by the government - forexample a rise in the specific duty on alcohol and cigarettes,an increase in fuel duties or a rise in the standard rate of ValueAdded Tax. These taxes are levied on producers who,depending on the price elasticity of demand and supply fortheir products can opt to pass on the burden of the tax ontoconsumers.c) Monetarist Theory of Inflation:Monetarist TheoryMonetarists argue that if the Money Supply rises faster than the rate of growthof national income then there will be inflation.· If money supply increases in line with inflation then there will be no inflation.Milton Friedman stated:“Inflation is always and everywhere a monetary phenomenon”Quantity theory of Money (Fisher Version) MV=PT,Where, M = Money Supply, V= Velocity of circulation, P= Price Level and T =Transactions.T is difficult to measure so it is often substituted for Y = National IncomeTherefore MV = PY, where Y =national output.
12The above equation must hold the value of expenditure on goods andservices must equal the value of output. However, they argue it isunwarranted increases in the money supply which cause inflation.Monetaristsbelieve that in the short term velocity (V) is fixed. This is because, the rate atwhich money circulates is determined by institutional factors e.g. how oftenworkers are paid does not change very much.Milton Friedman admitted it mayvary a little but not very much so it can be treated as fixed. Monetarists alsobelieve Output Y is fixed. They state it may vary in the short run but not in thelong Run (because LRAS is inelastic). Therefore an increase in the MoneySupply will lead to an increase in inflation.Monetarist inflation in the AD and AS model:i) Following a rise in the MS, consumers have more money so spend moregoods, this shifts AD to the rightii) Firms respond by increasing output along SRAS, from A to Biii) National output now exceeds the equilibrium level of output; therefore thereis an inflationary gap.iv) Firms need to hire more workers so wages rise leading to an increase incosts and hence prices. Initially workers agree to work more hours becausethey see an increase in nominal wages.v) As prices rise money can buy less therefore there is a movement to the leftalong the new AD.vi) Also workers realize the increase in nominal wage is not a real wageincrease. Therefore, workers also demand higher nominal wages to producemore output and to compensate them for rising prices, therefore SRAS shiftsto the left.vii) The economy has returned to the equilibrium level of output, but at ahigher price level.Therefore the rise in the Money Supply cause a rise in AD, But because theLRAS is inelastic there is no increase in therefore this is known as demandpull inflation.
135) Consequences of inflation:High and volatile inflation is widely seen by economists to have a range ofeconomic and social costs – hence the continued importance attached to the controlof inflationary pressure in an economy by both the government and also the centralbank.Why does inflation matter?The impact of inflation on individuals and businesses dependsin part on whether inflation is anticipated or unanticipated: Anticipated inflation: When people are able to makeaccurate predictions of inflation, they can take steps toprotect themselves from its effects. Unanticipated inflation: When inflation is volatile from yearto year, it becomes difficult for individuals and businesses tocorrectly predict the rate of inflation in the near future.Unanticipated inflation occurs when economic agents (i.e.people, businesses and governments) make errors in theirinflation forecasts.5) The Main Costs of Inflationi) Impact of Inflation on Savers:
14Inflation leads to a rise in the general price level so thatmoney loses its value. When inflation is high, people may loseconfidence in money as the real value of savings is severelyreduced. Savers will lose out if nominal interest rates are lower thaninflation – leading to negative real interest rates. For example asaver might receive a 3% nominal rate of interest on his/her depositaccount, but if the annual rate of inflation is 5%, then the real rateof interest on savings is -2%.ii) Inflation Expectations and Wage DemandsInflation can get out of control because price increases lead tohigher wage demands as people try to maintain their real livingstandards. Businesses then increase prices to maintain profits andhigher prices then put further pressure on wages. This process isknown as a ‘wage-price spiral’. Rising inflation leads to a build-upof inflation expectations that can worsen the trade-off betweenunemployment and inflation.iii) Arbitrary Re-Distributions of IncomeInflation tends to hurt those employees in jobs with poorbargaining positions in the labour market - for example people inlow paid jobs with little or no trade union protection may see thereal value of their pay fall. Inflation can also favour borrowers at theexpense of savers as inflation erodes the real value of existingdebts. And, the rate of interest on loans may not cover the rate ofinflation. When the real rate of interest is negative, savers lose outat the expense of borrowers.iv) Business Planning and InvestmentMore generally, inflation can disrupt business planning.Budgeting becomes difficult because of the uncertainty created byrising inflation of both prices and costs - and this may reduceplanned capital investment spending. Lower investment then has adetrimental effect on the economy’s long run growth potentialv) Competitiveness and Unemployment
15Inflation is a possible cause of higher unemployment in themedium term if one country experiences a much higher rate ofinflation than another, leading to a loss of internationalcompetitiveness and a subsequent worsening of their tradeperformance. If inflation inTrinidad and Tobago is persistently abovetheir major trading partners, TT exporters may struggle to maintaintheir share in overseas markets and import penetration into the TTdomestic market will grow. Both trends could lead to a worseningbalance of payments.The Advantages of Inflation:1. Business GrowthControlled growth of Inflation can become part of business growth,simply because savings are often invested, because of the net loss ifthey are kept in a Bank.During times of controlled Inflation, peoplein the past tended to spend, as they feared prices could rise, savingon buying now, rather than paying more later.2. Falling Debt ValuesHigher Inflation eats away at the real value of a currency. This couldmean that the actual value of debts decrease, benefiting indebtedbusinesses and private individuals.3. Higher Stock ValuesStocks bought at an earlier value, could rise in price and sold off ata higher price bringing higher profitability.4. Rising asset ValuesValues of fixed assets could rise, making some Companies morefinancially secure. Traditionally higher Inflation often leads to higherprices; therefore fixed assets in theory should rise in value.
166) Remedies for inflation: Income policy, monetary policy, fiscal policyand supply side measures.The control of inflation has become one of the dominantobjectives of government economic policy in many countries.Effective policies to control inflation need to focus on the underlyingcauses of inflation in the economy. For example if the main cause isexcess demand for goods and services, then government policyshould look to reduce the level of aggregate demand. If cost-pushinflation is the root cause, production costs need to be controlled forthe problem to be reduced.i) Monetary Policy:Monetary policy is a policy that influences the economy throughchanges in the money supply and available credit. Monetary policyis adopted by the Central Bank of Trinidad and Tobago. Monetarypolicy can control the growth of demand through an increase ininterest rates and a contraction in the real money supply.The effects of higher interest rates:Higher interest rates reduce aggregate demand in three main ways;• Discouraging borrowing by both households and companies.
17• Increasing the rate of saving (the opportunity cost of spendinghas increased).• The rise in mortgage interest payments will reduce homeownersreal effective disposable income and their ability to spend.Increased mortgage costs will also reduce market demand in thehousing market.• Business investment may also fall, as the cost of borrowing fundswill increase. Some planned investment projects will now becomeunprofitable and, as a result, aggregate demand will fall.• Higher interest rates could also be used to limit monetaryinflation. A rise in real interest rates should reduce the demand forlending and therefore reduce the growth of broad money.ii) Fiscal policy:Fiscal policy is the deliberate change in either governmentspending or taxes to stimulate or slow down the economy. It is thebudgetary policy of the government relating to taxes publicexpenditure, public borrowing and deficit financing. Fiscal policy isbased upon demand management i.e. raising or lowering the levelof aggregate demand by controlling various expenditures,government expenditure, consumption expenditure and investmentexpenditure.Higher direct taxes (causing a fall in disposable income)Lower Government spendingA reduction in the amount the government sector borrowseach yearThese fiscal policies increase the rate of leakages from the circularflow and reduce injections into the circular flow of income and willreduce demand pull inflation at the cost of slower growth andunemployment.
18iii) Direct wage controls - incomes policiesIncomes policies (or direct wage controls) set limits on the rate ofgrowth of wages and have the potential to reduce cost inflation. TheGovernment tries to influence wage growth by restricting pay risesin the public sector and by setting cash limits for the pay of publicsector employees.In the private sector the government may trymoral suasion to persuade firms and employees to exercisemoderation in wage negotiations. This is rarely sufficient on its own.Wage inflation normally falls when the economy is heading intorecession and unemployment starts to rise. This causes greater jobinsecurity and some workers may trade off lower pay claims forsome degree of employment protection.Long-term policies to control inflationi) Labour market reformsThe weakening of trade union power, the growth of part-timeand temporary working along with the expansion of flexible workinghours are all moves that have increased flexibility in the labourmarket. If this does allow firms to control their labour costs it mayreduce cost push inflationary pressure.ii) Supply-side reformsIf a greater output can be produced at a lower cost per unit,then the economy can achieve sustained economic growth withoutinflation. An increase in aggregate supply is often a key long termobjective of Government economic policy. In the diagram below wesee the benefits of an outward shift in the long run aggregatesupply curve. The equilibrium level of real national income increasesand the average price level remains relatively constant.
19Conclusion:The key to controlling inflation in the long run is for the authorities to keepcontrol of aggregate demand (through fiscal and monetary policy) and at the sametime seek to achieve improvements to the supply side of the economy.7) Phillips Curve:The essence of the Phillips Curve is that there is a short-term trade-offbetween unemployment and inflation.