Chapter 20(2).ppt

Chapter 20: Inflation In 1887 there was a bar and grill owner in San Francisco named George Inflation. One day he failed to receive a shipment of his finest whiskeys and brandy from the East.  Since the demand for booze was great, George Inflation decided to charge 15c for a shot of whiske...

Chapter 20: Inflation In 1887 there was a bar and grill owner in San Francisco named George Inflation. One day he failed to receive a shipment of his finest whiskeys and brandy from the East.  Since the demand for booze was great, George Inflation decided to charge 15c for a shot of whiskey, instead of the standard 10c. He also made the shot glass smaller. This did not stop his customers from buying booze, so he raised the price to 20c, then 25c.  The other bars in San Francisco raised their prices accordingly and when their customers complained, the other bar and grill owners would say, “Blame it on Inflation”. Thus, inflation soon became part of the English Language. Source: Posted in Gazette (Montreal), 1969 in the insights column Learning Outcomes Define inflation Describe how inflation is measured. Distinguish between the different measures of inflation Explain why inflation is regarded as a problem. Distinguish between three approaches to explaining what causes inflation: Discuss the different policies that can be used to combat inflation Explain demand-pull and cost-push inflation Mention policies that can be used to combat inflation. KFC price s 1976 KFC prices 2018 20.1 Inflation "Public enemy number one" Inflation reduces the power of money ▫ Makes your salary looks bigger, but you buy less and less with it Inflation: a continuous and considerable rise in prices in general, but the quality of the product remains the same. Four aspects need to be emphasised with this definition:  Neutral – allows for all possible causes of inflation to be taken into account, and provides a sounder basis for anti-inflation policy. Process – continuous increase in prices, not a once-off price increase A considerable increase in prices. Prices in general, not an increase in the price of a particular good. 20.2 Measuring inflation 20.2 Consumer Price Index (CPI) Most commonly used indicator of the general price level Reflect the cost of a representative basket of consumer goods and services Reported each month since inflation is a continuous process Expressed as an annual rate (always in %) How do we measure inflation for a particular year? Since its measured monthly meaning each year = 12 figures (not restricted to calendar years; any 12 month average may be compared with the previous 12 month average) When we say that the inflation rate is 10%, this means  Method 1: Month on the same month of the Table 20-1 previous year: Compare the index of the corresponding month in the previous year. To calculate inflation for December 2013 CPI 2013  CPI 2012 100 CPI 2012 105.4  100.0 100 100.0 = 5.4% (subject to fluctuations)  Method 2: Inflation Table 20-1 annual average: Calculate the average of all the monthly index values, Compare it with the corresponding average of the previous year. Avg 2013  Avg 2012 100 Avg 2012 103.4  97.8 97.8 = 5.7 % (not subject to fluctuations)  Class activity The South African Reserve Bank has released the following CPI figures for 2016 in their first Monetary Policy Review. Using the information in the table below, calculate the current inflation rate.  Answer CPI inflation rate2016 = [(CPI2016 - CPI2015)/CPI2015] x100% = [(106.9 – 102.3)/102.3] x 100% = 4.5% 20.2 Producer Price Index (PPI) Also important price index but differs from CPI Associated with the cost of production Basket consists of capital & intermediate goods Measures change in wholesale prices, i.e. prices of production Table 20-2 20.2 GDP Deflator Implicit index – used as another measure to calculate the inflation rate. Side effect of the calculation of economic growth The GDP deflator shows the difference between nominal and real GDP in a particular year: o GDP at current prices: Nominal GDP (current price level) o GDP at constant prices: Real GDP (true value, adjusting for the effects of inflation) The transformation of GDP at current prices (nominal) to constant prices (real – adjusting for the effect of inflation) measures economic growth, but also yields an inflation measure. Calculating inflation using the GDP deflator method  Nom.GDPYearB  Defl.YearB   *100  Re al.GDPYearB   Nom.GDPYearA  Defl.YearA   *100  Re al.GDPYearA   Defl.YearB  Defl.YearA   YearB   *100  Defl.YearA   Exercise Consider the following information provided by Statistics South Africa: Calculate the inflation rate for 2016 Year GDP at GDP at 2000 current prices constant prices 2014 888 057 624379 2015 982 944 642 038 2016 1098 714 661 147  Answer Year GDP at GDP at 2000 current prices constant prices 2014 888 057 624379 2015 982 944 642 038 2016 1098 714 661 147 GDP deflator 2016 = (1098714 / 661147) x 100 = 166.2 GDP deflator 2015 = (982944 / 642038) x 100 = 153.1 Inflation 2016 = (166.2-153.1)/153.1 x 100 The causes of inflation We can explain some elements of the inflation process by examining three approaches to diagnosing inflation. The approaches are: o The demand-pull and cost-push approach o The structural approach o The conflict approach 20.4 Demand-Pull Inflation AD increase while AS remains unchanged. “Too much money chasing too few goods” This is associated with an increase in money stock (M) REMEMBER: AD = C + I + G + X – Z THUS an increase in AD is caused by an increase in C,I,G,X  (C): credit  (I): lower interest rates/profits expectation  (G): combat unemployment/better services  (X) earnings: Improved economic conditions Fig 20.1 Demand-pull inflation  AD ↑ lead to ↑ in P & increase in production and income (Y) (see AD1 & AD2)  + impact on employment, production and income provided that there's still unemployed resources.  At full employment (economy), increases in AD will simply lead to increases in price only.  Indicated by the shift from AD3 to AD4.  How do we fix? Monetary Policy... i.... M Fiscal Policy... t... G 20.4 Cost-Push Inflation Prices are pushed up by increases in costs of production Higher cost leads to lower supply AS shifts to the left 5 main causes: Increase in wages and salaries Increase in imported capital & intermediate goods Increase in profit margins Decrease in productivity Natural disasters 20.4 Cost-Push Inflation Cost-push inflation has a negative impact on production, income and employment. Stagflation occurs, because increasing prices (inflation) are accompanied by increased unemployment. Cost-push inflation can be combat with an income policy (see chapter 21) Monetary policy & Fiscal policy cannot combat cost-push inflation. Fig 20.2 Cost-push inflation  An increase in production cost results in an increase in the price and a decrease in the total production (stagflation).  This has a negative impact on employment, income and production. 20.4 Structuralist Approach Retains the distinction between demand-pull and cost-push, but in a broader context. The inflation process is the result of the interaction between three interrelated sets of factors: ▫ The underlying factors  which provide the background against which the inflation process occurs (provides an indication of the vulnerability of economy to inflation).  For instance, a lack of fiscal discipline, the size of the public sector. ▫ The initiating factors  which triggers or intensify a particular inflation process.  Classified into three broad factors (demand pull factors, Cost push and other price/cost increases). For instance, natural disasters. 20.4 Structuralist Approach ▫ The propagating factors  which explains the transmission to the rest of the economy in sustaining inflation  Generate the process of rising inflation  Three sets of propagating factors  For instance, inflationary expectations The sustained process of inflation can occur if all the three factors are present Take note of Table 20-4 Conflict approach to inflation Inflation is a symptom of disharmony/imbalance in society (among various social groups like trade unions, large firms, politicians etc.) Everyone tries to claim a bigger share of the national income; claiming more than what is available – triggering inflation Hence - according to this approach, inflation is a symptom of the lack of effective economic and/or political mechanisms to reconcile reported income levels 20.3 The costs/effects of inflation Distribution effects Economic effects No equal impact on individuals impact on employment and and groups growth Debtors (borrowers) tend to productive activity neglected gain at the expense of creditors (real value of their repayments Saving (e.g. fixed deposit) is reduced over time) discouraged Government (biggest debtor in exports may suffer (if inflation the country) tends to gain at in SA is higher than that of expense of private sector. main trading partners) Government also gains via the imports may be stimulated progressive tax system (individuals will pay a higher tax rate even when they are not better off) – bracket creep Redistributes income and wealth from the elderly to the young Affects poor households  Social and political effects Expected inflation inflation may result in the expectation of further inflation self-fulfilling prophesy may give rise to hyperinflation Creates a climate of conflict that is not conducive to economic progress Gives rise to social and political unrests Makes people unhappy 20.5 Anti-inflation policy Demand-pull inflation Use restrictive monetary and fiscal policy by  the tax & interest rates and  government spending. Discourage spending Such an approach would reduce inflation or even lead to reduced price levels. 20.5 Anti-inflation policy Cost-push inflation Cannot use restrictive monetary and fiscal policy (Cost push is already accompanied by a decline in production/income) Restrictive policy would increase unemployment further and push the economy deeper into a recession Increasing supply is therefore ideal, despite increased costs Difficult in practice 20.5 Anti-inflation policy Indexation Prices, wages and so on are linked to price indices like the CPI to eliminate the distributional effects of inflation. Inflation rate should be 100% or more (only used in emergency conditions) Inflation targeting An economic policy in which a central bank estimates and makes a public projected, or "target", inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools The key features are:  The announcement of quantitative targets The primary of price stability as the objective of monetary policy (in addition, the central bank should be operationally independent) A broad-based, pragmatic approach to the analysis of inflation (use a wide range of variables to decide on the suitable setting of the policy instrument (repo rate)) Transparency (central bank should regularly inform the public and markets about its plans, decisions and objectives). Accountability (central bank should be held accountable to the parliament or public at large for achieving its main objectives) Advantages and disadvantages (textbook page 397)  Inflation Targeting in South Africa Announced inflation targeting framework in 2000 Inflation target range: 3 – 6% Uses repo rate as monetary policy instrument to control inflation Repo rate set by Governor of Reserve Bank in consultation with Monetary Policy Committee MPC meetings six times during the year 21.5) Unemployment and inflation The Phillips curve Table 21-2: Aggregate demand, production, prices and unemployment (Textbook page 405)  The Phillips curve  Inverse relationship between inflation and unemployment  Lower unemployment levels are associated with higher rate of increase in general price level, vice versa  Trade-off  Inflation can be reduced to 0 only if the unemployment rate is allowed to increase to 5% 21.5.1) Stagflation in the Phillips curve  1970s:  Inflation +  unemployment  Illustrated by a rightward shift of short-run Phillips curve  Causes of stagflation? Occurs due to factors such as higher rate of increase in import prices, wages due to trade union pressure or higher profit margins  Associated with a supply shock (↓AS↑P) Fig. 21-3  P1 is the worse position for A simultaneous increase in inflation and unemployment the economy  solution is an income policy 21.6) Supply side Policies Income policy  Three – way agreement to allow the income policy to work  Government  Employers (firms)  Workers (unions)  Policy directed at the control of inflation  Refers to some form of government intervention in the determination of wages and prices (usually by limiting increases)  Usually requires workers (and unions) to limit their demands for nominal wage increases  Firms are required to limit their profit margins Cont…  If prices can be kept constant, relative share of profits and wages remains constant  Difficult to implement – Refer to box 21-3  Uncertainties as to whether parties involved will keep to the agreement  Unrealistic to expect all sectors to grant uniform increases in wages  Also prevents the working of the market mechanism at the microeconomic level  Industries will not attract labour through higher wages  As a result, they will not grow/expand – same profit margin throughout  If implemented, income policies generally do not last long, particularly in market oriented economies  U.S (1971 – 74); UK (1972 – 74); Canada (1975 – 78)  Further reading in textbook page 407- 408 Other important concepts Hyperinflation very high inflation which tends to escalate out of control Deflation continuous fall in prices in general falling prices even more damaging than rising prices Disinflation falling inflation rate prices still increase but at a declining rate Stagflation High inflation accompanied by high unemployment rate (explained in Chapter 21)  Test Your Knowledge Question 1 Consider the following information provided by Statistics South Africa: Calculate the inflation rate for 2017 Year Nominal GDP Real GDP 2013 3 561 238 3 027 654 2014 4 155 965 3 390 972 2015 4 795984 3 730 069 2016 5 130 703 4 028 475 2017 5 643 773 4 391 038  Answer GDP deflator = Nominal GDP/Real GDP *100 Deflator 2016 = 5 130 703/4 028 475 x100 = 127.36 Deflator 2017 = 5 643 773/4 391 038 x 100 = 128.53 Inflation rate 2017 = deflator current year - deflator previous year/deflator previous year *100 Inflation rate 2017 = 128.53-127.36/127.36 x 100 = 0.92% Question 2 Complete the following table by calculating the rate of inflation for each given month of 2002 Month CPI 2001 CPI 2002 January 103.8 109.0 February 104.1 110.2 March 104.8 111.3 April 105.3 113.1  Answers Complete the following table by calculating the rate of inflation for each given month of 2002 CPI CPI Rate of Month 2001 2002 inflation January 103.8 109.0 5.0 February 104.1 110.2 5.9 March 104.8 111.3 6.2 April 105.3 113.1 7.4 Recap Inflation: a continuous increase in the general price level Measured through three different methods 2 Main causes/approaches of inflation? Other two approaches? Effects/costs of inflation. SA’s inflation target. Watch video on eFundi ‘chapter videos’ – ‘chapter 20’ Thank you