ECON 201 Lecture 16: Inflation (Fall 2024) PDF

Lecture 16: Inflation Fall 2024 Jonas Jin November 4, 2024 Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 1 / 28 Outline 1...

Lecture 16: Inflation Fall 2024 Jonas Jin November 4, 2024 Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 1 / 28 Outline 1 Introduction 2 Measuring Inflation 3 Real vs. Nominal Interest Rates 4 What is Money? 5 Causes and Effects of Inflation Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 2 / 28 Introduction We’ve talked about inflation in general terms: Nominal GDP = Real GDP * GDP Deflator/100 Shifts in the AS/AD curve change the price level, and an increase in the price level is inflation (decrease is deflation) P SRAS1 SRAS2 P∗ ′ P∗ AD Y∗ Y∗ ′ Y Today, we will cover this idea more precisely: What does the “price level” mean, and how do we measure it? What are the causes and effects of inflation? Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 3 / 28 Terminology: Nominal vs. Real When discussing inflation, we distinguish between nominal and real Nominal: “in name only”; just a number, without telling you what it can buy (i.e. not adjusting for inflation) ▶ Interpretation: doesn’t tell you much unless you know how much things cost ▶ For example, a $100 bill 50 years ago meant a lot more than a $100 bill today Real: “...real”; numbers adjusted for inflation ▶ Interpretation: in terms of production or goods, without any price changes For example, we have seen Nominal and Real GDP, with the difference being the GDP deflator (price level) Nominal: dollar value of GDP Real: value of GDP with fixed prices from a base year : isolates actual production Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 4 / 28 What is Inflation? Inflation is the rate at which prices of goods and services increase over time Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 5 / 28 Inflation Data Inflation is a hot-button issue, especially recently! We haven’t experienced inflation of this level since stagflation in the 1970s and 80s Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 6 / 28 Measuring Inflation: Motivation Inflation aims to measure changes in the price level or cost of living Cost of living: the amount of money needed to cover basic expenses such as housing, food, taxes, and healthcare Could be specific to location: country, county, city, etc. Of course, the cost of living depends on what each person buys...but as always, we just do our best Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 7 / 28 Measuring Inflation: Consumer Price Index The standard measure of the price level is the Consumer Price Index (CPI), which measures the change in price of a representative basket: “The CPI represents all goods and services purchased for consumption by the reference population. BLS has classified all expenditure items into more than 200 categories, arranged into eight major groups (food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services).” Source: Department of Labor Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 8 / 28 Measuring Inflation: Representative Basket Weights Basket items are weighted differently depending on how much of the cost of living they represent: Source: Pew Research Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 9 / 28 Measuring Inflation: Example Calculation Overall CPI measured as weighted average of group CPIs: Inflation measured as a percent change relative to a base year (in this case, t): CPIt+1 − CPIt CPIt Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 10 / 28 Difficulties in Measuring Inflation The standard CPI measurement often overestimates inflation due to: Quality changes: increase in price due to increase in quality, not pure inflation ▶ Consider the history of the iPhone: how has it changed? Do increases in price reflect inflation or changes in the quality of the iPhone? New products/basket changes from innovations ▶ CPI slow to add new goods, which tend to decrease in price after being introduced Substitution/discounting: when prices (of CPI basket items) increase, consumers substitute to other (cheaper) items instead of purchasing basket item The 1996 Boskin Commission found that the CPI overestimated inflation slightly more than ∼ 1% per year. Why does this matter? Social Security benefits indexed to CPI inflation: payments increased with inflation If CPI overestimated inflation, we overpaid in benefits! Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 11 / 28 Other Measures of Inflation The CPI is only one way to measure inflation. Alternative measures: GDP Deflator: measures overall price changes for all of production GDPNominal GDP Deflator = GDPReal ∗ 100 Price level of all production, not just CPI basket Personal Consumption Expenditures (PCE) Index Measures change in actual consumption rather than fixed basket Core CPI Same as CPI, without food and energy prices (which are more volatile) For each measure, try to think carefully and understand how it captures a different measure of overall price changes in the economy Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 12 / 28 CPI vs. Core CPI Red: Core CPI Blue: CPI Fluctuations in Core CPI smaller than CPI Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 13 / 28 CPI vs. PCE Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 14 / 28 Real vs. Nominal Interest Rates The interest rate is the return to an interest-bearing asset (to a saver) or the cost of loaning money (to a borrower) Nominal (or market) interest rate i: exchange rate in terms of present dollars for future dollars Real interest rate r : exchange rate in terms of present goods for future goods Example: Suppose the nominal interest rate = 5%, and inflation π = 2%. Today, we could use $100 to buy 1 basket of goods worth $100 If we save, in one year: ▶We have $105 due to 5% nominal interest on $100 ▶$100 basket of goods now costs $102 due to 2% inflation → We can now purchase 105 102 = 1.029 baskets of goods, so the real return is 2.9% Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 15 / 28 Fisher Equation We generalize this relationship into the Fisher equation: 1+i Nominal return on money 1+r = ← 1+π Loss in money’s value due to inflation We can take the natural log of both sides to obtain an approximation: 1+i 1+r = 1+π   1+i ln(1 + r ) = ln = ln(1 + i) − ln(1 + π) (Log property) 1+π r ≈i −π (Log approximation; Fisher Equation) Can apply a similar idea to raises: if you receive a 5% raise with 2% inflation, your raise in real terms was 5 - 2 = 3% *Works for small values of i and π Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 16 / 28 Costs of Inflation What are the costs of inflation? Well, of course an increase in prices decreases purchasing power...but what if nominal incomes still increase with inflation, so that real incomes stay the same? The next few slides discuss some costs of inflation beyond the decrease in purchasing power Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 17 / 28 Costs of Inflation Shoeleather costs Inflation reduces value of money, so people put money in interest-bearing assets instead of holding cash → Costly time making more trips to the bank (“shoeleather”) More salient during hyperinflation Menu costs Costs of price adjustment: deciding new prices, creating new catalogs, giving time to adjust, etc. Redistribution of income With higher (unanticipated) inflation, money owed/paid in future has lower value than expected → Redistribution of wealth from lenders to borrowers Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 18 / 28 Other Costs: Policies Distorted by Inflation Social Security and income tax codes based on nominal incomes Marginal tax brackets based on nominal incomes If your nominal income increases, you may enter into a higher tax bracket even if your real income stays the same! Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 19 / 28 Deflation So there are costs of inflation...what about deflation? The consequences of deflation are even worse! Same costs (shoeleather costs, menu costs) apply Redistribution of wealth goes in direction from borrowers to lenders, and borrowers typically worse off More generally, deflation also occurs a result of falling aggregate demand; often a symptom of broader economic issues Think of negative demand shock in AS/AD model Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 20 / 28 What is Money? Money is the set of assets in the economy that people use to buy goods and services. Money has three functions: 1 Medium of exchange: can be exchanged for goods and services 2 Unit of account: used to measure prices 3 Store of value: used to transfer purchasing power from present to the future Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 21 / 28 Definitions A few definitions: Currency (Cur ): paper bills and coins held by people ($20 bill in your wallet) Demand deposits (Dep): bank balance that can be accessed via check or debit card ($20 in checking account) Reserves (Res): money held by banks ($20 bill either in a bank vault or in a commercial bank account at the Federal Reserve) ▶ Used by banks to service withdrawals Based on these quantities, we define the following: Monetary base (MB) currency + reserves ▶ Interpret loosely as all cash ever printed (either held by individuals or banks) Money supply (M1): currency + demand deposits ▶ Interpret (loosely) as everything that can be used as purchasing power ▶ Credit cards excluded; not a method of payment, but rather deferring payment Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 22 / 28 Money in the US Economy The money supply, or money stock, can take a few different definitions: M1, M2, M3, or M4 M1 is the most “liquid” (easily transformed into purchasing power), comprised of currency and demand deposits M2 − M4 are progressively less liquid, e.g. including financial assets Unless otherwise specified, assume the money supply refers to M1 What has happened to M1 in recent years? Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 23 / 28 Milton Friedman on Inflation “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” -Milton Friedman Friedman believes that inflation driven by increases in money supply We will first see the theory establishing this connection, then explore some data Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 24 / 28 Theory of Inflation: Quantity Theory of Money The quantity theory of money establishes this proposed relationship between growth in the money supply and inflation. MV = PY where: M = money supply V = “money velocity” P = price level Y = real GDP Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 25 / 28 Interpretation MV = PY |{z} or gM + gV = gP + gY Nominal GDP can be rewritten as: PY V = or gV = gP + gY − gM M In other words, money velocity represents the average number of times each dollar of money supply must change hands in order to purchase nominal GDP Typically, V is relatively stable (gV ≈ 0) =⇒ If M grows, PY (nominal GDP) must grow =⇒ If Y (real GDP) grows slower than M, gP (inflation) makes up the difference In particular, money neutrality is this hypothesis that changes in money supply do not affect real variables (e.g. real GDP Y ) If constant V , suggests that M and P grow at the same rate Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 26 / 28 Money Supply, Nominal GDP, and Velocity Typically, V is relatively stable =⇒ If M grows, PY (nominal GDP) must grow =⇒ If Y (real GDP) grows slower than M, growth in P (inflation) makes up the difference Does this hold? Nominal GDP, money supply, and velocity in the US from 1959 - 2019: Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 27 / 28 Money Supply and Price Level Graphs below depict relationship between money supply and price level during hyperinflation: Seems like hyperinflation largely driven by increases in money supply Where does this money supply come from? To be discussed next time! Jonas Jin (Northwestern University) ECON 201 Lecture 16 November 4, 2024 28 / 28