Session 11 - Inflation and Money

Question 1

Inflation

Answer 1

Inflation
- A generalized rise in the overall level of prices (cost of living)
- can also be seen as a decline in the purchasing power of money

Inflation rate
- The annual percentage increase in the average price level

Question 2

Common measures of inflation - CPI

What does the CPI track?

Answer 2

Consumer Price Index (CPI):

• tracks the average price consumers pay over time for a representative “basket” of goods and services
• most commonly discussed and used

Question 3

Challenges in measuring the cost of living with CPI

Answer 3

1. Quality improvements can hide price decreases
   Ex: quality of mobile phones; price increase partially reflects this
2. New products can reduce the cost of living
   Ex: invention of smartphones reduced the cost of living as smartphones replaced many goods and services
   -> CPI misses such cost reductions as it tracks only existing goods’ prices
3. People adapt consumption decisions
   - Whenever prices rise, people adapt and update their consumption basket
   - CPI’s fixed basket doesn’t capture these shifts, potentially overstating inflation
   -> Substitution bias

• The basket gets updated but infrequently and imprecisely

–> all 3 biases can lead to overestimation but infrequently and imprecisely

Question 4

Measures of inflation - PCE deflator

1. What does PCE stand for? How is it used?
2. What are PCE’s advantages compared to the CPI (2)?
3. What are the disadvantages (2)?

Answer 4

1. Personal consumption expenditure (PCE) deflator is used for monetary policy, like the Federal Reserve’s target inflation rate of 2%
2. The PCE includes a wider range of goods and services compared to the CPI, accounting for indirect consumption like medical care paid by employers or the government

The goods and services in the PCE basket are continually updated to account for changing patterns of spending. So the PCE avoids the substitution bias and tends to be lower

3. • But PCE basket may not align closely with consumers’ actual out-of-pocket spending, so CPI is often preferred for calculating inflation-adjusted wages

• But constantly changing basket may not accurately reflect the consumption patterns of low-income individuals, who may have less flexibility to substitute goods

Question 5

Alternative measures of inflation: PPI Index

Answer 5

The producer price index (PPI) measures the price of inputs into the production process - it measures the inflation experienced by the businesses

Because goods in the PPI basket are inputs to the production of final consumer goods, one might think that changes in the PPI could forecast future changes in the CPI

However, the empirical evidence is mixed, potentially due to the differences in how these indices are constructed

Question 6

Measures of inflation - GDP deflator

What is the GDP deflator? Difference to CPI?
How is it calculated?
Shortcomings of GDP deflator?

Answer 6

GDP deflator is a measure of inflation based on the basket of all goods and services produced domestically

Difference to CPI: includes capital goods but excludes imported goods

GDP deflator = Nominal GDP / Real GDP * 100

Challenges to interpretation:

• for small economies reliant on a few key sectors (such as Kuwait), a price surge in an export sector may inflate the deflator even when prices are generally stable
• the GDP deflator ignores the prices of imported goods. If economy highly relies on imports, the deflator may not fully capture consumer price inflation

Question 7

Summary: Measures of inflation (3)

Answer 7

• Consumer Price Index (CPI): representative consumption basket
• Personal consumption expenditure (PCE) deflator:

-producer price index (PPI):

Question 8

How is the CPI constructed?

Answer 8

CPI = consumer price index; measure of inflation

1. Find out what people buy (Survey consumers on spending habits)
2. Collect prices
3. tally up the cost of the basket (aggregate total cost of the basket giving higher weights to more commonly consumed items)
4. Calculate inflation (calculate the percentage change in the cost of the basket over time)

Question 9

Nominal interest rate

What is the nominal interest rate?
What have central banks to do with the nominal interest rate?

Answer 9

Nominal interest rate is the stated interest rate without a correction for the effects of inflation

Central banks control the money supply that directly affects the Nominal interest rate

-> their ultimate goal is indirectly controlling inflation

Question 10

Real internst rate

Answer 10

Real interest rate is the interest rate in terms of changes in your purchasing
power, ≈ Nominal interest rate − Inflation rate

Question 11

Money illusion

What is money illusion?

Answer 11

Money illusion refers to the (mistaken) tendency to focus on nominal dollar amounts instead of real amounts

Question 12

What can be the consequence of money illusion (3) ?

Answer 12

Money illusion may:

• Distort decision-making: people are less likely to buy goods that are nominally more expensive even if the difference is purely due to inflation
• Lead to mis-pricing: people sometimes price a good based on the prices they bought it for, which may be disastrous if price levels changed starkly over time
• Create nominal wage-rigidity: employees often do not respond negatively to real wage decreases due to inflation as long as their nominal wages are constant

Question 13

Three functions of money

Answer 13

1. Medium of exchange
2. Unit of account: terms in which prices are quoted
3. Store of value: a way to transfer purchasing power to the future

Question 14

What is hyper-inflation?

Answer 14

Hyperinflation is extremely high rates of inflation

• No precise cut-off, but imagine prices at least doubling every few months

Question 15

What are the effects of hyper inflation?

Answer 15

Hyperinflation has terrible effects on life and erodes all three functions of money

[1. Medium of exchange
2. unit of account
3. store of value ]

Question 16

Causes of Hyperinflation

Answer 16

Governments can generate revenue by printing money at virtually zero cost, using it to purchase goods <-seignorage

The ease of printing money tempts governments to do so in the face of serious fiscal problems like wars, reparations, and external debts

Question 17

Challenges of ending hyperinflation

Answer 17

Hyperinflation creates expectations of future inflation, leading to immediate consumer spending, which in turn further hikes up prices

SO the government is forced to print even more money to cover expenses

With expectations of future inflation, escaping hyperinflation becomes difficult

often, ending hyperinflation requires major monetary/fiscal reforms that convince the public that the inflation will stabilize

Question 18

Costs of inflation (3)

Answer 18

Moderate expected inflation entails costs:

1) Menu costs for sellers - marginal cost for adjusting prices
2) shoe-leather costs for buyers; money losses value -> people keep more wealth in other assets, takes time and effort

Unexpected inflation:
3)Confusing price signals - difficulty in linking price changes to actual demand shifts

Question 19

Deflation

Answer 19

Deflation is a generalized decrease in the overall price level (negative inflation)

Question 20

Negative consequences of Deflation (4)

Answer 20

• people delay consumption due to expected lower prices
• reduced spending decreases output -> prices fall further
• spending falls further -> vicious cycle of more deflation
• real interest rate becomes higher, which also further depresses spending

Question 21

Central banks

Define Currency & Reserves

Answer 21

Currency: cash held by households, firms, and banks

Reserves: balances held by commercial banks in their accounts at the central bank

Question 22

What is the main mandate of central banks?

Answer 22

Price stability: when inflations remains low, stable and predictable; but not too low to risk deflation

usually aimed at an inflation rate of 2%

Question 23

Some central banks have a dual mandate - what is meant by that?

Answer 23

Some central banks, like the Federal Reserve, have a dual mandate

This means that in addition to price stability it should also promote maximum employment

Question 24

What is the difference in the central bank balance sheets today and in the past?

Whats the mechanism behind it?

Answer 24

Balance Sheets consist of assets and liabilities which make up the total size

in the past assets mostly consisted of short-term gov bonds ; today these bonds are long-term

as well as the liabilities are not only currency but also reserves

-> total size from very small to very large (today)
-> changes due to quantitative easing

Question 25

What is quantitative easing? Key aspects (3)

Answer 25

QE is a novel monetary policy that aims to increase aggregate demand by buying assets, even when the policy interest rate is zero

Key aspects:
- central bank buys gov bonds and other financial assets
- focuses on purchasing the long-term gov bonds to target longer-term interest rates
- these purchases raise asset prices and increase money supply, boosting spending and borrowing

Question 26

Direct instruments of monetary policy (3)

Answer 26

Interest rate controls -> frequently used when other instruments cannot be applied

Credit ceilings -> restrictions on the quantity rather than price of credit; can deliver effective control over bank credit

direct lending policy -> requires banks to allocate credit to specific sectors, such as agriculture

Question 27

Indirect instruments of monetary policy (4)

Answer 27

Legal reserve requirements
Discount window
Open market operations
Repurchase operations (Repos) (- effectively short-term loan; temporarily reducing market liquidity