The Monetary System, Prices, and Inflation

The Monetary System, Prices, and Inflation

The Monetary System • Establishes two different types of standardization in the economy • Unit of value—a common unit for measuring how much something is worth • Refers to the way we think about and record transactions • Means of payment—things we can use as payment when we buy goods and services • Refers to how payment is actually made • In United States, the dollar is centerpiece of our monetary system

History of the Dollar • How did the dollar come to play such an important role in the economy? • Prior to 1790, each colony had its own currency • Called the “pound” in every colony, but it had a different purchasing power in each of them • In 1790 Congress created a new unit of value called the dollar • Primary means of payment in United States until Civil War was paper currency issued by private banks • However, during Civil War government issued first federal paper currency—greenback • Functioned as both unit of value and major means of payment until 1879 • In 1913, a new institution was created to be the national monetary authority in United States • Federal Reserve System

Why Paper Currency is Accepted as A Means of Payment • Paper currency is a relatively recent development in the history of the means of payment • Earliest means of payment were precious metals and other valuable commodities such as furs or jewels • Called commodity money because they had important uses other than as a means of payment • Commodity money eventually gave way to paper currency • Today paper currency is no longer backed by gold or any other physical commodity • This type of currency is called fiat money • Fiat, in Latin, means “Let there be,” and fiat money serves as a means of payment by government declaration • While government can declare that paper currency is to be accepted as a means of payment, it cannot declare the terms • Value of the dollar—its purchasing power—does change from year to year • Reflected in changing prices of things we buy

Measuring the Price Level and Inflation • Microeconomic causes—changes in individual markets—can explain only a tiny fraction of price change • For the most part, price rises came about because of a continually rising price level • Average level of dollar prices in the economy

Index Numbers • Most measures of the price level are reported in the form of an index • Series of numbers, each one representing a different period • In general, an index number for any measure is calculated as • Compress and simplify information so that we can see how things are changing at a glance

The Consumer Price Index • Most widely used measure of the price level in United States • Designed to track price paid by typical consumer • Compiled and reported by Bureau of Labor Statistics (BLS) • Two problems must be solved before we even begin • Must decide which goods and services should be included in average • How to combine all the different prices into a average price level • CPI’s approach is to track cost of CPI market basket • Collection of goods and services typical consumer bought in some base period

From Price Index to Inflation Rate • Consumer Price Index is a measure of the price level in the economy • Inflation rate measures how fast price level is changing, as a percentage rate • When price level is rising, as it almost always is, inflation rate is positive • When price level is falling, as it did during Great Depression, we have a negative inflation rate • Called deflation

How the CPI is Used • CPI is one of the most important measures of performance of the economy • Used in three major ways • As a policy target • Measure most often used to gauge our success in achieving low inflation • To index payments • A payment is indexed when it is set by a formula so that it rises and falls proportionately with a price index • To translate from nominal to real values • In order to compare economic values from different periods, we must • Translate nominal variables • Measured in the number of dollars • Into real variables • Adjusted for the change in dollar’s purchasing power • CPI is often used for this translation

Figure 1: The Rate of Inflation Using the Consumer Price Index, 1950-2001

Real Variables and Adjustment for Inflation • Suppose that from December 2004 to December 2005, your nominal wage rises from $15 to $30 per hour • Are you better off? • That depends • To track your real wage, need to look at number of dollars you earn relative to price level • Real wage formula is as follows

Real Variables and Adjustment for Inflation • Important point • When we measure changes in macroeconomy, we usually care about purchasing power those dollars represent • Not about the number of dollars we are counting • Translate nominal values into real values using the formula • How most real values in the economy are calculated • One important exception • To calculate real GDP, government uses a different procedure

Inflation and the Measurement of Real GDP • A special price index called GDP price index is calculated for GDP • Most important differences between CPI and GDP price index • Types of goods and services covered by each index • GDP price index includes some prices that CPI ignores • GDP price index excludes some prices that are part of CPI • Can summarize chief difference between CPI and GDP price index • GDP price index measures prices of all goods and services that are included in U.S. GDP • While CPI measures prices of all goods and services bought by U.S. households

The Inflation Myth • Most people think inflation erodes average purchasing power of income • By making goods and services more expensive • However, this statement is mostly wrong • Inflation can redistribute purchasing power from one group to another • But it does not directly decrease average real income • Often blame inflation for lowering our purchasing power when the real cause lies elsewhere

The Redistributive Cost of Inflation • One cost of inflation is that it often redistributes purchasing power within society • How does inflation sometimes redistribute real income? • An increase in price level reduces purchasing power of any payment that is specified in nominal terms • Inflation can shift purchasing power away from those who are awaiting future payments specified in dollars • Toward those who are obligated to make such payments • Does inflation always redistribute income from one party in a contract to another? • No—if inflation is expected by both parties, it should not redistribute income

Expected Inflation Need Not Shift Purchasing Power • Over any period, percentage change in a real value (%Δ Real) is approximately equal to percentage change in associated nominal value (%Δ Nominal) minus the rate of inflation • %ΔReal = %ΔNominal – Rate of Inflation • If inflation is fully anticipated, and if both parties take it into account, then inflation will not redistribute purchasing power • When inflation is not correctly anticipated, however, our conclusion is very different • Nominal interest rate • Annual percent increase in a lender’s dollars from making a loan • Real interest rate • Annual percent increase in a lender’s purchasing power from making a loan • In absence of inflation, real and nominal interest rates would always be equal

Unexpected Inflation Does Shift Purchasing Power • When inflationary expectations are inaccurate • Purchasing power is shifted between those obliged to make future payments and those waiting to be paid • An inflation rate higher than expected harms those awaiting payment and benefits the payers • An inflation rate lower than expected harms the payers and benefits those awaiting payment

The Resource Cost of Inflation • Inflation imposes an opportunity cost on society as a whole and on each of its members • When people must spend time and other resources coping with inflation they pay an opportunity cost • Sacrifice goods and services those resources could have produced instead • Resources used by consumers to cope with inflation • Time you could have spent earning income or enjoying leisure activities

The Resource Cost of Inflation • Inflation also forces sellers to use up resources • Sellers of goods and services are also buyers of resources and intermediate goods • Each time sellers raise prices, labor is needed to • Put new price tags on merchandise • Enter new prices into a computer scanning system • Update HTML code on a Web page • Change prices on advertising brochures, menus, and so on • Inflation makes us all use up resources managing our financial affairs • All these additional activities—use up not only time, but other resources as well • From society’s point of view, these resources could have been used to produce other goods and services that we’d enjoy

A Preliminary Word About Deflation • In early 2000s, as annual inflation rate approached 2%, a new worry appeared on the American political and economic scene • That disinflation ( a decreasing inflation rate) might lead to deflation (a negative inflation rate) • In some respects, deflation creates costs for society similar to those of inflation • However, deflation has some special costs and risks of its own, entirely different from those of inflation

Is the CPI Accurate? • Bureau of Labor Statistics spends millions of dollars gathering data to ensure measure of inflation is accurate • BLS is a highly professional agency, typically headed by an economist • Billions of dollars are at stake for each 1% change in CPI • BLS deserves high praise for keeping its measurement honest and free of political manipulation • Economists widely agree CPI overstates U.S. inflation rate • Even those who work at BLS • BLS has been working hard to reduce this upward bias, and—especially in the late 1990s—it made some progress • But significant bias remains

Sources of Bias in the CPI • Several reasons for upward bias in CPI • Substitution bias • New technologies • Changes in quality • Growth in discounting

Substitution Bias • Until recently, CPI almost completely ignored a general principle of consumer behavior • People tend to substitute goods that have become relatively cheaper in place of those that have become relatively more expensive • Although BLS has partially fixed the problem, CPI still suffers from substitution bias • Categories of goods whose prices are rising most rapidly tend to be given exaggerated importance in CPI • Categories of goods whose prices are rising most slowly tend to be given too little importance in CPI

New Technologies • CPI excludes new products that tend to drop in price when they first come on the market • When included, CPI regards them as entirely separate from existing goods and services • Instead of recognizing that they lower cost of achieving a given standard of living • Result is an overestimate of the inflation rate

Changes in Quality • Many products are improving over time • BLS struggles to deal with these changes • In recent years, BLS has adopted some routine statistical procedures to automatically adjust price changes for quality improvements

Growth in Discounting • CPI treats toothpaste bought at a high-priced drugstore and toothpaste bought at Wal-Mart or Drugstore.com as different products • Assumes we continue to buy from high- and low-priced stores in unchanged proportions • But that is not what has been happening • In fact, Americans are buying more and more of their toothpaste and other products from discounters • CPI omits reductions in the prices people pay from more frequent shopping at discount stores • Overstates inflation rate

Using the Theory: The Use and Misuse of an Imperfect CPI • Inaccuracies in measuring CPI suggest that CPI should be used and interpreted with great care • Unfortunately, CPI is often used for purposes which—by its nature—it cannot handle accurately • Indexing • Justification for indexing is to protect these people from any deterioration in living standards caused by inflation • But because changes in CPI overstate inflation, these beneficiaries are overindexed • Nominal benefit rises by a greater percentage than a more accurately measured price index would rise • When a payment is indexed and price index overstates inflation, real payment increases over time • Purchasing power is automatically shifted toward those who are indexed, and away from rest of society • General principle applies whether the economy is growing rapidly or slowly, and it applies to anyone who is indexed • Social security recipients, government pensioners, union workers with indexed wage contracts, or anyone else

Using the Theory: Long-Run Comparisons • Because BLS does not correct previously-reported CPI numbers to reflect later methodological improvements • Long-term comparisons of real variables based on official CPI will remain inaccurate, even as CPI measurement improves • Using or viewing CPI as an index of the cost of living creates an added source of inaccuracy • Because CPI ignores impact of new goods on living standards • Raises a further objection to CPI-based indexing for maintaining (rather than increasing) living standards • Ad to CPI-based inferences about changes in economic well-being over time

Using the Theory: What the CPI Does Well • CPI has another purpose besides indexing and making inferences about living standards • To measure inflationary tendencies in economy • CPI is one of several useful tools to help achieve this goal • Other measures not based on the CPI are available for tracking consumer prices • Including a special index calculated by commerce department’s Bureau of Economic Analysis (BEA) to track prices of consumer goods in GDP • Called chain-type consumer expenditures price index • While the two measures of inflation tend to rise and fall together, they often give different results • Inflation based on the BEA’s index is generally lower than inflation based on CPI • Still, because the CPI is based on a different set of data, and because it includes some goods ignored by other indices, it provides policy makers with valuable information about price changes

The Monetary System, Prices, and Inflation