Lecture 5 : Inflation

Definition of inflation • Inflation is a process in which the average level of prices rises and the value of money falls.. • Notes:  money is losing value  not prices of all goods and

All lectures of the course

9 Combined effects of monetary and fiscal policy;

10 Trading with the world;

Definition of inflation

• Inflation is a process in which the

average level of prices rises and the

value of money falls

• Notes:

 money is losing value

 not prices of all goods and services increase, but the average price rises

 some price changes are more important than others

 the inflation rate and the price level: the

inflation rate is the percentage change in the price level

•

An example of inflation measurement

𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑃𝑡 − 𝑃𝑡−1

𝑃𝑡−1

• the price index in June 2015 was 218.0,

• and the price index in June 2014 was 215.7

• Then, the inflation rate during the twelve months to June

Price index measurement

GDP deflator

GDP deflator measures the average level of prices of all goods and services that make up GDP

Two common methods

The Consumer Price Index (CPI)

is a price index based on the consumption expenditures of a basket of goods & services

The consumer price index (CPI)

• CPI is calculated as the ratio of the value of a basket in the

current period to its value in the base period (multiplied by 100)

A basket of goods: an example

A typical basket of goods & services should represent

common choices of a majority of households

Fish Rice

An example of calculating CPI and inflation rate

Year

Price of rice(1000 đ/kg)

Price of fish (1.000 đ/kg)

Expenditure (1000 đ) CPI

Inflation rate %

Calculate expenditure and inflation rates (the base year: 2013)

Make interpretation of results

Does the consumer price index measure the cost of living? Does a 5 percent increase in the CPI mean that the cost of living has increased by 5 percent?

A typical of a basket of goods & services in Vietnam

Groups of goods and services Weight (%) Total expenditure on final goods and services 100,00

Using GDP deflator to measure price index

• GDP Deflator is the ratio of the value of aggregate final output at

current market prices (Nominal GDP) to its value at the base year prices (Real GDP)

• 𝐺𝐷𝑃𝐷 = 𝐺𝐷𝑃𝑛

𝐺𝐷𝑃𝑟 ∗ 100

• The GDP deflator is a price index telling us the average price change

of the whole economy

• GDP deflator = qitpit

qitpi0

• Of which: i is the commodity or service i

• q is the quantity and p is the price

• t: the year of interest, 0: the base year

• D-GDP tells us a percentage increase in the average price level of the whole economy Example

Interpretation: the average price level in the economy

increased by 199.5% percent from 2000 (the base period for estimating real GDP) to 2015

GDP deflator & inflation: an exercise

• Assume that an economy produces two final goods

including rice and fish sauce Price and quantity of each

good is provided as follows:

2015 15 1.350 12 210 ? ? ? ?

Calculate real, nominal GDP, GDP deflator and inflation rate (the

base year: 2013) Make interpretation of results

CPI vs GDP deflator

Difference

points

1 includes anything bought by

consumers including foreign goods

includes only domestic goods and not anything that is imported

2 is a measure of only goods

bought by consumers

is a measure of the prices

of all goods and services

3 Commonly used to measure

inflation

Less common to measure inflation

Causes of inflation

An increase in aggregate demand-

demand pull inflation

(money supply, government purchases)

a decrease in aggregate supply –

Stagflation

(wage rates+, prices of raw materials+)

Inflation over the business cycle

(the Phillips Curve)

Inflation

Causes of inflation: Demand pull inflation

AS0

AD1 AD0

P1

Qa ∆Y Qp

Price index

(CPI, GDP deflator)

I+

G+

X+

IM-

Value of quantities of final goods and services

P1

AS(-):

Prices of materials(+) Wage (+) Rent (+) Interest rate (+)

Technology(-) Weather (-)

Inflation

Business cycle: inflation tend to change cyclically over time

Causes of business cycles:

Disturbances (i.e: war);

policies (i.e:

interest rate…);

• Supply shocks (i.e: flood, drought, earthquake…);

Inflation high

Inflation low

Inflation rise

Causes of inflation: Business cycles

Effects of inflation on redistribution of income and wealth

• Debtors gain and Creditors lose Why?

Price (+) Money(-) Goods and services (-)

• Salaried Persons (white collar persons) lose Why?

Salaries are slow to adjust when prices are rising

• Wage Earners may gain or lose Why?

• Depending upon the speed with which their wages adjust to rising prices

• And also depends on their unions’ power

• Fixed Income Group loses Why?

• The recipients of transfer payments such as pensions,

unemployment insurance, social security, etc and recipients of interest and rent live on fixed incomes

Effects of inflation on redistribution of income

and wealth

• Equity Holders or Investors

Persons who hold shares or stocks of companies gain during inflation Why?

Price (+)  Business activities (+)  Profits (+)  Dividends (+)

• But those who invest in debentures, securities, bonds, etc which carry a fixed interest rate lose during inflation because they receive a fixed sum while the purchasing power is falling

• Businessmen of all types (producers, traders and real estate holders) gain during periods of rising prices

Price (+)  Business activities (+)  Profits (+)

Effects of inflation on redistribution of

income and wealth

• Agriculturists:

• Landlords lose during rising prices because they get fixed rents

• Peasant proprietors who own and cultivate their farms gain Prices of farm products increase more than the cost of

production

• The landless agricultural workers are hit hard by rising prices Their wages are not raised by the farm owners, because trade unionism is absent among them

Effects of inflation on savings and

investment

• Less saving: High rate of inflation will have an adverse effect

on the savings in the economy Why?

• As people spend more to sustain their present standard of living, less

is being saved

• This will result in less loanable funds being available to firms for

investment

• Inflation tends to discourage investment and long term

economic growth Why?

• The uncertainty and confusion are more likely to occur during periods

of high inflation

• High inflation is said to discourage stability and discourage firms to take risks and invest

Conclusion on effects of inflation

Thus inflation redistributes income from wage earners and fixed income groups to profit recipients, and from creditors

to debtors

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The very poor and the very rich are more likely

to lose than middle income groups

How to control inflation?

 Control credits

2

Fiscal measures:

 Unnecessary expenditure (-);

 Taxes (+);

 Savings (+);

 Surplus budgets

 Public debt to reduce money supply

3

Other measures:

• To increase production;

• Rational wage policy;

• Price control;

Assigment 5

1 Find the latest inflation figures of

Vietnam/Laos for the last five year

(2010-2015);

2 Compare inflation rates of two countries and

make comments on resutls

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