Ch. 14: Inflation CIE3M1-01 M. Nicholson

What Is Inflation?

�  Inflation is the increase in the prices of goods & services over a period of time

�  Figure 14.1 pg. 290 à comments?

How To Increase Your Income Without Doing More Work � Cost of living allowances can be

calculated in the following manner: (Costs Today / Past Costs) x 100%

� Gas = $1.25 / $0.50 x 100% = 250%

The Consumer Price Index � CPI is a measure of the general changes in

market prices of a selected group of goods & services (< 400) purchased by the typical urban (> 30,000) family

� Products are weighted according their proportion of total household expenditures with seven components (food 18.1, housing 36.3, clothing 8.7, transportation 18.3, health 4.2, recreation and education 8.8, tobacco / alcohol 5.6)

The Consumer Price Index

� Current base year 1986 given the number 100 whereas 1990 is 117, which means there was 17 % inflation (Current Year CPI / Base Year CPI x 100%)

� CPI, GDP and unemployment rate are the three most commonly used indicators of how the Canadian economy is doing

Inflation Since 1940

� 1940 – 42 prices rose rapidly because of WW 2

� 1943 – 45 government controlled prices � 1946 – 49 rapid price increase with end

of war � 1951 Korean War drove up prices

Inflation Since 1940

1.  1953 – 65 (low inflation of 1.5%) 2.  1966 – 72 (higher inflation of 4.8%) 3.  1973 – 82 (9% inflation) 4.  1983 – 91 (< 5% inflation) 5.  1991 - (low inflation of < 2%) 6.  Figure 14.5 pg. 293 #1 - 3

Inflation: The Winner & Losers � Those who owe money (borrowers) win

and those who are owed money (lenders) lose

�  Inflation Race – expanding businesses, workers in powerful bargaining positions, and those who borrowed money are the winners

� Declining industries, workers in weak bargaining positions, and those on fixed incomes lose

Inflation: The Winner & Losers

�  Inflation shifts benefits from creditors to debtors

� Hyperinflation or extremely high rates of inflation devastates an economy causing money to become worthless à people turn to barter destroying benefits specialization (higher quality, cheaper products and more leisure time)

Inflation: The Winner & Losers

� Deflation – decrease in the general level of prices over time (Depression 1930s)

� Pgs. 301 – 302 #1 - 2

What Causes Inflation?

�  Full employment and no inflation is the ideal situation (i.e. full bucket)

� Bucket shows real output which is adjusted for inflation so that different year’s outputs can be compared

What Causes Inflation?

Demand-Pull Inflation

�  If full employment exists (full bucket) and injections (X + I + G) > leakages M + S + T) then no more goods & services can be produced, only prices will rise (inflation, water spilling out of the bucket)

� Demand for goods & services > quantity of goods & services pulls up prices

Demand-Pull Inflation

Government Policies to Control Demand-Pull Inflation 1.  Contractionary Fiscal Policy – G ↓ and

T ↑ à ↑ gov’t revenue for use during a recession

2.  Contractionary / Tight Money Policy – Sell bonds, ↑ the bank rate and use moral suasion to discourage bank loans

3.  Pg. 303 #3 - 5

Applying Fiscal & Monetary Policy To Demand-Pull Inflation 1.  Unemployment – the biggest negative

consequence of controlling inflation with contractionary policies

2.  Delays in applying the policy – recognition lag; decision lag; implementation lag

Cost-Push / Sellers’ Inflation

�  resource costs (e.g. ,wages) increase à producers pass on the increased costs to consumers in the form of higher priced products

� The worst situation is the twin evils of inflation & unemployment existing at the same time à stagflation

Cost-Push / Sellers’ Inflation

�  Stagflation - occurred in the 1970s when OPEC raised the price of oil which was an essential source of energy for the Canadian economy (e.g. bucket has holes on the side that leak)

� Oil Crisis Video

Cost-Push / Sellers’ Inflation

Income vs. Expenditure Method Of Measuring The Economy � C + I + G + (X – M) = GDP à

Expenditure Method � M (supply of money) x V (velocity of

circulation of money) = GDP � GDP = P x Q à MV = PQ � Recession – M ↑ x V = P x Q↑ �  Full Employment – M ↑ x V = P ↑ x Q

Income vs. Expenditure Method Of Measuring The Economy � Monetary Rule – economist Milton

Friedman believed that the money supply (M) should only be increased by the same amount as the increase in the amount of GDP which would solve the problem of inflation

� ∆% GDP ↑  = ∆% M ↑

Income vs. Expenditure Method Of Measuring The Economy � Keynesians believe in using G and T to

solve the problems of the economy � Monetarists believe G and T cause more

problems than they solve and the economy would be healthiest if money supply grows proportionally with GDP

Wage & Price Controls

� Policies aimed at restraining inflation by holding wages and prices below a specific level

�  Successful controls during WW 2 but unsuccessful controls in the 1960s and 70s. Video

Wage & Price Controls

1.  lack of united support 2.  large bureaucracy needed 3.  interference with the operation of the

market 4.  import prices Ø  all contributed to the lack of success