Money, the economy, and inflation

Lecture # 06

Inflation

• Inflation is an increase in the overall price level.

• Deflation is a decrease in the overall price level.

• Sustained inflation is an increase in the overall price level that continues over a significant period.

Price Indexes

• Price indexes are used to measure overall price levels. The price index that pertains to all goods and services in the economy is the GDP price index.

• The consumer price index (CPI) is a price index computed each month by the Bureau of Labor Statistics using a bundle that is meant to represent the “market basket” purchased monthly by the typical urban consumer.

Inflation

Price of basket in any given year

CPI= --------------------------------------------Price of basket in the BASE year

The inflation rate is the percent change in the CPI .

Good Year 1 2 3Quantity Price Price Price

Pizzas 20 $ 10 $ 11 $ 13 Rent 1 $ 600 $ 640 $ 650 Car 1 $ 100 $ 120 $ 120 Phone 1 $ 50 $ 40 $ 40

Types of Inflation

• Cost Push Inflation• Demand Pull inflation• Hyper Inflation

The Costs of Inflation

• People’s income increases during inflations, when most prices, including input prices, tend to rise together.

• Inflation changes the distribution of income. People living on fixed incomes are particularly hurt by inflation.

The Costs of Inflation

• The benefits received by many retired workers, including social security, are fully indexed to inflation. When prices rise, benefits rise.

• The poor have not fared so well. Welfare benefits are not indexed and have not kept pace with inflation.

The Costs of Inflation

• Unanticipated inflation—an inflation that takes people by surprise—can hurt creditors.

• Inflation that is higher than expected benefits debtors; inflation that is lower than expected benefits creditors.

• The real interest rate is the difference between the interest rate on a loan and the inflation rate.

The Costs of Inflation

• Inflation creates administrative costs and inefficiencies. Without inflation, time could be used more efficiently.

• The opportunity cost of holding cash is high during inflations. People therefore hold less cash and need to stop at the bank more often.

Gross Domestic Product

• Gross domestic product (GDP) is the total market value of all final goods and services produced within a given period by factors of production located within a country.

Final Goods and Services

• The term final goods and services in GDP refers to goods and services produced for final use.

• Intermediate goods are goods produced by one firm for use in further processing by another firm.

Value Added

• Value added is the difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage.– In calculating GDP, we can either sum

up the value added at each stage of production, or we can take the value of final sales.

Value Added

Value Added in the Production of a Gallon of Gasoline (Hypothetical Numbers)

STAGE OF PRODUCTION VALUE OF SALES VALUE ADDED

(1) Oil drilling $ .50 $ .50

(2) Refining .65 .15

(3) Shipping .80 .15

(4) Retail sale 1.00 .20

Total value added $1.00

Exclusions of Used Goodsand Paper Transactions

• GDP ignores all transactions in which money or goods change hands but in which no new goods and services are produced.

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Exclusion of Output Produced Abroadby Domestically Owned Factors of Production

• GDP is the value of output produced by factors of production located within a country. Output produced by a country’s citizens, regardless of where the output is produced, is measured by gross national product (GNP).

Calculating GDP

GDP can be computed in two ways:

• The expenditure approach: A method of computing GDP that measures the total amount spent on all final goods during a given period.

• The income approach: A method of computing GDP that measures the income—wages, rents, interest, and profits—received by all factors of production in producing final goods.

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The Expenditure Approach

Expenditure categories:• Personal consumption

expenditures (C)—household spending on consumer goods.

• Gross private domestic investment (I)—spending by firms and households on new capital: plant, equipment, inventory, and new residential structures.

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The Expenditure Approach

• Government consumption and gross investment (G)

Expenditure categories:

• Net exports (EX – IM)—net spending by the rest of the world, or exports (EX) minus imports (IM)

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The Expenditure Approach

• The expenditure approach calculates GDP by adding together the four components of spending. In equation form:

GDP C I G EX IM ( )

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Components of GDP, 1999:The Expenditure Approach

Components of GDP, 2002: The Expenditure ApproachBILLIONS OF

DOLLARSPERCENTAGE

OF GDPPersonal consumption expenditures (C) 7303.7 69.9

Durable goods 871.9 8.3Nondurable goods 2115.0 20.2Services 4316.8 41.3

Gross private domestic investment (l) 1543.2 14.8Nonresidential 1117.4 10.7Residential 471.9 4.5Change in business inventories 3.9 0

Government consumption and gross investment (G) 1972.9 18.9Federal 693.7 6.6State and local 1279.2 12.2

Net exports (EX – IM) 423.6 4.1Exports (EX) 1014.9 9.8Imports (IM) 1438.5 13.8

Total gross domestic product (GDP) 10446.2 100.0Note: Numbers may not add exactly because of rounding.Source: U.S. Department of Commerce, Bureau of Economic Analysis.

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Personal Consumption Expenditures

• Personal consumption expenditures (C) are expenditures by consumers on the following:– Durable goods: Goods that last a relatively long

time, such as cars and appliances.

– Nondurable goods: Goods that are used up fairly quickly, such as food and clothing.

– Services: Things that do not involve the production of physical things, such as legal services, medical services, and education.

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Gross Private Domestic Investment

• Investment refers to the purchase of new capital.

• Total investment by the private sector is called gross private domestic investment. It includes the purchase of new housing, plants, equipment, and inventory by the private sector.

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Gross Private Domestic Investment

• Nonresidential investment includes expenditures by firms for machines, tools, plants, and so on.

• Residential investment includes expenditures by households and firms on new houses and apartment buildings.

• Change in inventories computes the amount by which firms’ inventories change during a given period. Inventories are the goods that firms produce now but intend to sell later.

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Gross Private Domestic Investment

• Remember that GDP is not the market value of total sales during a period—it is the market value of total production.

• The relationship between total production and total sales is:

GDP = final sales + change in business inventories

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Gross Investmentversus Net Investment

• Gross investment is the total value of all newly produced capital goods (plant, equipment, housing, and inventory) produced in a given period.

• Depreciation is the amount by which an asset’s value falls in a given period.

• Net investment equals gross investment minus depreciation.

capitalend of period = capitalbeginning of period + net investment

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Government Consumptionand Gross Investment

• Government consumption and gross investment (G) counts expenditures by federal, state, and local governments for final goods and services.

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Net Exports

• Net exports (EX – IM) is the difference between exports and imports. The figure can be positive or negative.– Exports (EX) are sales to foreigners of

U.S.-produced goods and services.– Imports (IM) are U.S. purchases of

goods and services from abroad).

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The Income Approach

• National income is the total income earned by the factors of production owned by a country’s citizens.

• The income approach to GDP breaks down GDP into four components:

GDP = national income + depreciation + (indirect taxes – subsidies) + net factor payments to the rest of the world + other

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The Income Approach

Components of GDP, 2002: The Income Approach

BILLIONS OFDOLLARS

PERCENTAGEOF GDP

National income 8,199.9 80.3Compensation of employees 6,010.0 58.9

Proprietors’ income 943.5 7.3

Corporate profits 748.9 7.3

Net interest 554.8 5.4

Rental income 142.7 1.4

Depreciation 1,351.3 13.2

Indirect taxes minus subsidies 739.4 7.2

Net factor payments to the rest of the world 11.1 0.1

Other 96.1 0.9

Gross domestic product 10,205.6 100.0Source: See Table 18.2.

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From GDP to Disposable Personal Income

GDP, GNP, NNP, National Income, Personal Income, and Disposable Personal Income, 2002

DOLLARS(BILLIONS)

GDP 10,205.6Plus: receipts of factor income from the rest of the world + 342.1Less: payments of factor income to the rest of the world 353.2

Equals: GNP 10,194.5Less: depreciation 1,351.3

Equals: net national product (NNP) 8,843.2Less: indirect taxes minus subsidies plus other 643.3

Equals: national income 8,199.9Less: corporate profits minus dividends 332.6Less: social insurance payments 731.2Plus: personal interest income received from the government and consumers + 439.1Plus: transfer payments to persons +1,148.7

Equals: personal income 8,723.9Less: personal taxes 1,306.2

Equals: disposable personal income 7,417.7Source: See Table 18.2.

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From GDP to Disposable Personal Income

• Net national product equals gross national product minus depreciation; a nation’s total product minus what is required to maintain the value of its capital stock.

• Personal income is the income received by households after paying social insurance taxes but before paying personal income taxes.

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Disposable PersonalIncome and Personal Saving

Disposable Personal Income and Personal Saving, 2002

DOLLARS(BILLIONS)

Disposable personal income 7,417.7

Less:

Personal consumption expenditures 7063.5

Interest paid by consumers to business 204.3

Personal transfer payments to foreigners 31.3

Equals: personal saving 118.6

Personal savings as a percentage of disposable personal income: 1.6%Source: See Table 18.2.

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Disposable Personal Income and Personal Saving

• The personal saving rate is the percentage of disposable personal income that is saved.

• If the personal saving rate is low, households are spending a large amount relative to their incomes; if it is high, households are spending cautiously.

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Nominal Versus Real GDP

• Nominal GDP is GDP measured in current dollars, or the current prices we pay for things. Nominal GDP includes all the components of GDP valued at their current prices.

• When a variable is measured in current dollars, it is described in nominal terms.

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Calculating Real GDP

• A weight is the importance attached to an item within a group of items.

• A base year is the year chosen for the weights in a fixed-weight procedure.

• A fixed-weight procedure uses weights from a given base year.

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Calculating Real GDP

A Three-Good Economy(1) (2) (3) (4) (5) (6) (7) (8)

GDP IN GDP IN GDP IN GDP INYEAR 1 YEAR 2 YEAR 1 YEAR 2

IN IN IN INPRODUCTION PRICE PER UNIT YEAR 1 YEAR 1 YEAR 2 YEAR 2

YEAR 1 YEAR 2 YEAR 1 YEAR 2 PRICES PRICES PRICES PRICESQ1 Q2 P1 P2 P1 x Q1 P1 x Q2 P2 x Q1 P2 X Q2

Good A 6 11 $.50 $ .40 $3.00 $5.50 $2.40 $4.40

Good B 7 4 .30 1.00 2.10 1.20 7.00 4.00

Good C 10 12 .70 .90 7.00 8.40 9.00 10.80

Total $12.10 $15.10 $18.40 $19.20

Nominal GDP

in year 1

Nominal GDP

in year 2

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Calculating the GDP Deflator

• The GDP deflator is one measure of the overall price level. The GDP deflator is computed by the Bureau of Economic Analysis (BEA).

• Overall price increases can be sensitive to the choice of the base year. For this reason, using fixed-price weights to compute real GDP has some problems.

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The Problems of Fixed Weights

1. Structural changes in the economy.2. Supply shifts, which cause large

decreases in price and large increases in quantity supplied.

3. The substitution effect of price increases.

The use of fixed price weights to The use of fixed price weights to estimate real GDP leads to problems estimate real GDP leads to problems because it ignores:because it ignores:

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GDP and Social Welfare

• Society is better off when crime decreases, however, a decrease in crime is not reflected in GDP.

• An increase in leisure is an increase in social welfare, but not counted in GDP.

• Nonmarket and household activities are not counted in GDP even though they amount to real production.

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GDP and Social Welfare

• GDP accounting rules do not adjust for production that pollutes the environment.

• GDP has nothing to say about the distribution of output. Redistributive income policies have no direct impact on GDP.

• GDP is neutral to the kinds of goods an economy produces.

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The Underground Economy

• The underground economy is the part of an economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP.

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Gross National Income per Capita

• To make comparisons of GNP between countries, currency exchange rates must be taken into account.

• Gross National Income (GNI) is a measure used to make international comparisons of output. GNI is GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation.

• GNI divided by population equals gross national income per capita.

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Gross National Income per Capita

Per Capita Gross National Income for Selected Countries, 2002COUNTRY U.S. DOLLARS COUNTRY U.S. DOLLARS

Switzerland 36,970 Portugal 10,670Japan 35,990 South Korea 9,400Norway 35,530 Argentina 6,860United States 34,870 Mexico 5,540Denmark 31,090 Czech Republic 5,270Ireland 28,880 Brazil 3,060Sweden 25,400 South Africa 2,900United Kingdom 24,230 Turkey 2,540Netherlands 24,040 Colombia 1,910Austria 23,940 Jordan 1,750Finland 23,840 Romania 1,710Germany 23,700 Philippines 1,050Belgium 23,340 China 890France 22,640 Indonesia 680Canada 21,340 India 460Australia 18,770 Pakistan 420Italy 18,470 Nepal 250Spain 14,860 Rwanda 220Greece 11,780 Ethiopia 100

Source: The World Bank Atlas, 2002.