|Answer any five questions and post in the assignment box (not on the discussion board) by due date.|
1) Suppose that the value of the CPI in January of 1999 was 165 and its value on January 2000 was 172. What was the rate of inflation in 1999?
Hint: Inflation rate can be measured by any specific year compared to another by the following equation:
delta CPI/CPI = CPI1 – CPIo/CPI0; where, CPI1 is current year price and CPIo is previous year CPI.
2) Suppose that your annual salary in 1997 was $50000 and rose to $62000 by the year 2000. If during that same time the CPI rose from 160 to 175, what was the % increase in your “real wage” over this three period?
3) Why do the CPI and the GDPD show different rates of inflation for the same time period?
4) Why has the tremendous growth in household consumption of computers since the CPI base year of 1983 imparted an upward bias to the rate of increase of the CPI?
5) If the rate of inflation in the U. S. expected by participants in Treasury bill markets rose from 2% to 4%, what would you expect to happen to the level of 1-year Treasury bill prices? Assume that investors required a 2% “real” return to willingly hold the entire existing supply of T-bills both before and after the change in inflation expectations. (If possible calculate the % Change in T-bill prices per $100 of face value… at least explain the direction of change in T-bill prices.)
6) Draw a supply demand diagram to illustrate your answer to #5.
7) The nominal yield on 10 year treasury bonds is currently ~4.9%. If an investor wishes to earn at least a 3.5% real before tax rate of return on her capital, what expectations about future inflation levels must she hold in order to willingly hold 10 year treasury bonds at existing prices?
8) Agree or disagree with the following statements and explain your reasoning:
A) The major problem with inflation is that it reduces everyone’s real income.
B) If actual inflation exceeds market expectations of inflation, income is transferred from lenders to borrowers.
9) Explain why high inflation rates are likely to lower the growth rate of RGDP over time.
The Costs of Inflation
Later in this term we will see that once an economy has reached its “full employment level” of potential output, there is often a conflict between pursuing faster real economic growth in the short run and maintaining low stable inflation rates. In particular, the central bank (the “Fed”) has often increased interest rates to slow down the rate of growth of spending and reduce inflation pressures, even though higher interest rates also typically reduce real investment and real growth. Often students don’t understand exactly why the central bank places such high importance on the goal of price stability that it is willing to risk recession (and has actually triggered recessions on several occasions in the last 50 years) pursuing price stability. What’s so bad about inflation?
In the assigned reading in your text for this week, there is an extensive discussion of the costs of inflation. In this set of notes, I’m not going to repeat each of the 6 different inflation costs the text lists individually. Instead, I’m going to situate the text’s discussion in a broader overview of the key issues involved.
Note first that, contrary to popular opinion, inflation does not automatically lower aggregate real income. That is, when prices of goods and services are generally rising, the money revenues from the sale of those goods and services must also be rising. This revenue becomes someone’s income. Indeed, if labor productivity and the employment level were unaffected by inflation, then real output would be unaffected and money incomes in the aggregate would rise as fast as prices. Aggregate real income would be unchanged by inflation. The case against inflation rests on arguments that: 1) High and unpredictable rates of inflation change the behavior of savers, investors, entrepreneurs and consumers in ways which lower the growth rate of productivity, thus indirectly, but profoundly reducing the growth rate of real output & income. 2)Inflation redistributes income in ways which neither reflect individuals’ contributions to real output growth nor their level of neediness. This perceived irrationality and unfairness of income redistributions associated with inflation undermines the legitimacy of established political and economic institutions.
Inflation and Real Output Growth
As we saw in the set of notes previous to this one, uncertainty about future rates of inflation creates uncertainty about the real rates of return on loans and/or investments in debt instruments like bonds. Moreover, inflation creates uncertainty about the extent of central bank efforts to restrain inflation, thus creating uncertainty about the possibility of future recessions. This tends to depress stock prices. The higher the current inflation rate, the greater will be the uncertainty about future inflation. Savers and lenders dislike risk and uncertainty. Therefore, financial capital will tend to flow out of countries with higher inflation rates, which raises the real rate of return that borrowers must pay in those countries to obtain funds. The higher cost of funding in turn discourages investment in physical capital and in new products and technologies. This lowers the growth rate of labor productivity and, therefore, the growth rate of RGDP.
The tax code in this country, which taxes both interest income and capital gains on a nominal rather than on a real basis, accentuates savers’/lenders’ dislike of inflation and further forces up real borrowing costs to firms and entrepreneurs. For example, if the marginal tax rate on interest income were 25%, inflation was expected to be 3% and lenders required a 6% after tax rate of return in order to assume the risks of lending, the nominal lending rate would be 12%. However, if the expected inflation rate were 6%, even if lenders were still content with a 6% after tax rate of return, the nominal lending rate would rise to 16%.
While the real value of many financial assets such as bonds and stocks decline in inflationary periods, the prices of some assets whose supply is relatively fixed such as beachfront property, paintings by old masters, precious metals, etc. typically rise faster than the general price level. That is, the real value of such assets increases. This encourages entrepreneurs to shift the focus of their investment and risk-taking efforts towards markets for these assets and away from pioneering new technologies and products. This shift of investment activity away from productivity enhancing physical capital and towards property and collectibles, also contributes to a reduction in the growth rate of labor productivity and RGDP.
Also, during an inflation period, it is more difficult for consumers to engage in comparison-shopping and select the producer among a group of competitors who is supplying the best value. If the consumer walks into a store and sees that its prices are higher than those of a store visited a month earlier, the consumer doesn’t know if this means that the store is not offering good relative value or if it simply means that prices have gone up everywhere and might go up even more while the consumer “shops around”! However, if consumers do less comparison-shopping, market competition is less likely to reward the most efficient producers. This reduces the incentive for producers to continuously look for ways to reduce costs and increase productivity. Once again, RGDP growth will be reduced.
All of the problems mentioned in the last few paragraphs that reduce real capital accumulation, productivity and output growth are relatively minor if inflation rates are low, stable and, therefore, predictable. However, they escalate dramatically as the inflation rate increases and becomes less predictable. In extreme cases of “hyperinflation” the focus of everyone’s effort shifts away from productive activity and towards hoarding physical goods and assets. No one wants to hold money or lend money. The country’s financial intermediaries and capital markets collapse. Real output and living standards drop precipitously and the country’s political institutions and leadership lose their legitimacy.
In short, even though inflation does not automatically “reduce” real income directly, it distorts relative prices of goods and financial assets in ways that reduce incentives to save, to lend and to assume entrepreneurial risk in potentially productivity enhancing technologies. Moreover, as we will discuss in more detail later in this course, expectations of higher inflation tend to elicit behavior that increases the actual rate of inflation. (For example, if both union leaders and a firm’s management believe there will be significant inflation in the next few years when they arte negotiating a contract, they will likely agree on a higher rate of money wage growth than otherwise, assuming that the firm can “pass on” the higher wages in the form of higher prices to consumers without losing market share since “everybody” will be raising prices.) Thus, the FED is always concerned that even a modest increase in inflation could set in motion a self reinforcing spiral in which higher observed inflation leads to higher inflation expectations which, in turn, leads to higher actual inflation.