InflationBusiness CyclesInflationBusiness CyclesInflationElias YannopoulosSeptember 12, 2012Elias Yannopoulos InflationInflationBusiness CyclesInflationInflation - a continual rise in the price levelDeflation - a continual fall in the price levelPrice Index - a number that summarizes what happens to aweighted comosite of prices of a selection of goods andservicesPrice Index is a measure of the Price LevelGDP Deflator - an index of the price level of aggregateoutput , or the average price of the components in totaloutput relative to a base yearFavored by economists because it includes the most goodsBut including so many goods makes it difficult to computeElias Yannopoulos InflationInflationBusiness CyclesInflation Cont.Consumer Price Index (CPI) - measures the price of a fixedbasket of consumer goods, weighted according to eachcomponent’s share of an average consumer’s expenditureCPI is published monthly, while GDP Deflator is publishedquarterlyMost relevant to consumersUsed most often in new reportsUsing a fixed basket causes overestimation of inflationNot all prices rise when there is inflationPrices of new technology tends to fallRelative price changes reflect real changes, inflation nominalchangesElias Yannopoulos InflationInflationBusiness CyclesCalculating InflationInflation rate - growth rate of the price indexi =P2−P1P1× 100Ex: Price index in the second year is 110 and the first year isthe base yeari =110−100100× 100 = 10%Ex: Price index in the third year is 121i =121−110110× 100 = 10%Rule of 72 - To estimate how many years it takes for a valueto double divide 72 by the growth rateYearsToDouble =72GrowthRateElias Yannopoulos InflationInflationBusiness CyclesExpectations and InflationExpected Inflation - inflation that people expect to occurExpected Inflation has been about 2% - 3% a year in the USsince World War IIUnexpected Inflation - inflation that is a surpriseInflation that can have real effectsExpected Inflation is self fulfillingEx: Both sides expect inflationElias Yannopoulos InflationInflationBusiness CyclesCosts of InflationSpecifically cost of Unexpected inflationFuture price level uncertaintyPeople do not want to engage in long term contractsWage contracts that last several yearsBorrowers and lendersSignal Extraction ProblemDifficult to discern price increases as inflation or relative pricechangesRelative price increase implies that firms should increaseoutput hiring workers and building factoriesIf all prices go up because of inflation that implies that firmsshould not change outputcan lead to mis-allocation of resourcesElias Yannopoulos InflationInflationBusiness CyclesCosts of Inflation Cont.Menu CostsThere are costs to changing the prices on a menuPhysical cost - actually replacing the physical menusGas stations have easily changed signs, Stephen Colbert buysall the ”4”sPsychological cost - cost to consumer demand from changingpricesConsumers may reduce demand in response to price increaseeven if it is inflationaryVending machine soda pricesResult is that some prices do not adjustElias Yannopoulos InflationInflationBusiness CyclesCosts of Inflation Cont.Money IllusionPeople interpret nominal changes as real changesWage increases make people feel richer even if it is onlyinflationHyperinflation - triple digit inflation, above 100%Inflation is a monetary phenomenon, but can have an impacton the real economyElias Yannopoulos InflationInflationBusiness CyclesBusiness CyclesLong Run - a period of time where no factor of production isfixedShort Run - at least one factor of production is fixedThere is no specific lengths of time for the long or short runEx: wage contracts, leasesThis will reappear in the AS/AD modelThe long run framework, textbook refers to as ”ClassicalEconomics”Focus on growthThe short run framework, textbook refers to as ”KeynesianEconomics”Focus on business cycle fluctuationsElias Yannopoulos InflationInflationBusiness CyclesBusiness Cycle TerminologyA business cycle - the upward or downward movement ofeconomic activity (real GDP) that occurs around the growthtrendThe National Bureau of Economic Research - announces thegovernment’s official dates of contractions and expansionsPeak - the top of a business cycleDownturn - economic activity falling from a peakpart of the downturn is still above trendRecession - a decline in real output that persist for more thantwo consecutive quarters of a yearDepression - a long recessionHow long is long is a debated topicElias Yannopoulos InflationInflationBusiness CyclesBusiness Cycle Terminology Cont.Trough - the bottom of a recessionUpturn - economic activity rising from a troughExpansion - an upturn that lasts at least two consecutivequartersEconomists generally agree that fluctuations are caused bychanges in demand for goods and services in the economyEconomists disagree on what if anything should be done aboutitEx: Graph, total output changes vs growth rate changesElias Yannopoulos
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