Inflation and Real GDP

Learning Objectives
• Concept and the need to measure inflation.
• The use of price indices to measure inflation
• Measuring changes in real GDP
• Causes of inflation
• Real Interest Rates and the Market for
Loanable Funds
• Impact of inflation (anticipated vs.
unanticipated).
 Inflation Terminology
• Inflation; a sustained increase in the average
or general price level
• Hyperinflation; an extremely rapid rate of
increase in the general price level (note costs)
• Deflation; a sustained decrease in the general
price level
• Disinflation; a reduction in the rate of inflation
 The Need to Measure Inflation
• Inflation (changes in prices) distort the
measurement of output.
• It also distorts the measurement of
consumption
• It distorts the value of interest rates as the
value of returns on financial transactions
• It distorts the value of wages and especially
the well being of people who have relatively
fixed incomes.
 The Use of Price Indices
• Price Index: a weighted sum of prices of different goods and
services
• The increase of different sets of prices is measured by different
price indices.
• The most commonly cited is the Consumer Price Index (CPI) that
measures the rate of increase in the prices of consumer goods and
services.
• The Producer Price Index (PPI) does the same for Producer Prices
• The GDP Price Index (Deflator) is a comprehensive price index of all
the prices of the goods and services included in GDP. (Recall Y = PQ
→ P = Y/Q or Deflator = Nominal GDP divided by real GDP.
 Components of a Price Index
• The “basket”; what goods or services are included;
definition and survey.
• The weights; what percentage of the total value of
the index is contributed by each good or service;
definition and survey.
• The base year or base period; taken to be relatively
normal; not influenced by extraordinary
circumstances.
• Price information; initial and subsequent monthly
surveys.
 Price Index Computation
• The value of the index in any year is the aggregate measure
of prices in that year divided by the aggregate measure of
prices in the base year multiplied by 100.
ie Indext =(Pt/Pby) x 100
• Therefore Index in base year is (Pby/Pby) x 100 = 100
• Index in any other year gives the general or average price
level in that year as a percentage of prices in the base year.
• e.g. Indext = 115 means that prices in time period t are
15% higher than in base year. ((New – Old)/Old) x 100
• If Index increases from 600 to 630 during a year, then the
rate of inflation for that year is ((630-600)/600) x 100 = 5%
 CPI Jamaica_statinja.gov.jm
• Table 1. Weight Structure in the Revised CPI Percentages(%)
• * The weights applied are based on the 2004/2005 Household Expenditure Survey.
• 01 Food and Non-Alcoholic Beverages 37.4
• 02 Alcoholic Beverages and Tobacco 1.4
• 03 Clothing and Footwear 3.3
• 04Housing, Water, Electricity, Gas and Other Fuels12.8
• 05Furnishings, Household Equipment and Routine, Household Maintenance 4.9
• 06 Health 3.3
• 07 Transport 12.8
• 08 Communication 4.0
• 09 Recreation & Culture 3.4
• 10 Education 2.1
• 11Restaurants & Accommodation Services6.2
• 12 Miscellaneous Goods & Services 8.4
• Total Expenditure 100
Distribution of Jamaica CPI Weights

8.4

6.2

Food & Beverage

7.4
38.8 Clothing & Household
Housing Elec Gas
Health & Education
Transport
12.8 Comm, Rec & Culture
Restaurants & Accomodation
Miscell Goods/Services

5.4

8.2
12.8
Index One Good
Index with Three Commodities
 Rate of Inflation
• The general rate of price increase (inflation)
for the three commodities is the change in the
cost of the basket for the current year relative
to the base year, divided by the cost of the
basket in the base year, all multiplied by 100.
((New –Old)/Old) x 100 = ((New/Old)-1) x 100
• (∆Cost/Cost in Base Year) x 100 = ((Cost in
Current Year/Cost in Base Year)-1)x100
• ((1398.35-1184.85)/1184.85))x100 = 18%
 Measurement of Real GDP
• Real GDP seeks to isolate output independent of price
• Due to the difficulty of adding up different types of output,
a monetary value derived from the prices of output is still
necessary
• To isolate output and changes in output, it is necessary to
use the prices from a particular year in valuing output of
that particular year and in comparison to other specific
years.
• By using the prices of one year to value the output of that
year and of other years, we eliminate the impact of price
changes and isolate the impact of changes in output.
 Change in Real GDP
• GDP =P xQ
• GDP2000 = P xQ
• The change in GDP between 1980 and 2000 may
be due to a change in price and/or a change in
output.
• We need to eliminate the effect of the change in
prices to isolate the impact of the change in
output i.e. to compare P1980 x Q1980 with P1980 x
Q2000 where the only difference is in Q -output.
 Change in Real GDP contd.
• We measure output in 2000 at 1980 prices by
dividing GDP in 2000 by the ratio of prices in
2000 to prices in 1980, where 1980 is the base
year.
• (P2000xQ2000)/(P2000/P1980) = P1980xQ2000
 Change in Real GDP- Numerical
Example
• Price1980=100 and Price2000 = 120
• Nominal GDP1980 ( =P1980xQ1980 ) = $ 56,395,480.00
• Nominal GDP2000 (=P2000xQ2000) = $ 78,235,649.00
• To find GDP2000 at 1980 prices we divide GDP2000 by the
ratio of prices in 2000 tp prices in 1980 which is
P2000/P1980 ie (P2000xQ2000)/(P2000/P1980 )=P1980xQ2000
• GDP in 2000 at 1980 prices is $78,235,649.00 divided by
120/100 = $65,196,374.17
• By this measure the increase in output between 1980
and 2000 is $((65,196,274.17 -
56,395,480.00)/56,395,480.00)x100% =
$((65,196,274.17/$56,395,480.00)-1)x100% = 15.61%
 Problems with Price Indices
• Proper selection of base year, basket (for
partial indices) and weights
• Changes of expenditure patterns over time
• Technological change and the introduction of
new goods
• Technological change and falling prices (e.g.
computers)
• Changes in quality of goods over time
 Sources: Demand Pull vs. Cost Push
• Demand Pull; the result of aggregate demand
increasing faster than aggregate supply (AD
shifting to right)
• Monetarism; a case of demand pull resulting
from money supply increasing too rapidly.
• Quantity Theory of Money: MV = PT
• Cost Push; the result of increases in costs of
production for each level of output (AS
shifting to left).
Demand Pull vs. Cost Push Graphs
Real Interest Rate
Market for Loanable Funds
 Impact on Loanable Funds Market
• An increase in expected inflation
-makes borrowers willing to pay higher interest
rates and the demand for loanable funds shifts
to the right
-makes lenders demand higher interest rates
and the supply of loanable funds shifts to the
left
• The impact is an increase in the equilibrium
nominal interest rate.
 Other Effects of Inflation
• Labour market; wage-price spiral, industrial unrest,
output loss
• Uncertainty and the inability to plan and engage long
term contracts
• Social welfare; negative impact on fixed incomes,
pensions, low interest saving
• Impact on expenditure patterns; e.g. Immediate
consumption and real estate.
• Impact on captital flight and exchange rate stability
Anticipated vs. Unanticipated Inflation
• Unanticipated inflation creates more problems than
anticipated inflation.
• If inflation is fully anticipated, people take steps to
protect themselves in the contracts they make.
(Wages, interest rates)
• If inflation is unanticipated there will be winners and
losers; e.g. Expected inflation at 3%, wage settlement
at 4% and out turn at 6%
• Industrial unrest, lost production and forward
indexation that may worsen inflation.
• Impact of uncertainty on planning.
 Learning Objectives Again
• Concept and the need to measure inflation.
• The use of price indices to measure inflation
• Measuring changes in real GDP
• Causes of inflation
• Real Interest Rates and the Market for
Loanable Funds
• Impact of inflation (anticipated vs.
unanticipated).
 Readings
• Baumol & Blinder Ch 23
• Frank 7 Bernanke Chs 16-17
• Case, Fair, Oster Chs 21-22