Chapter 12

Inflation:How to Gain and Lose

at the Same Time

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What Is Inflation?

• Inflation – a continuing rise in the general level of prices• Dynamic, self-sustaining• Suppressed inflation

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How Is Inflation Measured?

The inflation rate between year 0 and year 1 is calculated as follows:

If CPI in year 0 = 100 and CPI in Year 1 = 108, then:

Inflation Rate in Year 1 = 108 – 100 * 100 = 8% 100

Inflation rate in year 1 = CPI in Year 1 – CPI in Year 0 * 100 CPI in Year 0

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Price Indexes

• Consumer Price Index (CPI) = cost-of-living index• Implicit price deflator

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Year 0 1

P Cost P Cost

40 lbs grapes $2.00 $80.00 $2.10 $84.00

120 Knitting Needles

$1.00 $120.00 $1.10 $132.00

Cost of Market Basket $200.00 $216.00

Constructing the Consumer Price Index

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How the Consumer Price IndexIs Calculated

• Choose a Base Year • Index = Cost of Market Basket year i * 100

Cost of Market Basket in base year • Index(Year 0) = ($200/$200) * 100 = 100 • Index(Year 1) = ($216/$200) * 100 = 108

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Problems in Measuring the Cost of Living

• Typical household• Substitution bias• Introduction of new goods• Unmeasured quality changes

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The Rate of Inflation Over Time

1.3

4.6

7.7

10.6

6.1

4.3

2.6 2.3 1.9

0

2

4

6

8

10

12

60-65 65-70 70-75 75-80 80-85 85-90 90-95 95-00 00-04

Percent

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Inflation Loan Terms Nominal Value Real Value

0% inflation $1,000 @ 5% $1,050 $1,050

10% inflation $1,000 @ 5% $1,050 $950

10% inflation $1,000 @ 15% $1,150 $1,050

Equity Effects

• People on relatively fixed incomes• Creditors and Debtors

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Efficiency Effects

• Impact on resource allocation• Costs of adjusting to inflation

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Output Effects

• Positive effect of mild inflation• Negative effect of runaway or hyperinflation• Pure inflation

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What Is Money?

• Money is anything generally acceptable in payment for goods and services and in payment of debt

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Functions of Money

• Medium of Exchange• Measure of Account• Store of Value

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Currency and Coins 702.0 51.4%

Traveler’s Checks 7.5 0.5%

Demand Deposits 335.5 24.5%

Other Checkable Deposits 321.8 23.5%

Total 1,366.7 100.0%

Source: Federal Reserve System, Feb. 2005.

M1

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M1 1,366.7 21.2%

Small-denomination time deposits 835.9 12.9%

Savings deposits 3,546.9 54.9%

Money market mutual funds 706.8 10.9%

Total 6,456.1 100.0%

Source: Federal Reserve System, Feb. 2005.

M2

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Commercial Banks and Other Depository Institutions

• The Business of Banking• State versus National Banks• Monetary Control Act of 1980• Savings and Loan Institutions• Mutual Savings Banks• Credit Unions

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Banking Regulation

• Glass-Steagall Act 1933• Gramm-Leach-Biley Act 1999• Merger wave

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Assets Liabilities + Net Worth

Reserves:Legal reservesExcess reserves

Loans and investmentsFixed investments

Liabilities:Demand depositsTime Deposits

Net Worth

Balance Sheet

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The Fractional Reserve Banking System

• Legal reserves- Deposits at Federal Reserve Banks- Vault cash

• Excess reserves

R 2,000

L 23,000

DD 20,000

NW 5,000

A

R 12,000

L 23,000

DD 30,000

NW 11,000

A

R 12,000

L 32,000

CD 39,000

NW 5,000

A Money Supply

Cash -10,000

DD +10,000

Net 0

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R 12,000

L 32,000

DD 39,000

NW 5,000

A

DD +9000

B

R 3,000L 32,000

DD 30,000

NW 11,000

A

Money Supply

Cash -1,000

DD +19,000

Net + 9000

R + 9000

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Bank Increase in Deposit ($)

Increase in Loans ($)

Increase in Reserves ($)

A 10,000.00 9,000.00 1,000.00

B 9,000.00 8,100.00 900.00

C 8,100.00 7,290.00 810.00

D 7,290.00 6,560.10 720.90

E 6,560.10 5,900.50 650.60

F 5,900.50 5,310.40 590.10

… … … …

… … … …

Total for all banks 100,000.00 90,000.00 10,000.00

Deposit Creation

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Money Multiplier

DrD = maximum deposit creation

E = excess legal reservesr = reserve ratio

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Structure of the Federal Reserve System

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Board of Governors

• 7 members appointed by the President and confirmed by Congress

• 14-year terms; reappointment prohibited if member serves full term

• Chair of the Board selected by President

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Federal Open Market Committee

• FOMC Meetings• FOMC Announcements

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Federal Reserve Controls

• Legal Reserve Requirement• Discount Rate• Open Market Operations

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Federal Reserve Targets

• Interest rate target- Federal funds rate

• Money growth target

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Quantity Theory of Money

M x V = P x Q

Where: VV = income velocity

P P = price level of final goods and services

QQ = quantity of final goods and services

MM = money supply

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Demand Pull Inflation

Price level

qfq

S

D2

D2

D1

D1

D

D

p1

p

p2

Output demanded and supplied per year

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Cures for Demand Pull Inflation

• Monetary policy- Raise legal reserve requirement- Raise discount rate- Sell bonds in open market

• Fiscal policy- Raise taxes- Lower government spending

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Cost Push Inflation

Price level

qfq

S

D

D

p1

p

p2

Output demanded and supplied per year

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Is There a Cure for Cost-Push Inflation?

• Incomes policies• Tax-based incomes policy (TIP)