MDU Macroeconomics Lecture 5: Inflation and Growth

MDU Macroeconomics Lecture 5: Inflation and Growth

Today:

0. Defining Inflation

1. Inflation and the Business Cycle

2. Cyclical v. Structural Inflation

3. The Unemployment Trade off

4. Costly Inflation

5. Inflation and Inequality

6. Money Wages and Real Wages

7. Purchasing Power in Ireland

8. Inflation Targeting and Central Banks

0. Defining Inflation

Inflation is defined as a general increase in prices, which we proxy by the Consumer Price Index. (CPI). Deflation is corresponding fall in the price level.

Ireland’s baseline inflation index looks like this for the last 30 years:

Cpi19702006-2

We can see the influence of the “Celtic Tiger” years on Irish Inflation, especially if we look at changes in Inflation over the period 1992-2006:

Cpi1992-2006-1

Broadly speaking, inflation is a reduction in purchasing power over time. So, each euro one earns will be worth less as it purchases less than it did before. There are many factors which can cause inflation to increase: wars, industrial conflicts, supply constraints, trade blockades, and more.

There are six main points to consider when talking about inflation (elaborating on Bowles et al, pg. 479).

1. Inflation and the Business Cycle

The level of inflation varies over the business cycle and between business cycles. So if we plot Irish GDP and Inflation, over 1992-2006, we see this:

Gdpvcpi1992-2006-1

2. Cyclical v. Structural Inflation



We typically see more rapid inflation as we approach the top of the business cycle. This is called cyclical inflation.

Structural Inflation occurs when the price level increases uniformly through the whole of a business cycle, boom and bust. We can see this in sub sections of the consumer price index, for example in construction. Note, the index construction changed during this period. I’ll talk about what that means in the lecture, but you should be aware of it. Details of the indexation methodology are here.

3. The Unemployment Trade off

The Unemployment Trade off describes a tendency we observe during a business cycle for inflation to rise when unemployment falls. If we graph Inflation as measured by the CPI against Unemployment over a ten year period for Ireland and fit a straight line to the cloud of points we assemble, we see the following relationship. This graph is telling us the wrong thing, as I’ll explain in the lecture, but have a look at it for the moment to get the general idea. All data is from here.

Inflationunemployment1-1

4. Costly Inflation

Inflation is very costly because it makes economic outcomes more unpredictable. Economists say that the windfall effects of inflation are uncertain, and you can think of many reasons why that might be. There is also a cost to controlling inflation. For lots of information on this set of costs and how inflation is actually controlled, look here.

5. Inflation and Inequality

Each country’s mix of inflation and unemployment is both a product of and a determinant of that country’s income distribution. Data is from Nolan et al, pg. 17. Ireland’s Income distribution looks like this. approximately. See the paper linked to for a more nuanced picture and a more in depth analysis.

Incomedeciles-1

6. Money Wages and Real Wages

What you are paid each month is not what you can buy with that money. Your earnings are always determined by what you can purchase with them. The difference between your real wage (your wage taking inflation into account) and your nominal wage (what you see on your pay-slip) can sometimes make a real difference to what you can buy at the end of the month.

7. Purchasing Power in Ireland



Look at the table on page 489 of Bowles at al. We see the difference between the nominal wage (valued at 1982 $) and the real wage. We can see in each case a drop in purchasing power over the period from 1982-2002. For Ireland, we can compute the cost in today’s euros of purchasing 1 euros worth of goods in 1940. The change in purchasing power is staggering.

Ppp-1

8. Inflation Targeting and Central Banks

The ECB is committed to inflation targeting. In the lecture we’ll discuss why this is and what effects it might have on your mortgage.

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