A primer on inflation: A must read for all IB Economics students

 

Page One Economics is a tremendous resource for IB Economics teachers and students.  I’ve been using it for a number of years, and I always look forward to a new edition. The latest one  Inflation Expectations, the Phillips Curve and Fed's Dual Mandate written by Jane Ihrig, Ekaterina Peneva, and Scott A. Wolla is a jewel for us.

It starts off by clearly explaining what is meant by price stability. Price stability is one of the main goals of macroeconomic policy. Interestingly, it does not mean zero inflation.  Instead, the Federal Reserve (the US central Bank), as well as all central banks, considers that “a moderate, stable and positive rate of inflation is most consistent with its price stability mandate.” Why not target zero (0%) inflation?  It is explained beautifully in the article.  To protect the economy from deflation is one reason (deflation is when the average price level is decreasing which induces households to postpone purchases and thus forces firms to cut wages and/or jobs leading to a deflationary spiral).  The rate of inflation cannot be pinned at any level but tends to fluctuate, so entering negative territory is to be avoided. Also, there is an upward bias in measuring inflation meaning that if measured inflation is 0.5%, it could actually be minus 0.4% having entered deflation territory (see the Ellie Tragakes IB Economics textbook on this overestimation bias or the Oxford Economics Study Guide).  In addition, if inflation is extremely low for a long period, typically interest rates are also close to zero leaving no room for an interest rate cut if the economy faces the risk of recession.  This is the ZLB ('zero lower bound' problem – see the new Oxford IB Economics Study Guide for a brief explanation of this).  So, what do central banks mean by ‘price stability’?  If 0% inflation was not desirable as a target, what rate of inflation should central banks aim for? We know that high inflation is costly for many reasons.  Inflation decreases the purchasing power of all households with fixed money incomes (like wage earners or pensioners); it increases income inequality as low income individuals can only save any income they do not spend in bank savings accounts where the real interest rate earned (their real return of return) may be negative (remember, the real interest rate is the nominal interest rate minus (expected) inflation) and they cannot borrow to purchase (invest in) assets whose market value is expected to rise faster than inflation (while richer folk can invest in real estate, art, gold, etc.); it distorts the signaling power of relative price changes leading to allocative inefficiency; it leads to increased uncertainty that stifles investment and it renders exports less competitive in foreign markets, among other costs.  Where does this leave us? Well, the Fed, as most central banks did, gravitated to a 2 percent ‘healthy compromise’. So, for most central banks their announced target has been to achieve and maintain inflation “below, but close to 2 percent”.  The 2% target has become the orthodoxy despite being a rather arbitrary choice.  The story behind the choice is actually pretty funny. 

The St. Louis article, after explaining why now the US central Bank has chosen the Personal Consumption Expenditures Price Index (PCEPI) over the CPI (from my understanding the PCEPI also corrects for the substitution bias that plagues the CPI – note here that IB Economics students should stick with the CPI as it is the CPI that is in the new IB syllabus), continues with a short but beautiful exposition of the Phillips Curve which all IB Economics students should read.  The Phillips Curve reflects that (at least in the short run) there is a trade off between inflation and unemployment  

"which policymakers considered when setting monetary policy: They could pursue an economy with lower unemployment if they were willing to accept higher inflation. Conversely, if policymakers wanted to pursue lower inflation, they would have to accept higher unemployment and lower economic activity."

Interestingly enough this “tradeoff has weakened”.  There is evidence that the “Phillips Curve has flattened” (see "Is the Phillips Curve alive?") which allows them to pursue lower unemployment without having to accept higher inflation.” Now, in the US, “…policymakers are willing to allow employment to expand as long as inflation expectations are anchored around the 2 percent target.”

The important phrase to note from the last quote is the phrase ‘… inflation expectations are anchored’. Expectations about future inflation are perhaps the most important determinant of inflation.  Why? Because “they influence peoples’ decisionmaking today, which then impacts future inflation.”  Read the box on page 4 of the St. Louis article as this is explained in a way that all IB Economics students will understand.  If a firm believes that inflation will be around 2% this year and next year and the year after, it will increase its prices and wages by 2%, and based on this expectation, plan its investments. Similarly with households.  It follows that if expectations are anchored at 2% then inflation will indeed prove to be 2%. 

This brings us to my earlier July 2 post on the Summers-Krugman inflation debate where Krugman distinguishes between 'transitory' inflation and ‘hard core’ inflation.  I mentioned in the earlier post Krugman’s definition of transitory inflation as “easy come, easy go” but you will find a fuller explanation in the box titled “What is transitory inflation” on page 5.  You will then understand why the Fed has recently slightly changed its target to what is referred to as “flexible average inflation target”  (FAIT).  Inflation can now exceed 2%, as long as, on the average, it remains at 2%.  This really boils down to as long as peoples’ expectations about future inflation remain anchored at 2% and a higher rate of inflation does not become ‘embedded’ in their expectations. 

This St. Louis article is a great resource for not just my but for all IB Economics students.  Not only will it help them better understand inflation and policymaking (remember the Paper 3 new ‘recommend a policy’ part) but also provide them with plenty of real world information to satisfy a number of possible Paper 1 macroeconomics questions.

Please read the St. Louis Page One Economics article!

 

IB Economics New Syllabus Paper 3 (micro calculations)

 

Focus on micro P3 calculation topics (new IB Economics syllabus)

The new IB Economics syllabus has changed quite significantly concerning Paper 3.  In terms of microeconomics related calculations, there are significantly fewer.  No need to bother anymore with linear demand and supply functions (a good development IMO, since candidates taking any IB math level know how to fool around with linear functions and many of the related calculations in past paper 3 questions could often be solved by inspection - no need even for a simple calculator); no need to fool around with fixed and variable costs and their averages (which again I think proved of little value); and, focusing on micro questions only, no need to know how to calculate MP, AP and TP from tables (data) or from diagrams.  IB Economics candidates now need to know what marginal whatever and average whatever are (HL only), and this is achieved in the new syllabus from requiring them to understand how to play (make calculations) only with MC, AC, MR, AR and also TR (from data tables). 

The new IB economics syllabus includes the following (micro related) calculations:

Calculation (HL only): consumer surplus and producer surplus from a diagram

Calculation: PED, change in price, quantity demanded or total revenue from data provided

Calculation: YED, change in income, quantity demanded from data provided

Calculation: PES, change in price or quantity supplied from data provided

Calculation (HL only): the effects on markets and stakeholders of:

• price ceilings (maximum prices) and price floors (minimum prices)

• indirect taxes and subsidies.

Calculation (HL only): welfare loss from a diagram

Calculation (HL only): profit, MC, MR, AC, AR from data

I will try to upload here some examples for these topics, taken mostly from my OUP Economics Skills and Practice volume.

BUT…

To me, the trickiest point perhaps that (HL) IB economics candidates should have in mind relates to indirect taxation.  It is very simple, but it differs a bit from the treatment in the old syllabus.  The new economics syllabus is not explicit about this (correct) twist but if one checks out the specimen paper 3 provided to all teachers (and thus to all students) you’ll see what I mean and why all HL IB economics candidates must have this in mind {see specimen question 2a(ii)}.

Assume I went out to buy myself a shirt.  I come back home and my wife asks me how much did I pay.  I reply that I paid 93 euros.  The tax rate (VAT) in Greece is (unfortunately) 24% on most items. (a GST or sales tax in other countries)

The questions are:

(a) how much was the tax paid (in euros)

(b) what was the price of the shirt I bought net of tax (i.e. before the VAT/sales tax was applied).

We must realize that the 93 euros I paid included the tax.  So how do we go about answering the above questions?

First some notation. Let:

* P(wt) be the price paid (say, for the shirt) with the tax 

* t be the tax rate; in this case, say 24%

* Po be the price (of the shirt) net of tax i.e., before the 24% tax was applied

Then it should be that:

P(wt) = Po + tPo (i.e., the net of tax price plus the amount of the tax paid on the item)

P(wt) = Po (1+t)

So Po = P(wt) / (1+t)

Using our figures:

Po = 93/1.24 So Po = 75 euros (this is the net of tax price of the shirt on which the 24% sales tax was applied)

And thus, the tax I paid on the shirt I bought was P(wt) – Po or, 93 – 75 = 18 euros

(or equivalently, tPo= 0.24*75 = 18 euros)

I will try to post on a regular basis not only articles on issues that may be of interest to IB Economics students but also questions that I will construct, mostly P3 questions and P2 questions that may help.  I’ll also try to provide some insights on Paper1, part(b), questions, focusing mostly on the role of investigations that IB economics candidates should now regularly undertake in their classes to be able to effectively use real world examples (note the plural and the verb ‘use’ – not list or mention) in their responses.

 

This is great for IB economics kids (and, not only)

Our World in Data has tons of information on a myriad of variables where all IB (not just Economics candidates) will find stuff they are interested in.  For example:

On outdoor air pollution

On child and infant mortality

On life expectancy

On smoking

On alcohol consumption

On fossil fuels

On homelessness

On happiness and life satisfaction

and on much more

You can fool around here: Our World in Data

Preannounced sales tax increases as a form of unconventional expansionary fiscal policy

Fiscal policy is a short run demand management stabilization policy that includes changes in government expenditures (G) and/or in taxes (T).  Mind you that it is changes in direct taxes that are considered part of the fiscal policy arsenal.  More specifically, if an economy is about to enter, or is in a recession (or suffers from a large negative output gap), then the government can decrease direct taxes (T). Disposable income (Yd) will increase and thus consumption expenditures (C) and aggregate demand (AD) will increase leading to an increase in overall economic activity (remember, disposable income (Yd) is income minus direct taxes plus transfer payments {so: Yd = Y – T + Tr}, and is not the same as the real income which is money divided by the average price level). On the other hand, if an economy is overheating then policymakers could increase (direct) taxes so that Yd decreases, decreasing consumption expenditures and thus AD (this analysis could also refer to corporate -profit- taxes but let's keep it simple). 

What about changes in indirect taxes?  We treat these at the IB Economics course as possibly affecting the short run aggregate supply.  If they increase across the board (say, an increase in a country’s VAT / GST to 20%) this will increase production costs of firms and as a result decrease the SRAS, shifting it to the left.  This is the typical impact of a change in indirect taxation on an economy according to the IB Economics syllabus).

BUT:

In a recent paper in the American Economic Journal: Macroeconomics, titled  “Shopping for Lower Sales Tax Rates ” the authors (Scott R. Baker et al.) show that “shoppers do actually adjust spending on all kinds of items when state or local (sales) taxes change”. They used data for more than 150,000 households across 40 states to examine whether spending changed in response to increases in sales taxes (the full paper found here).

The researchers found that “…in the month before an increase, consumers stocked up on storable goods, like laundry detergent and alcohol, while they were less expensive.” The same authors find in another recent paper that car sales increased by over 8% in the month before a 1% increase in the sales tax rate!  Click  here for this paper.

The question is ‘so what?”  Why would a HL or SL IB Economics candidate be interested in this finding? Well, the answer is that it provides an alternative policy choice to policymakers who face the threat of recession and are constrained by interest rates at, or very close to zero (the ZLB -zero lower bound- problem) and also by little room for conventional expansionary fiscal policy.

"This research suggests that sales tax adjustments can be a way to stimulate spending at a time when monetary policymakers can’t turn to lowering interest rates because they are already near zero."

Policymakers confronted with the risk of a recession may announce that “..there's going to be a temporary sales tax cut that's going to be paid for by a sales tax increase in the future” 

Their finding imply that this may “induce people to spend more now, buy cars, or buy other things when they are in the low tax environment”. 

NOTE

If you are to include this finding in a paper 1 (essay) response, make sure you first clearly explain the conventional tools for stimulating an economy.  Only then you can explain this finding making sure you remember to quote the title of the paper, the journal and one of the authors.  

Lastly, an absolutely excellent short piece on fiscal policy where everything an IB Economics student need to know is clearly explained is a 2020 article in the (free) IMF journal Finance and Development titled Fiscal Policy: Taking and Giving Away” by Mark Horton and Asmaa El-Ganainy.  

May I remind IB Economics students that they should make sure to subscribe to the Finance and Development IMF publication.  It has very many, easy and interesting articles that can help them achieve high grades in exams. 

 

Big tobacco: High taxes in the North and their unintended consequences in the South

 

Negative consumption externalities are a most important topic in the new IB economics syllabus. A negative consumption externality arises when the consumption of a good imposes costs on 3rd parties for which they do not get compensated.  Tobacco (smoking) and alcohol (drinking) are prime examples.  The consumption of both not only harms those who consume these 'goods' but also society at large.  

Taxation on alcohol is considered ineffective (but a great way to collect high tax revenues which can also be used to finance other policies aimed at decreasing consumption of these 'demerit' goods).  Why won't even a high an indirect tax be effective in lowering consumption of alcohol?  Because taxes on alcohol lead to a "chain of substitutions".  There are very many different types of alcohol (vodka, whisky, wine, beer, tequila, rum, cider, ouzo, you name it...) and each type has zillions of brands and qualities and thus prices range from very low to extremely high. A high tax on alcohol (say 50%) would induce this "chain of substitutions": many consumers, especially individuals in lower socio-economic status (SES) groups where greater prevalence of harmful alcohol consumption (binge drinking) is documented will simply switch to equally strong but cheaper and often lower quality alcohol or brands.  Note though that the minimum unit price (MYP) policy implemented in Scotland and Wales (for which, BTW, you can not use a typical demand and supply diagram that we use to illustrate a minimum price on, say, corn, because the markets for vodka, whisky etc. are not perfectly competitive and there is no supply curve  in markets where firms are price setters) is considered most effective especially if complemented by other policies, such as increased education and awareness in the population (note that also some techniques -nudges- associated with behavioral economics have also produced promising results).

Cigarettes are a different story.  Why? Because even though there are again many brands of cigarettes, they are typically sold at roughly the same price.  An indirect tax can thus prove effective but only if it is high enough (very high) so that the post-tax price rises to the elastic section of the demand for cigarettes curve.  Remember that PED is affected by the number and closeness of available substitutes, whether the good is addictive (tobacco is very addictive)  but also, and most importantly, by the proportion of income spent on the good.  So a low indirect tax will not lead to a significant decrease in smoking (but it will fill the state's coffers with a lot of tax revenues) and will thus prove ineffective.  But a very high tax has a greater chance of proving effective because if smokers continue to smoke as much, their monthly expenditure on cigarettes will become a much too high proportion of their monthly income and many will be forced to cut back and even kick the habit as all are aware of the fact that smoking is a killer.  

But what about 'close substitutes'? That's a big one these days.  In order for a tobacco tax to prove effective it must be imposed on all tobacco-related products and this will have to include heat-not-burn nicotine delivery systems (like IQOS, devised and marketed by -take a guess- Philip Morris International, one of the biggest 'big tobacco' companies) and e-cigarettes (like JUULs).  In addition, the state must make sure that no illegal markets arise (relatively easy if there is the political will).

So, assume that with the high taxes that many countries have imposed and with the impact other necessary complementary policies sales of cigarettes do go down in many advanced economies

Well, unfortunately this would not be the end of the story for  the huge tobacco multinationals.

Watch this (very short): Big Tobacco Goes South 

In the search for new consumers, Big Tobacco is setting its sights on markets in the Global South, using the same tactics that hooked smokers in rich countries decades ago. But with weak health-care systems and low regulatory capacity, the developing world will have a harder time fending off the industry’s marketing blitz.

Remember though that in many countries in the South, the State needs high tax revenues to be able to finance pro-development projects: so they are caught between a rock and a hard place...

PS: I've quit very many years now but the first couple of years of my graduate work in the States I was, unfortunately, a smoker.  I still remember when, late one night, I ran out of cigarettes and, not having a car during my 1st year, I called a cab to get to the nearest ‘Store 24’ and buy me a pack.  The driver took me there and when he saw what I bought, he remarked “Oh, you went to buy coffin nails, I see’. Still, haven’t forgotten his comment.

IB Economics: new syllabus: sections 2.11 and 3.4 On market power, possible abuses of and impact on wages and income inequality

There is significant emphasis in the new IB Economics syllabus on market power, its abuse and the impact on income distribution.  This Project Syndicate video (Project Syndicate a source mostly of great short articles) explains the rise in concentration in many markets and the impact it has had on wages and consequently on income distribution in 2 minutes and 32 seconds.  A nice intro perhaps on the risks of market power being abused and also of possible use in student inquiries on market power and income distribution.  Very topical of course. We'll be focusing on abuse of market power and on income distribution issues a lot.

Watch here: The rise of monopsony power