INFLATION

Part 1: An Overview
Part 2: Measures and Calculations

Part 1: InflationAn
Overview

The level of prices doesnt matter but

the rate of change of price does

If wages and price level increase at the

same time, then the real value of your
money has stayed the same!

Nominal wage: dollar amount of any given wage

paid
Real wage: the wage rate divided by the price
level

INFLATION RATE (overall percentage

increase of prices) makes people poorer
(because it outpaces wage increases).

Inflation rate= Price level in Year 2 Price level in

base year X 100

Three Main Economic Costs

High rates of inflation impose significant economic
cost
1. Shoe-Leather Costs: increased costs of
transactions caused by inflation

Ex. German Hyperinflation of 1921-1923

Menu Costs: the real cost of changing list prices

2.

Ex. Brazil Supermarket workers

Unit-of-Account Costs: costs arising from the

way inflation makes money a less reliable unit of
measurement
. All of these costs are felt more severely when the
inflation rate is severe
3.

Winners and Losers from

Inflation

Economic transactions, such as loans, often

involve contracts that extend over a period of
time and these contracts are normally
specified in nominal term.
Nominal interest rate the interest rate
as stated in the contract (i.e., a car loan
with 7% interest)
Real interest rate interest rate after
adjustment for inflation

Nominal interest rate Inflation rate = Real interest

rate

Winners and Losers from

Inflation

If the inflation rate is higher than expected, borrowers

win! The money they pay back has lower real value
(less purchasing power) than the money they borrowed.

For this reason, long-term contracts are rare in regions with

high inflation.
If lenders attempt to battle this by setting higher nominal
interest rates, borrowers lose!

If the inflation rate is lower, lenders win! The money

they receive back from the borrower is worth more than
the money they lent.
Inflation reduces the real interest rate of savings. Money
in the bank/invested is earning interest, but inflation
cuts into the value of the money saved and earned in
interest (real interest rate), so savers lose!

Inflationary Spirals
This
increases
inflation

Inflation
reduces
incentive to
save, so
consumers
spend

Higher prices
cause
workers to
demand
higher
wages, which
increases
cost of
production

This cause
demand-pull
inflation

Disinflation

Recessions/depressions bring down inflation.

Government actions to deflate (bring down
the inflation rate) can create a decrease in
GDP, so the government responds early (2%
or so) in order to minimize the impact of
these policies.
Disinflation is NOT deflation. Deflation is a
decrease in price levels. Disinflation is a
decrease in the inflation rate.
To read more on the distinction between
them:
http://www.nbcnews.com/id/7149156/ns/business-ans
wer_desk/#.UR58QR2ceSo

Cost-Push Inflation

Cost-push inflation occurs when certain

inputs that are universally important to
business operations rise in price (i.e., oil).
For all businesses, this creates a situation
in which the cost of producing has gone
up so many will choose to produce less.

Demand-Pull Inflation

Demand-pull inflation occurs when

aggregate demand is greater than
aggregate supply. People have money to
spend and there simply isnt enough for
consumers to buy.

Part 2: The Measurement and

Calculations of Inflation

Price Indexes and the Aggregate Price Level

Aggregate Price Level: measures the

overall level of prices in the economy.

To measure the average price changes for

consumer goods and services, economists
track changes in the cost of a typical
consumers consumption bundle
Market Basket: a hypothetical set of
consumer purchases of goods and services

What goes into the US Market Basket?

Market Baskets and Price

Indexes

Economists track changes in the cost of

buying a given market basket. Working
with a market basket and a base year,
we obtain a price index, a measure of
the overall price level.
Price Index: measures the cost of
purchasing a given market basket in a
given year. The index value is
normalized so that it is equal to 100 in
the selected base year.

Trend of CPI since 1913

Formulas
Price index = Cost of basket for that year
X 100
Cost of market basket in base year
Price index for the base year is always 100
This is the method for calculating both
Consumer Price Index and Producer Price
Index
Inflation rate = PI in Year 2 PI in Year 1 X
100
PI in Year 1

Consumer Price Index

Consumer Price Index (CPI):

measures the cost of the market basket
of a typical urban American family
CPI is used to accomplish two things:

Simplify the way we notice the changes in

prices
Measure inflation rates

Other Price Indices

Producer Price Index (PPI): measures

the cost of a typical basket of goods and
servicescontaining raw commodities
such as steel, electricity, coal, and so on
purchased by producers
GDP Deflator: for to measure change in
nominal vs real GDP; measures
aggregate price level

Key Concepts (Part 1)

Rapid inflation imposes costs on society in the

form of: shoe-leather, menu, and unit-ofaccount costs
Nominal interest rate = real interest rate +
expected inflation
Unexpectedly high rates on inflation benefit
borrowers and hurt lenders. Unexpectedly low
rates of inflation hurt borrowers and benefit
lenders.
If the inflation rate gets too high, the process
of reducing (disinflation) can be painful for the
economy

Key Concepts (Part 2)

Inflation is a broad measure of how fast

overall prices in the economy are rising. Its
important to understand that some goods
may actually be falling in price, yet overall
the economy is experiencing inflation.
Creation of a price index allows economists
to track changes to overall price of a
market basket of items.
Consumer inflation is the rate of increase in
the CPI