Causes of Inflation
What is inflation?
• A sustained rise in the level of prices OR a fall
in the purchasing power of money
• How do you measure inflation?
– Use the CPI (consumer price index)
• A measure of changes in the prices of goods and
services purchased by consumers
• US gov’t surveys people across the country to see what
people buy regularly
Produce Price Index (PPI)
• Shows the level of inflation experienced by
producers
• Constructed similarly to the CPI but takes into
account the prices the producers get for the
goods rather than the prices consumers pay
• PPI leads CPI as an indicator of inflation
• Use both CPI and PPI to calculate the inflation
rate = the rate of change in prices over a set
period of time
The Rate of Inflation
Year A
Year B
Year C
1 gallon of milk
$2.50
$2.40
$2.60
1 loaf of bread
$1.00
$1.35
$1.53
1 gallon of juice
$2.00
$2.30
$2.20
Price of market
basket
$5.50
$6.05
$6.33
CPI, base: Year A
100
110
115
To calculate the rate of inflation, economists use a market basket of hundreds
of goods. The market basket is intended to represent the goods that are
purchased by a typical urban consumer.
Types of inflation
• Hyperinflation = a rapid, uncontrolled of
inflation in excess of 50% per month
– Ex: Hyperinflation in Germany in the 1922 and
1923 when prices rose at about 322% per month
• Deflation, a decrease in general price level
– Happens more rarely
– Ex: Great Depression in 1930s marked by deflation
What causes inflation?
• The Quantity theory = too much money in the
economy
• When demand increases:
– Demand-pull inflation occurs = when total
demand rises faster than the production of goods
and services
– Creates scarcity that drives up prices
What causes inflation?
• When supply increases:
– Cost-push inflation occurs = prices are pushed up by rising
production costs
– When production costs increase, producers make less of a
profit
– Ex: OPEC in 1973 and 1974 limited the amount of oil sold
to the US  rapid rise in the price of oil led to cost-push
inflation
• Wages are also part of the production costs
– Wage-price spiral = a cycle that begins with increase
wages, which leads to higher production costs, which
results in higher prices, which results in demands for even
higher wages
Impact of Inflation
• Effect #1: Decreasing value of the dollar
– Today’s dollar buys less than last year’s dollar
– Those vulnerable: senior citizens (live on a fixed retirement
income); college students
• Effect #2: Increasing Interest Rates
– As prices increase, so do interest rates
– Happens to ensure lenders earn money on their loans
despite inflation
– Means that borrowing money becomes more expensive
• Effect #3: Decreasing Returns on Savings
– People who save at a fixed interest rate get a lower rate of
return