Inflation
Chapter 7
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights7-1
reserved.
Inflation
• Inflation is a serious problem
– What kind of price increases are referred to as
inflation?
– Who is hurt (or helped) by inflation?
– What is an appropriate goal for price stability?
7-2
What Is Inflation?
• Inflation: An increase in the average level of
prices of goods and services
• The average price level is determined by
finding the average price of all output
– A rise in the average price level is inflation
– A decrease in the average price level is deflation
7-3
Relative Prices vs. the Price Level
• It’s possible for individual prices to rise or fall
without changing the average price level
• Relative price: The price of one good in
comparison with the price of other goods
– In a large economy, relative prices are always
changing
7-4
Redistributive Effects of Inflation
• Although inflation makes some people worse
off, it makes others better off
• The impact on individuals depends on how
prices change for the goods and services each
person actually buys or sells
7-5
Price Effects
• If prices rise you can’t buy as many goods and
services as you could before
• The effect on economic welfare is shown in
the difference between nominal and real
income
7-6
Price Effects
• Nominal income: The amount of money
income received in a given time period,
measured in current dollars
• Real income: Income in constant dollars;
nominal income adjusted for inflation
7-7
Price Effects
• Two basic lessons about inflation:
– Not all prices rise at the same rate during an
inflation
– Not everyone suffers equally from inflation
7-8
Price Changes in 2008
Prices That Rose (%)
Prices That Fell (%)
Bananas
+ 15.8%
New cars
- 1.1%
Bread
+ 12.5
Eggs
- 9.1
Bus fares
+ 8.2
Computers
- 11.5
Textbooks
+ 7.5
Televisions
- 19.4
College tuition
+ 5.5
Gasoline
- 44.0
Average inflation rate: +3.8%
Source: U.S. Bureau of Labor Statistics
The average rate of inflation conceals substantial differences in the
price changes of specific products. The impact of inflation on
individuals depends in part on which goods and services are consumed.
7-9
Income Effects
• Even if all prices rose at the same rate,
inflation would still redistribute income
• Redistributive effects originate in both
expenditure and income patterns
• What looks like a price to a buyer looks like an
income to a seller
– If prices are rising, incomes must be rising too
7-10
Nominal Wages and Prices
Source: Economic Report of the President, 2009
Inflation implies not only higher prices but higher incomes as well.
7-11
Wealth Effects
• Who wins and who loses from inflation also
depends on the forms of wealth held
• When inflation reduces the real value of
wealth, it is a loss
7-12
The Real Story of Wealth
Asset
Stocks
Diamonds
Oil
Housing
U.S. farmland
Change in Value (%), 1991–2001
+ 250%
+ 71
+ 66
+ 56
+ 49
Average price level
+ 32
Silver
Bonds
Stamps
Gold
+ 22
+ 20
-9
- 29
Households hold their wealth in many different forms. As the
value of various assets changes, so does a person’s wealth.
7-13
Redistributions
• Redistributive mechanics of inflation include:
– Price effects: Those who buy products that are
increasing in price the fastest end up worse off
– Income effects: People with nominal incomes
rising more slowly than inflation end up worse off
– Wealth effects: Those who own assets that are
declining in real value end up with less real wealth
7-14
Redistributions
• Inflation acts like a tax, taking income or
wealth from one group and giving it to another
• Some are better off while some are worse off
7-15
Social Tensions
• Inflation increases social and economic
tensions
• Tensions between labor and management,
between government and the people, and
among consumers may overwhelm a society
and its institutions
7-16
Money Illusion
• Even those whose nominal incomes keep up
with inflation feel oppressed by rising prices
• Money illusion: The use of nominal dollars
rather than real dollars to gauge changes in
one’s income or wealth
7-17
Macro Consequences
• In addition to redistributing income and
wealth, inflation has macroeconomic effects
–
–
–
–
Uncertainty
Speculation
Bracket Creep
Deflation Dangers
7-18
Uncertainty
• When price level changes significantly,
economic decisions become more difficult
• Time horizons are shortened as people attempt
to spend money before it loses further value
• Price uncertainties affect production decisions
as well
7-19
Speculation
• If expect prices to rise, buy goods and
resources now for resale later
• Few engage in production if it’s easy to make
speculative profits
• Such speculation may fuel hyperinflation
– Hyperinflation: Inflation rate in excess of 200
percent, lasting at least one year
7-20
Bracket Creep
• Bracket creep: The movement of taxpayers
into higher tax brackets (rates) as nominal
incomes grow
• Can reduce disposable income
7-21
Deflation Dangers
• Deflation reverses redistributions caused by
inflation
• Businesses are more reluctant to borrow
money or to invest
• People lose confidence due to declining price
levels deflating incomes and asset values
7-22
Measuring Inflation
• Measuring inflation serves to gauge the
average rate and identify principal victims
• Common measures include
– Consumer Price Index (CPI)
– Producer Price Indexes (PPI)
– GDP Deflator
7-23
Consumer Price Index (CPI)
• Consumer price index (CPI): A measure
(index) of changes in the average price of
consumer goods and services
• Used to calculate the inflation rate
– Inflation rate: The annual percentage rate of
increase in the average price level
7-24
Constructing the CPI
• The Bureau of Labor Statistics determines a
market basket of goods and services typically
purchased by consumers
• Prices for each good are tracked monthly
• Base year: The year used for comparative
analysis: the basis for indexing
7-25
The Market Basket
To measure changes
in average prices, we
must first know what
goods and services
consumers buy.
Housing,
transportation, and
food account for over
two-thirds of
consumer spending.
Source: U.S. Bureau of Labor Statistics, Consumer Expenditure Survey (2007 data)
7-26
Constructing the CPI
• Item weight: The percentage of total
expenditure spent on a specific product; used
to compute inflation indexes
• Core inflation rate: Changes in the CPI,
excluding food and energy prices
7-27
Computing Changes in the CPI
• The impact of any price change on the average
price level depends on the importance of an
item in the typical consumer budget
• The impact on the CPI of a price change for a
specific good is calculated as follows:
Item weight   % change in price  % change in CPI
7-28
Producer Price Indexes
• There are three Producer Price Indexes
(PPIs) which keep track of average prices
received by producers
– Crude materials
– Intermediate goods
– Finished goods
7-29
The GDP Deflator:
• GDP deflator: A price index that refers to all
goods and services included in GDP, including
consumer goods, investment goods, and
government services
• Not limited to a fixed basket
• Reflects price changes and market responses
7-30
Real vs. Nominal GDP
• Nominal GDP: The value of final output
produced in a given period, measured in the
prices of that period (current prices)
• Real GDP: The value of final output produced
in a given period, adjusted for changing prices
nominal GDP
Real GDP 
GDP deflator
7-31
The Goal: Price Stability
• Price stability: The absence of significant
changes in the average price level; officially
defined as a rate of inflation of less than 3
percent
• Explicit goal established by Full Employment
and Balanced Growth Act of 1978
7-32
Unemployment Concerns
• The goal of full employment is defined as the
lowest rate of unemployment consistent with
stable prices
• There might be a trade-off between declining
inflation and rising unemployment
7-33
Quality Changes
• The CPI is not a perfect measure of inflation
because price increases may be due to quality
improvements
• U.S. Bureau of Labor Statistics does adjust the
CPI for quality changes
7-34
New Products
• CPI is biased upward when new products
whose prices are falling are left out of the
market basket
• Market basket is now updated more frequently
than previously
7-35
The Historical Record
• U.S. inflation performance is very uneven
• During the 1920s and 1930s, consumer prices
fell significantly – a general deflation
• Since the Great Depression average prices
have risen almost every year
7-36
Annual Inflation Rates
Source: U.S. Bureau of Labor Statistics
The annual rate has varied widely: The highest rate of inflation was 13.5 percent in
1980 (point A ); the lowest rate (1.6 percent) occurred in 2002 (point B ).
7-37
Causes of Inflation
• Changing prices are rooted in supply and
demand
– Demand-pull inflation results from excessive
pressure on the demand side of the economy
– Cost-push inflation is due to higher production
costs putting upward pressure on supplier’s prices
7-38
Protective Mechanisms
• Low rates of inflation don’t have the drama of
hyperinflation, but they still redistribute real
wealth and income
7-39
Protective Mechanisms
• Cost-of-living adjustment (COLA):
Automatic adjustments of nominal income to
the rate of inflation
• Adjustable-rate mortgage (ARM): A
mortgage (home loan) that adjusts the nominal
interest rate to changing rates of inflation
7-40
The Real Interest Rate
• Real interest rate: The nominal interest rate
minus the anticipated inflation rate
– The inflation-adjusted rate of interest
Real
nominal
anticipated rate


interest rate interest rate
of inflation
• The distinction is critical for long-term loans
7-41
Inflation
End of Chapter 7
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights7-42
reserved.