
Inflation is an increase in the average level of
prices, not a change in any specific price.

The average price is determined by finding
the average price of all output.
◦ A rise in the average price is called inflation.
◦ A fall in the average price is called deflation.


Changes in relative prices may occur in a
period of stable average price, or in periods
of inflation or deflation.
A relative price is the price of one good in
comparison with the price of other goods.


By reallocating resources in the economy,
relative price changes are an essential
ingredient of the market mechanism.
A general inflation doesn’t perform this
market function.


Although inflation makes some people worse
off, it makes some people better off.
The three major methods inflation
redistributes money by are:
◦ The Price Effect
◦ The Income Effect
◦ The Wealth Effect


Nominal income is the amount of money
income received in a given time period,
measured in current dollars.
Real income is income in constant dollars:
nominal income adjusted for inflation.

Two basic lessons about inflation:
◦ Not all prices rise at the same rate during inflation.
◦ Not everyone suffers equally from inflation.
Not all prices rise at the same rate during
inflation.
 Not everyone suffers equally from inflation.


People who prefer goods and services that
are increasing in price least quickly end up
with a larger share of income.
Prices That Rose
(percent)
Gasoline
+28.5
Prices That Fell
(percent)
Coffee
–0.5
Lettuce
+9.5
Video rentals
–1.5
Airfares
+9.4
Women’s dresses
–6.9
Textbooks
+7.0
Oranges
–14.7
Cable TV
+4.8
Computers
–23.2
College tuition
+4.1
Average inflation rate: +3.4%


Even if all prices rose at the same rate,
inflation would still redistribute income.
Redistributive effects originate both in
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.
 People whose nominal income rise faster
than inflation end up with a larger share of
total income.

200
180
160
140
Prices
Wages
120
100
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
YEAR


People hold wealth in different forms
(accounts, stocks, commodities).
When the value of these changes due to
inflation, some people will get wealthier and
some will lose wealth.
Asset
Percentage change in value:
1991-2001
Asset
Percentage change in value:
1991-2001
Stocks
+250
Silver
+22
Diamonds
+71
Bonds
+20
Oil
+66
Stamps
–9
Housing
+56
Gold
–29
U.S. farmland
+49
The average price level increased 32%


One of the most immediate consequences of
inflation is uncertainty.
Uncertainties created by changing price levels
affect consumption and production decisions.


People tend to shorten their time horizons in
the face of inflation uncertainties.
Time horizons are shortened as people
attempt to spend money before it loses
further value.

During the German hyperinflation, workers
were paid two or three times a day so that
they could buy goods in the morning before
prices increased in the afternoon.

Hyperinflation is an inflation rate in excess of
200 percent, lasting at least one year.



If you expect prices to rise, it makes sense to
buy things now for resale later.
Few people will engage in production if it is
easy to make speculative profits.
People may be encouraged to withhold
resources from the production process,
hoping to sell them later at higher prices.

As such behavior becomes widespread,
production declines and unemployment rises.


Bracket creep is the movement of taxpayers
into higher tax brackets (rates) as nominal
incomes grow.
As prices rise, incomes rise, and then taxes
rise.



Deflation — a falling price level — might not
make people happy either.
Deflation reverses the redistributions caused
by inflation.
Lenders win and creditors lose.

When prices are falling, people on fixed
incomes and long-term contracts gain more
real income.

Falling price levels have similar macro
consequences.
Time horizons get shorter.
 Businesses are more reluctant to borrow
money or to invest.


People lose confidence in themselves and
public institutions when declining price levels
deflate their incomes and assets.

Measuring inflation serves two purposes:
◦ Gauges the average rate of inflation.
◦ Identifies its principal victims.


The CPI is the most common measure of
inflation.
The consumer price index (CPI) is a measure
(index) of changes in the average price of
consumer goods and services.


By observing the extent of price increases, we
can calculate the inflation rate.
The inflation rate is the annual
percentage rate of increase in the average
price level.


The Bureau of Labor Statistics constructs a
market basket of goods and services that
consumers usually buy.
Specific goods and services are itemized
within the broad categories of expenditures.


The relative importance of a product in the
CPI is reflected in its item weight.
Item weight is the percentage of total
expenditure spent on a specific product;
used to compute inflation indexes.

The impact on the CPI of a price change for a
specific good is calculated as follows:
percentage change in CPI =
item weight X percentage change in
price of item
Transportation
19.0%
Housing
32.6%
Food
13.6%
Insurance and pensions 9.3%
Clothing 4.7%
Entertainment 5.1%
Miscellaneous 10.5%
Health care 5.3%


There are three producer price indexes (PPI)
which keep track of average prices received
by producers.
One includes crude materials, another
intermediate goods, and the last covers
finished goods.

PPIs are watched as a clue to potential
changes in consumer prices.
In the short run, the PPIs usually increase
before the CPI.
 The PPIs and the CPI generally reflect the
same inflation rate over long periods.


The GDP deflator is a price index that refers
to all goods and services included in GDP.
◦ It is the broadest price index is the GDP deflator.
◦ It covers all output including consumer goods,
investment goods, and government services.

The GDP deflator usually registers a lower
inflation rate than the CPI.
Unlike the CPI and PPI, the GDP deflator
is not limited to a fixed basket.
 Its value reflects both price changes and
market responses to those changes.


The GDP deflator is used to adjust nominal
output values for changing price levels.
◦ Nominal GDP is the value of final output produced
in a given period, measured in the prices of that
period (current prices).
◦ Real GDP is the value of final output produced in a
given period, adjusted for changing prices.

Nominal and Real GDP are connected by the
GDP deflator:
nominal GDP
Real GDP =
GDP deflator
nominal GDP
2000 real GDP =
GDP deflator
$10 trillion

 $8.06 trillion
1.24

Price stability is the absence of significant
changes in the average price level; officially
defined as an inflation rate of less than 3
percent.


A little bit of inflation might be the “price” the
economy has to pay to keep unemployment
rates from rising.
Some unemployment may be the “price”
society has to pay for price stability.


In the long view of history, the U.S. has done
a good job in maintaining price stability.
Upon closer inspection, however, our inflation
performance is very uneven.
20
Inflation
16
A
12
8
4
B
0
4
8
Deflation
12
1920
1930
1940
1950
1960
1970
1980
1990
2000


Inflation is rooted in supply and demand.
The most common types of inflation come
from demand-pull and cost-push.


Demand-pull inflation results from excessive
pressure on the demand side of the economy.
“Too much money chases too few goods”
enabling producers to raise prices.


The pressure on price could also originate on
the supply side.
Higher production costs put upward pressure
on product prices.

Low rates of inflation don’t have the drama of
hyperinflation, but they still redistribute real
wealth and income.
◦ For example, if prices rise by an average of just 4
percent a year, the real value of $1,000 drops to
$822 in five years and to only $676 in ten years.


Cost-of-living adjustments (COLAs) are
automatic adjustments of nominal income to
the rate of inflation.
COLAs are commonly used by landlords as
well as in labor agreements and government
transfer programs.


An adjustable-rate mortgage (ARM) is a
mortgage (home loan) that adjusts the
nominal interest rate to changing rates of
inflation.
ARMs were developed to protect lenders
against losses during long term rises in
inflation.

The real interest rate is the nominal interest
rate minus the anticipated inflation rate.
Real interest rate = nominal interest rate
– anticipated interest rate

If prices rise faster than interest accumulates,
the real interest rate will be negative.
End of Chapter 7