Measuring the Price
Level and Inflation
MB
MC
MB MC
Introduction

What Do You Think?

Could you retire in thirty years if you have
$100 million?
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Chapter 6: Measuring the Price Level and Inflation
Slide 2
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
The Consumer Price Index:
Measuring the Price Level
Consumer Price Index (CPI)

For any period, measures the cost in that
period of a standard basket of goods and
services relative to the cost of the same
basket of goods and services in a fixed
year, called the base year
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Chapter 6: Measuring the Price Level and Inflation
Slide 3
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Monthly Household Budget of the
Typical Family in 1995 (Base Year)
Constructing a Hypothetical CPI
Item
Cost (in 1995)
Rent, two-bedroom apartment
$500
Hamburgers (60 at $2.00 each)
120
Movie tickets (10 at $6.00 each)
60
Total expenditure
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Chapter 6: Measuring the Price Level and Inflation
$680
Slide 4
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Cost of Reproducing the 1995 (Base-Year)
Basket of Goods and Services in Year 2000
Constructing a Hypothetical CPI
Item
Cost (in 2000)
Cost (in 1995)
Rent, two-bedroom apartment
$630
$500
Hamburgers (60 at $2.00 each)
150
120
Movie tickets (10 at $6.00 each)
70
60
$850
$680
Total expenditure
850 - 680 170
Cost of Living 

 25%
680
680
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Chapter 6: Measuring the Price Level and Inflation
Slide 5
The Consumer Price Index:
Measuring the Price Level
MB MC

Constructing the CPI

Bureau of Labor Statistics (BLS)
 Pick
a base year
 Conduct the consumer expenditure survey to
determine the base-year basket of goods and
services
 Measure the current prices of the base-year
basket
CPI 
Cost of base - year basket of goods and services in current year
Cost of base - year basket of goods and services in base year
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Chapter 6: Measuring the Price Level and Inflation
Slide 6
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Cost of Reproducing the 1995 (Base-Year)
Basket of Goods and Services in Year 2000
Constructing a Hypothetical CPI
Item
Cost (in 2000)
Cost (in 1995)
Rent, two-bedroom apartment
$630
$500
Hamburgers (60 at $2.00 each)
150
120
Movie tickets (10 at $6.00 each)
70
60
$850
$680
Total expenditure
•The CPI in year 2000 = $850/$680 = 1.25
•Base year = 1.00
•The cost of living increased by 25% from 1995 to 2000
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Chapter 6: Measuring the Price Level and Inflation
Slide 7
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
The Consumer Price Index:
Measuring the Price Level
Constructing the CPI

The CPI for a given period measures the
cost of living for that period relative to the
base year
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Chapter 6: Measuring the Price Level and Inflation
Slide 8
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
Constructing the CPI


The Consumer Price Index:
Measuring the Price Level
The CPI is a price index.
Price Index

A measure of the average price of a given
class of goods or services relative to the
price of the same goods and services in a
base year
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Chapter 6: Measuring the Price Level and Inflation
Slide 9
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Inflation

CPI


Measures the average level of prices
relative to prices in the base year
Inflation

Measures how fast the average price level
is changing over time
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Chapter 6: Measuring the Price Level and Inflation
Slide 10
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Inflation

Rate of Inflation

The annual percentage rate of change in
the price level
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Chapter 6: Measuring the Price Level and Inflation
Slide 11
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Calculating Inflation
Rates: 1972 - 1976
Year
CPI
1972
0.418
1973
0.444
1974
0.493
1975
0.538
1976
0.569
Inflation rate : 1972 - '73 
0.444 - 0.418
 0.062 x 100  6.2%
0.418
Inflation rate : 1973 - '74 
0.493 - 0.444
 0.110 x 100  11.0%
0.444
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Chapter 6: Measuring the Price Level and Inflation
Slide 12
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Calculating Inflation
Rates: 1929 - 1933
Year
CPI
1929
0.171
1930
0.167
1931
0.152
1932
0.137
1933
0.130
Inflation rate : 1929 - '30 
0.167 - 0.171
 - 0.023 x 100  - 2.3%
0.171
Inflation rate : 1930 - '31 
0.152 - 0.167
 - 0.090 x 100  - 9.0%
0.167
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Chapter 6: Measuring the Price Level and Inflation
Slide 13
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Inflation

Deflation

A situation in which the prices of most
goods and services are falling over time so
that inflation is negative
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Chapter 6: Measuring the Price Level and Inflation
Slide 14
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Adjusting for Inflation

Deflating a Nominal Quantity

Nominal Quantity
A
quantity that is measured in terms of its
current dollar value

Real Quantity
A
quantity that is measured in physical terms -for example, in terms of quantities of goods and
services
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Chapter 6: Measuring the Price Level and Inflation
Slide 15
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Adjusting for Inflation

Deflating a Nominal Quantity

Deflating (a nominal quantity)
A
process of dividing a nominal quantity by a
price index (such as the CPI) to express the
quantity in real terms
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Chapter 6: Measuring the Price Level and Inflation
Slide 16
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Comparing the Real Values of a
Family’s Income in 1995 and 2000
Year
Nominal family
income
CPI
Real family income =
Nominal family income/CPI
1995
$20,000
1.00
$20,000/1.00 = $20,000
2000
$22,000
1.25
$22,000/1.25 = $17,600
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Chapter 6: Measuring the Price Level and Inflation
Slide 17
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Adjusting for Inflation

Example

Home run hitters drive Cadillacs
 1930
Babe Ruth’s salary was $80,000
 1998 Mark McGwire’s salary was $8.3 million
 CPI (1982 - 84 = 100)
o
o
o
o
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1930 = 0.167
1998 = 1.64
Babe Ruth’s real salary = $80,000/0.167 = $479,000
Mark McGwire’s real salary = $8.3 million/1.64 =
$5.06 million
Chapter 6: Measuring the Price Level and Inflation
Slide 18
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Adjusting for Inflation

Real Wage
The wage paid to workers measured in
terms of real purchasing power
 The real wage for any given period is
calculated by dividing the nominal (dollar)
wage by the CPI for that period

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Chapter 6: Measuring the Price Level and Inflation
Slide 19
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Adjusting for Inflation

Real Wages of U.S. Production Workers

An example:
Nominal Wages
CPI (1982 - 84 = 100)
Real Wage
1970
$3.23
0.388
$3.23/0.388 = $8.32
1990
$10.01
1.307
$10.01/1.307 = $7.66
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Chapter 6: Measuring the Price Level and Inflation
Slide 20
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Nominal and Real Wages for
Production Workers’ 1960 - 2001
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Chapter 6: Measuring the Price Level and Inflation
Slide 21
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Adjusting for Inflation

Indexing
The practice of increasing a nominal
quantity each period by an amount equal to
the percentage increase in a specified
price index
 Indexing prevents the purchasing power of
the nominal quantity from being eroded by
inflation

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Chapter 6: Measuring the Price Level and Inflation
Slide 22
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Adjusting for Inflation

Indexing to Maintain Buying Power

An example:
Social Security Payment
Inflation
2000
$1,000/month
2005
$1,200/month indexed to inflation
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2000 - 2005 = 20%
Chapter 6: Measuring the Price Level and Inflation
Slide 23
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Adjusting for Inflation

Example

An indexed labor contract
 Contract
specifics
o 1st year wage = $12/hr
o Real wage will rise 2 percent in the 2nd and 3rd year
 CPI:
Year 1 = 1.00; Year 2 = 1.05; Year 3 = 1.10
 Year
2 wage = w2/1.05 = $12 x 1.02 = $12.24
o W2 = $12.24 X 1.05 = $12.85
 Year
3 wage = w3/1.10 = 12.24 x 1.02 = $12.48
o W3 = $12.48 X 1.10 = $13.73
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Chapter 6: Measuring the Price Level and Inflation
Slide 24
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Adjusting for Inflation

Economic Naturalist
Every few years there is a well-publicized
battle in Congress over whether the minimum
wage should be raised.
 Why do these heated debates recur so
regularly?

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Chapter 6: Measuring the Price Level and Inflation
Slide 25
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Does the CPI Measure
“True” Inflation?

1996 report by the Boskin Commission
estimated that the CPI overstates inflation by
as much as 1 to 2 percentage points a year.

Overstating Inflation


Would unnecessarily increase government
spending
Underestimate the improvements in the standard
of living
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Chapter 6: Measuring the Price Level and Inflation
Slide 26
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
Does the CPI Measure
“True” Inflation?
Two Causes of the CPI Overestimation
of Inflation
Quality adjustment bias
 Substitution bias

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Chapter 6: Measuring the Price Level and Inflation
Slide 27
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
Does the CPI Measure
“True” Inflation?
Substitution Bias -- An Example

Assume 1995 CPI basket
 Inflation:
1995 - 2000 = $300/$200 = 1.50 or 50%
Items
Expenditure
1995 Prices
2000 Prices
Coffee (50 cups at $1/cup)
$50
$2/cup = $100
Tea (50 cups at $1/cup)
$50
$1/cup = $50
Scones (100 at $1 each)
$100
$1.50/cup = $150
$200
$300
Total
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Chapter 6: Measuring the Price Level and Inflation
Slide 28
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
Does the CPI Measure
“True” Inflation?
Substitution Bias -- An Example

Assume 1995 CPI basket
 Inflation:
1995 - 2000 w/substitution = $250/$200 =
25%
Item (2000 w/substitution)
Expenditure
Coffee (0 cups at $2/cup)
$0.00
Tea (100 cups at $1/cup)
100.00
Scones (100 at $1.50 each)
150.00
Total
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$250.00
Chapter 6: Measuring the Price Level and Inflation
Slide 29
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
Does the CPI Measure
“True” Inflation?
Economic Naturalist

Why is inflation in the health care sector
apparently high?
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Chapter 6: Measuring the Price Level and Inflation
Slide 30
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
Price Level


The Costs of Inflation:
Not What You Think
A measure of the overall level of prices at a
particular point in time as measured by a
price index such as the CPI
Relative Price

The price of a specific good or service in
comparison to the prices of other goods
and services
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Chapter 6: Measuring the Price Level and Inflation
Slide 31
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
The Costs of Inflation:
Not What You Think
Observations
Changes in relative price do not
necessarily imply a significant amount of
inflation.
 Inflation can be high without affecting
relative prices.

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Chapter 6: Measuring the Price Level and Inflation
Slide 32
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
The Costs of Inflation:
Not What You Think
Observations
To counteract relative price changes,
government policy would have to affect the
market for specific goods.
 To counteract inflation, the government
must use monetary and fiscal policy.

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Chapter 6: Measuring the Price Level and Inflation
Slide 33
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
The Costs of Inflation:
Not What You Think
The Price Level, Relative Prices, and
Inflation
CPI
% change in oil prices
Inflation
Relative price of oil
2000 1.20
8% (2000 - 2001)
10%
-2%
8% (2001 - 2002)
6%
+2%
2001 1.32
2002 1.40
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Chapter 6: Measuring the Price Level and Inflation
Slide 34
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The True Costs of Inflation

“Shoe-Leather” Costs

The use of resources to economize on
holding cash during periods of high
inflation
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Chapter 6: Measuring the Price Level and Inflation
Slide 35
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The True Costs of Inflation

“Shoe-Leather Costs at Woodrow’s
Hardware
Need $5,000 cash/day
 May withdraw $25,000 on Monday or
$5,000/day
 Cost of a withdraw = $4/trip

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Chapter 6: Measuring the Price Level and Inflation
Slide 36
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The True Costs of Inflation

“Shoe-Leather Costs at Woodrow’s
Hardware

Zero inflation
 Withdraw
$25,000
 Shoe-leather cost = $4/week
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Chapter 6: Measuring the Price Level and Inflation
Slide 37
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The True Costs of Inflation

“Shoe-Leather Costs at Woodrow’s
Hardware

10% inflation
 Withdraws
$25,000
o Average cash holding/day = $15,000
o Cost of holding cash = $15,000 x 10% = $1,500
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Chapter 6: Measuring the Price Level and Inflation
Slide 38
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The True Costs of Inflation

“Shoe-Leather Costs at Woodrow’s
Hardware

10% inflation
 Withdraws
$5,000 daily
o Average cash holding/day = $5,000
o Cost of holding cash = $5,000 x 10% = $500
o Shoe-leather cost = $4/trip x 200 trips (50 wks) =
$800
o Benefit of $1,000 > cost of $800
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Chapter 6: Measuring the Price Level and Inflation
Slide 39
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The True Costs of Inflation

“Noise” in the Price System

Inflation obscures the information
transmitted by prices and reduces the
efficiency of the market system
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Chapter 6: Measuring the Price Level and Inflation
Slide 40
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The True Costs of Inflation

Distortions of the Tax System

Inflation, Indexation, and -- Bracket
creep
 Capital depreciation allowance
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Chapter 6: Measuring the Price Level and Inflation
Slide 41
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The True Costs of Inflation

Observation

Inflation may distort the incentives provided
by the tax system for people to work, save,
and invest and reduce economic growth.
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Chapter 6: Measuring the Price Level and Inflation
Slide 42
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The True Costs of Inflation

Unexpected Redistribution of Wealth
From workers to employers if wages are
not indexed to inflation
 From lenders to borrowers

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Chapter 6: Measuring the Price Level and Inflation
Slide 43
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The True Costs of Inflation

Interference with Long-Run Planning
Retirement planning
 Investment and business strategies

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Chapter 6: Measuring the Price Level and Inflation
Slide 44
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Hyperinflation

Economic Naturalist

How costly is high inflation?
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Chapter 6: Measuring the Price Level and Inflation
Slide 45
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Hyperinflation

Economic Naturalist

Fischer, Sahay, and Vegh examined 133
market economies 1960 - 96
 45
episodes of high inflation (100% +) in 25
countries
o Real GDP/person fell by an average of 1.6%/yr
o Real consumption/ person fell by an average of
1.3%/yr
o Real investment/person fell by an average of 3.3%/yr
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Chapter 6: Measuring the Price Level and Inflation
Slide 46
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Inflation and Interest Rates

Nominal Interest Rate (market interest
rate)

The annual percentage increase in the
nominal value of a financial asset
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Chapter 6: Measuring the Price Level and Inflation
Slide 47
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Inflation and Interest Rates

Real Interest Rate
The annual percentage increase in the
purchasing power of a financial asset
 The real interest rate on any asset equals
the nominal interest rate on that asset
minus the inflation rate

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Chapter 6: Measuring the Price Level and Inflation
Slide 48
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Inflation and Interest Rates

Inflation and the Real Interest Rate
Real Interest Rate (r )  nominal interst (i ) - the inflation rate( )
r  i -
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Chapter 6: Measuring the Price Level and Inflation
Slide 49
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Inflation and Interest Rates
Year
Real Interest
1970
1975
1980
1985
1990
1995
2000
0.80
-3.3
-2.0
3.9
2.1
2.7
2.2
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=
Nominal Interest
6.5
5.8
11.5
7.5
7.5
5.5
4.7
Chapter 6: Measuring the Price Level and Inflation
-
Inflation
5.7
9.1
13.5
3.6
5.4
2.8
2.5
Slide 50
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The Real Interest Rate in the
United States, 1960 - 2001
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Chapter 6: Measuring the Price Level and Inflation
Slide 51
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Inflation and Interest Rates

Observations
Unexpected inflation will benefit borrowers
and hurt lenders
 Expected inflation may not hurt lenders if
they can adjust the nominal interest rates

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Chapter 6: Measuring the Price Level and Inflation
Slide 52
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Inflation and Interest Rates

Fisher-Effect

The tendency for nominal interest rates to
be high when inflation is high and low
when inflation is low
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Chapter 6: Measuring the Price Level and Inflation
Slide 53
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Inflation and Interest Rates in the
United States, 1960 - 2001
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Chapter 6: Measuring the Price Level and Inflation
Slide 54
End of
Chapter
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MC