Topic 2
The Monetary System, Prices, and Inflation
1
The Monetary System
• A monetary system establishes two different
types of standardization in the economy
– Unit of value—a common unit for measuring how much
something is worth
– Means of payment—things we can use as payment
when we buy goods and services
examples: dollar bills, personal checks, money orders, credit cards
2
History of Currency
• In a barter economy, where there is no commonly
accepted currency : cows, sheep, fish…
• Commodity money (with intrinsic value) like precious
metals: gold, silver
• Paper currency
 used to be backed by physical commodity
 Now, we have ‘fiat’ money, i.e. a means of payment by government
declaration.
Legal tender – payment that cannot be refused in settlement of a debt
denominated in the same currency by virtue of law.
3
Price Level and Inflation
• Price level
Average level of dollar prices in the economy
• Index numbers
 Series of numbers used to track the change of a
variable over time: crime index, air pollution index
 Most measures of the price level are reported in the
form of an index
Dow Jones Index, S&P 500, Consumer Price Index
4
Index Numbers
• In general, an index number for any measure is
calculated as
Value of measure in current period
x 100
Value of measure in base period
5
Index Numbers
• Create index numbers
Example: the number of traffic accidents in Youngstown, Ohio
Year
# of traffic
accidents
index
2000(base year)
325
100
2004
382
382
 100  117.5
325
2005
411
6
The Consumer Price Index
 An index of the cost, through time, of a fixed market basket
of goods and services purchased by a typical household in
some base period (1983).
 The market basket does not include goods and services
purchased by businesses, government, and foreigners, but
include consumer goods and services currently produced
in the U.S., used goods and imported goods.
7
From Price Index to Inflation Rate
• Consumer Price Index is a measure of the
price level in the economy
• Changes in price index
– Inflation when price level is rising
– Deflation when price level is falling, or negative
inflation
8
Calculate Inflation
• The rate of inflation is the
annual percentage change
in the price level
• Inflation in 2004
(1.889 – 1.840) / 1.840
= 0.027 = 2.7%
• Inflation in Great Depression
– Period of falling output
and prices
– Inflation rates are negative
Year
CPI
Inflation
2003
1.840
2004
1.889
2.7%
2005
1.953
3.4%
2006
2.016
3.2%
2007
2.073
2.8%
Year
CPI
Inflation
1929
0.171
1930
0.167
–2.3%
1931
0.152
–9.0%
1932
0.137
–9.9%
1933
0.130
–5.1%
9
The Rate of Inflation Using the
Consumer Price Index, 1947-2014
10
Inflation, Nominal and Real Values
• Important point
– When we measure changes in macroeconomy, we usually care
about purchasing power those dollars represent
• Not about the number of dollars we are counting
• Translate nominal values into real values using the
formula
𝑟𝑒𝑎𝑙 𝑣𝑎𝑙𝑢𝑒𝑡 =
𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒𝑡
× 100
𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑡
11
Inflation, Nominal and Real Values
• Suppose that from December 2004 to December
2005, your nominal wage rises from $15 to $30
per hour
– Are you better off?
• Real wage formula is as follows
Real wage in any year 
Nominal wage in that year
x 100
CPI in that year
12
Production Workers’ Wages, 1960 - 2006
13
Inflation, Nominal and Real Values
An example:
Year
CPI
Nominal Hourly Wage
Real Wage
1983
100
8
8
 100  8
100
1995
150
12
2004
180
15
2005
200
20
12
 100  8
150
15
 100  ?
180
?
14
Redistributive Effect of Inflation
• Inflation is not the cause behind the erosion of
purchasing power, but just the mechanism
• Inflation can redistribute purchasing power from
one group to another
15
Redistributive Effect of Inflation
• How does inflation redistribute real income?
 Inflation hurts those who receive a fixed amount of
payment specified in nominal terms
Example: salary specified in a contract
 Inflation benefits those who make a fixed amount of
payment specified in nominal terms
Examples: mortgage payment, car loan monthly
payment
16
Expected vs. Unexpected Inflation
• Over any period, percentage change in a real value (%Δ Real) is
approximately equal to percentage change in associated nominal value
(%Δ Nominal) minus the rate of inflation
%ΔReal = %ΔNominal – Rate of Inflation
• Real interest rate is the annual percentage increase in the purchasing
power of financial assets
– Real interest rate = nominal interest rate – inflation
r=i-
• If inflation is fully anticipated, and if both parties take it into account, then
inflation will not redistribute purchasing power
• When inflation is not correctly anticipated, however, inflation does shift
purchasing power from one group to another.
17
US Inflation and Interest Rates, 1960 - 2006
18
US Real Interest Rates, 1960 - 2006
19
Expected vs. Unexpected Inflation
An example:
Joe borrows $100 from Mike and promises to pay
back the money plus interest in a year. Mike wants to
charge a real return of 3%. Meanwhile, Mike expects the
inflation rate to be 3% for the next year and Joe expects it
to be 5%. So, Joe happily agrees to pay Mike 6% nominal
interest rate. If the actual inflation rate is 4%, how will the
purchasing power shift between Joe and Mike?
20
Expected vs. Unexpected Inflation
Continue with the previous example:
The key is to figure out the realized real rate of return –
r=i-
Since the actual inflation rate is 4% () and Joe pays Mike
6% (i), the real interest rate is r = 6% - 4% = 2%. As a
result, in the real term, Mike receives 2%, which is 1% less
than he wants, and Joe pays 2%, which is 1% less than he
agrees to pay. Therefore, the purchasing power shifts from
Mike to Joe.
See the generalization on the next slide.
21
Positive and Negative Unexpected Inflation
• Positive unexpected inflation
– An inflation rate higher than expected harms those
awaiting payment and benefits the payers
• Negative unexpected inflation
– An inflation rate lower than expected harms the payers
and benefits those awaiting payment
• Fisher effect is the tendency for nominal interest
rates to be high when inflation is high and low
when inflation is low
22